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Deadweight Loss Definition: Explanation – Calculation – Example

What Is Deadweight Loss?

Deadweight Loss A deadweight loss is a societal cost caused by market inefficiency.  It arises when supply and demand are out of balance. A deadweight loss is a term most commonly used in economics.  However, it may be applied to any shortcoming created by poor resource allocation. Ultimately, it results in a reduction in potential revenue for people and businesses.  Often it is the unwanted result of taxes and price restrictions limiting corporate development and recruiting capacity. For example, price ceilings, such as price restrictions and rent controls.  Also, price floors, such as minimum wage and living wage legislation.  Even taxation can result in deadweight loss. With a lower degree of commerce, a society’s resource allocation may become inefficient.

According to economic theory, free markets benefit society.  This is because they allow consumers and producers to trade products and services for money.  Both sides of the market profit at the equilibrium price in terms of consumer and producer surplus. Consider when the government decides to intervene in a market.  For example, by levying a tax on an item sold by producers to consumers.  The market will be forced to find a new equilibrium. A deadweight loss is a loss in economic efficiency.  It can be argued that social welfare was higher before the unit tax than after it was implemented. Proponents of free-market economics frequently highlight deadweight losses incurred by market interventions.  As a result, they often argue for less government intervention, less regulation, and lower taxation.

Deadweight Loss – A Closer Look

A deadweight loss arises when supply and demand are out of balance, resulting in market inefficiencies. When items in the market are either overpriced or underpriced, this is referred to as market inefficiency. Some members of society may gain from the imbalance.  However, others may suffer as a result of a move away from equilibrium. Customers judge an item in relation to its perceived usefulness.  As a result, they are less inclined to acquire the item if they believe the price is not justified.

  • Inelastic goods – meaning that demand for that specific good or service does not vary whether the price rises or falls. However, the additional cost may deter customers from purchasing in other market sectors. Overpriced prices, for example, may result in larger profit margins for a corporation.  However, it has a detrimental impact on potential customers. Furthermore, when feasible, certain customers may purchase a smaller quantity of the item.
  • Elastic goods – meaning that buyers and sellers adjust the demand for a good or service based on the price.  Consumers may cut spending in that market sector to compensate for higher prices. Or, they may be priced out of the market completely. On the other hand, underpriced items may be appealing to customers. However, that may prohibit a company from recouping its manufacturing expenses. Consider mandatory price controls where a product remains undervalued over an extended length of time.  Manufacturers will either choose not to sell it, raise the price to equilibrium, or be driven out of the market completely.

How Deadweight Loss Occurs

When trade no longer benefits the traders or consumers, this often results in deadweight loss. It is typically caused by factors that affect customer access to a product. Conversely, it causes additional hardship for sellers who are losing sales.

Economic Causes

  • Product surplus – Too many items and little demand may be harmful to a country’s economic health. Too many commodities on the market trap money in the entire surplus.  As a result, things lie idle in business storage rather than circulating in the market. This mechanism affects products with high elasticity—those whose demand varies in response to price fluctuations. Reduced consumer demand might result from a producer excess, repeating the cycle of wasted economic opportunities.
  • Product deficit – A lack of items to service interested consumers can also result in a lack of business.  This results in wasted financial possibilities for both sides. When there is a consumer surplus but a product shortfall, a company may lose future revenue.  In turn, this feeds a repeating and financially damaging cycle.

Legislative Causes 

  • Minimum wage and living wage legislation might result in a deadweight loss.  A price floor occurs when the government establishes a minimum price for products or services. While important as a legislative mechanism to prevent worker exploitation, the minimum wage is an example of a price floor. When the minimum wage rises, so do the costs of goods.  Raising prices is what allows companies to cover the higher cost of workers’ wages. This may also imply that firms will refuse to recruit low-skilled workers at minimum wage. There are fewer options for those just starting out making it difficult for low-skilled individuals to find work.
  • Price limits and rent restrictions can also result in deadweight loss.  Artificially low price controls can discourage the production and reduce the supply of products, services, or housing. Consumers face scarcity, while producers earn less than they would otherwise.
  • Taxes can also create a deadweight loss.  They can prevent people from engaging in purchases they would otherwise make.  This occurs when the final price of the product is above the equilibrium market price. If taxes on an item rise, the burden is often split between the producer and the consumer.  It can lead to both the producer receiving less profit from the item and the customer paying a higher price. This results in lower consumption of the item than previous levels.  The overall benefits to a robust consumer market are negatively impacted.  Simultaneously, businesses are impacted in regard to sales volume, revenue, and potential profits.

Monopolies and Collusion

Monopolies occur when one company controls the entire market for a product.  Oligopolies result when multiple companies band together to keep product prices high.  Both can cause deadweight loss for society by controlling the supply of a particular item and inflating its price. Because consumers have few alternatives, firms may charge exorbitant rates. Monopolists and oligopolists are free to conduct business as they see fit in the absence of a competitive market.  As a result, customers are effectively obliged to pay monopolistic prices in order to receive their goods.  This causes deadweight loss by eliminating the features of a fair market where competition precisely establishes prices. This would eventually result in fewer products and services being sold.

Example of Deadweight Loss

Taxation results in a deadweight loss because it raises the price of goods and services over their equilibrium price. Often this can result in a deadweight loss for both the manufacturer and the customer. For example, a manufacturer may charge $10 for a product and face a $2 tax. Instead of charging the consumer $12 for the commodity, they may price it at $11.  As a result, they absorb a $1 loss to sustain some of the demand. Manufacturers and consumers frequently foot the bill for the tax.  In turn, this decreases not only the firm’s profitability but also consumer demand. As a result, society suffers a deadweight loss as fewer customers obtain the items they desire.  Ultimately, some businesses may go out of business as a result of decreasing levels of demand.

Consider a lunch Mexican-style lunch take-out in your area that has been selling burritos for $10. The steady customers believe they receive fair value for their money and are willing to pay $10 for it. Assume that the local government puts a new sales tax on food items.  This raises the price of the burritos to $13, but the restaurant only passes along $2 of the tax and charges $12. Some, but not all of the customers believe that the burrito is overpriced at $12 and that the new price is not a fair price.  As a result, not as many customers are willing to purchase the burritos at $12, and sales drop.

The unsold burritos as a result of the increased $12 price are the deadweight loss in this case. If the drop in demand is significant enough, the sandwich shop may have to close or lay off workers.  This would further exacerbate the negative economic impact of the new food tax.

Up Next: What Is the Run Rate?

Run RateThe run rate is a company’s financial performance based on current financial data as a prediction of future performance. It is an extrapolation of current financial performance that assumes present conditions will persist. Sometimes, the term is used to refer to the average yearly dilution from stock option grants by the corporation during the most recent three-year period as reported in the annual report.

The run rate of a corporation is the predicted financial performance based on its limited current financial data. For example, using January’s financials, a firm made $200,000 in revenue for the month.  Therefore, it may project a run rate generating year-end total revenue of $2.4 million. The run rate can assist in estimating a company’s future performance.  However, it can also be deceptive if financial data is seasonal or changes dramatically from period to period. As a result, there are occasions when using the run rate offers useful information and other times when it is irrelevant.

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