In economics, a deadweight loss is a loss of economic efficiency that can occur when
equilibrium for a good or service is not achievable. Causes of deadweight loss can include monopoly
pricing, externalities, taxes or subsidies, and binding price ceilings or floors. The
term deadweight loss may also be referred to as the "excess burden" of monopoly or taxation.
Examples For example, consider a market for nails where
the cost of each nail is 10 cents and 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 there is one producer who has a
monopoly on the product, then they will charge whatever price will yield the greatest 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
foregone 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 describe this, let's use the same nail market, but
instead it will 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: resources
are not being used efficiently.
If the price of a glass of wine is $3.00 and the price of a glass of beer is $3.00, a consumer
might prefer to drink wine. If the government decides to levy a wine tax of $3.00 per glass,
the consumer might prefer to drink beer. The excess burden of taxation is the loss of utility
to the consumer for drinking beer instead of wine, since everything else remains unchanged.
Harberger's triangle Harberger's triangle, generally attributed
to Arnold Harberger, refers to the deadweight loss associated with government intervention
in a perfect market. This can happen through price floors, caps, taxes, tariffs, or quotas.
It also refers to the dead weight loss created by a government's failure to intervene in
a market with externalities. The area represented by the triangle comes
from the intersection of the supply and demand curves being cut short so that consumer surplus
and producer surplus are also cut short. The loss of such surplus, not recouped by e.g.
tax revenues, is the dead weight loss. Some economists like James Tobin have argued
that these triangles do not have a huge impact on the economy, whereas others maintain that
they can seriously affect long term economic trends by pivoting the trend downwards, thus
causing a magnification of losses in the long run.
Hicks vs. Marshall An important distinction should be made 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. However, 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 a substitution effect and that this substitution effect is a deadweight
loss. In modern economic literature, the most common
measure of a taxpayer’s loss from a distortionary tax, such as a tax on bicycles, is the equivalent
variation. The equivalent variation is the maximum amount that a taxpayer would be willing
to forgo in a lump sum to avoid the distortionary tax. The deadweight loss can then be interpreted
as the difference between the equivalent variation and the revenue raised by the tax. This difference
is attributable to the behavioural changes induced by a distortionary tax that are measured
by a substitution effect. However, this is not the only interpretation and Lind & Granqvist
point out that Pigou did not use a lump sum tax as the point of reference when discussing
deadweight loss. A comparable measure of loss is the compensating
variation, which depends on Hicksian demand instead of Marshallian demand. In the context
of a distortionary tax, the compensating variation is the minimum lump sum transfer that makes
an individual indifferent between the lump sum transfer with tax and no lump sum transfer
with no tax. The deadweight loss can then be interpreted as the minimum lump sum.
See also Tax choice
References
Further reading Case, Karl E. & Fair, Ray C.. Principles of
Economics. Prentice-Hall. ISBN 0-13-961905-4. Hines, James R., Jr., "Three sides of Harberger
Triangles", Journal of Economic Perspectives 13: 167–188, doi:10.1257/jep.13.2.167 .
Lind, H. & R. Granqvist A Note on the Concept of Excess Burden. Economic Analysis and Policy
40:63-73. External links
Worthwhile Canadian Initiative "Too much stuff: the deadweight loss from overconsumption"