A deadweight loss is a cost to society as a whole that is generated by an economically inefficient allocation of resources within the market.
A deadweight loss arises at times when supply and demand–the two most fundamental forces driving the economy–are not balanced.
What is a Deadweight Loss?
When supply and demand not balanced by market forces, consumers may choose not to pay for goods or services because they assess that the price is not worth the utility these goods/services will offer. With the overall exchange of items for money (trade) being reduced, the efficiency of overall resource allocation drops, and thus the overall societal welfare drops as well.
Why does a drop in the efficiency of resource allocation matter?
Well, welfare, in economic terms, refers to a society’s living standards and overall prosperity. These are typically measured via GDP, income, literacy, life span, etc. However, it is such a general term that the definition can often vary.
Causes of Deadweight Loss
Many of the causes of deadweight loss are unavoidable parts of a functioning society:
1. Taxes: These are charges by the government, in addition to the price of goods or services. One common example would be a sales tax.
2. Price ceilings: These price controls are also set by the government and prevent sellers from charging above a certain price for their goods or services. An example of a price ceiling is rent control.
3. Price floors: Price floors are similar to price ceilings but in reverse. They are price controls that prevent businesses or individuals from charging less than a specific amount for goods/services. One example is minimum wage, which prevents individuals from selling their labor for less than a certain amount per hour.
In all of these cases, external limits on prices of goods or services affect the supply and demand of these goods/services.
For instance, in the case of rent control (a type of price ceiling), the demand will be higher than the supply of a building as more people will want to live in a building as compared to the number of people that can get an apartment. Likewise, taxes increase the price of products, which naturally decreases their demand. And minimum wage may increase the unemployment rate (a clear deadweight loss) in cases when employers who need to hire employees are unable to pay the minimum wage.
Deadweight Loss Example
Let’s say you want to see a concert. The ticket costs $25. You personally assign a value of $35 to the experience of seeing this concert—your favorite musician is performing. You’ll go see this concert because the value is greater than the cost; more precisely, the net value is $10 (calculated as $35–$25).
However, in an alternate scenario, the government might begin taxing concert tickets at 75%. This leaves the new cost of the concert ticket at $43.75. Since you only value the concert at $35, you’ll choose not to attend. The deadweight loss ends up being the value of the concert tickets that don’t get purchased due to the extra cost created by the tax.
How to Calculate Deadweight Loss
In the graph above, the yellow triangle is representative of the deadweight loss.
The deadweight loss formula is as follows:
½ * (P2 – P1) x (Q0 – Q1)
Here’s what the graph and formula mean:
- Q1 and P1 are the equilibrium price as well as quantity before a tax is imposed.
- A tax shifts the supply curve from S1 to S2. That’s because producers are compelled to want to create less supply as a result of a tax.
- Price for buyers increases from P1 to P2 while the seller’s received price for the good decrease, going from P1 to P3.
- The tax means that producers’ supply decreases, from Q1 to Q2.