What Is Deadweight Loss?

What Is Deadweight Loss?

A cost to society that is created by market inefficiency (which takes place when supply and demand are not in equilibrium) is called a deadweight loss. This term is mainly used in economics. The concept of deadweight loss can be applied to any deficiency that is caused by the inefficient allocation of resources. 

Potential causes of deadweight loss include taxation, price ceilings, like rent controls and price controls, and price floors, such as living wage and minimum wage laws. A reduced level of trade can also make the allocation of a society’s resources inefficient. 

Key Takeaways

• A deadweight loss results from a market inefficiency caused by supply and demand being out of equilibrium.
• Insufficient allocation of resources is mostly responsible for deadweight losses. This insufficient allocation comes from various interventions like taxes, monopolies, price ceilings, and price floors. 
• The factors above lead to inaccurate product prices in which goods are undervalued or overvalued. 
• When products’ prices aren’t reflected accurately, consumer and producer behavior changes. This often negatively impacts the economy.

Understanding Deadweight Loss

When supply and demand aren’t in equilibrium, this leads to market inefficiency, which then results in a deadweight loss. When goods in the market are overvalued or undervalued, market inefficiency takes place. Some members of society may benefit from the imbalance, but others will be negatively impacted by the shift from equilibrium. 

When consumers don’t feel that the price of a good or service accurately reflects its perceived utility, they’re less likely to purchase the item. For instance, overvalued prices might lead to higher profit margins for a company, but the high prices will negatively affect the product’s consumers. 

For goods that are inelastic, meaning that their demand does not change when their price changes, the higher cost may keep consumers from making purchases in other sectors of the market. Some consumers may also purchase a lower quantity of the item if possible.

For goods that are elastic, meaning that buyers and sellers quickly adjust their demand for the good or service if its price changes, consumers might cut back on spending in that market sector in order to compensate or be priced out of the market altogether. 

Although undervalued products can be desirable for consumers, they may prevent producers from recuperating their production costs. If the product is undervalued for a substantial period, producers have a few choices. They can stop selling the product, increase the price to equilibrium, or be forced out of the market. 

How Deadweight Loss Is Created

Deadweight loss can be created by minimum wage and living wage laws. These laws lead employers to overpay for employees, and they prevent low-skilled workers from securing jobs. Deadweight loss can also be caused by price ceilings and rent controls because they discourage production. In addition, they can decrease the supply of housing, services, and goods below the amount that consumers truly demand. As a result, consumers experience shortages, and producers earn less than they would otherwise. 

Deadweight loss can also be created by taxes since they keep people from making purchases they would otherwise because the product’s final price is higher than the equilibrium market price. The burden of higher taxes on an item is typically split between the producer and the consumer. Thus, the producer makes less profit from the item, while the customer pays a higher price. This leads to lower consumption of the item, which in turn reduces the overall benefits the consumer market could’ve received. It simultaneously cuts back on the benefit the company might have seen regarding profits. 

Two other situations that can lead to deadweight loss are monopolies and oligopolies. They take away the aspects of a perfect market in which prices are accurately set by fair competition. Monopolies and oligopolies can control the supply of specific goods and services, leading to a false increase in their prices. Eventually, this leads to a smaller amount of goods and services sold. 

Example of Deadweight Loss

Let’s say a new sandwich restaurant opens in your neighborhood. It charges $10 for a sandwich. Since you perceive the value of this sandwich to be $12, you’re happy to pay $10 for it. But then the government imposes a new sales tax on food items, and the cost of the sandwich rises to $15. At that price, you feel that the sandwich is overvalued and that the new cost isn’t fair. Therefore, you’re not willing to buy the sandwich at the price of $15. 

The majority of consumers, but not all of them, feel the same way about the sandwich. Thus, the sandwich restaurant experiences a decrease in demand for its sandwich and a decline in revenue. In this example, the deadweight loss is the unsold sandwiches resulting from the new $15 cost. The sandwich restaurant could actually go out of business if the decrease in demand is severe enough. This only increases the negative economic effects resulting from the new tax.