Everything about Deadweight Loss totally explained
In
economics, a
deadweight loss (also known as
excess burden or
allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a
good or service isn't
Pareto optimal. In other words, either people who would have more
marginal benefit than
marginal cost are not buying the good or service or people who would have more marginal cost than marginal benefit are buying the product.
Causes of deadweight loss can include
monopoly pricing (see
artificial scarcity),
externalities,
taxes or subsidies (Case and Fair, 1999: 442), and binding
price ceilings or
floors. The term deadweight loss may also be referred to as the "excess burden of monopoly" or the "excess burden of
taxation".
Example
For example, consider a market for nails where the cost of each nail is 10 cents and that the demand will decrease linearly from a high demand for free nails to zero demand for nails at $1.10. In a
perfectly competitive market, producers would have to charge a price of 10 cents and every customer whose marginal benefit exceeds 10 cents would have a nail. However if only one producer has a monopoly on the product, then that'll charge whichever price will yield the highest profit. For this market, the producer would charge 60 cents and thus exclude every customer who had less than 60 cents of marginal benefit. The deadweight loss is then the economic benefit forgone by these customers due to the monopoly pricing.
Conversely, deadweight loss can also come from consumers buying a product even if it costs more than it benefits them. To see this, let's use the same nail market, but instead it'll be perfectly competitive with the government giving a 3 cent subsidy to every nail produced. This 3 cent subsidy will push the market price of each nail down to 7 cents. Some consumers then buy nails even though the benefit to them is less than the real cost of 10 cents. This unneeded expense then creates the deadweight loss.
Hicks vs. Marshall
An important distinction should be drawn between
Hicksian and
Marshallian deadweight loss. The latter is related to the concept of
consumer surplus, such that it can be shown that the Marshallian deadweight loss is zero where demand is perfectly
elastic or supply is perfectly inelastic. On the other hand, Hicks analyzed the situation through
indifference curves and noted that when the
Marshallian Demand Curve exhibits perfect inelasticity, the policy or economic situation which caused a distortion in
relative prices will have an income effect and that this income effect is a deadweight loss.
Further Information
Get more info on 'Deadweight Loss'.
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