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Deadweight loss
In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit (to society) does not equal marginal cost (to society). In other words, there are either goods being produced despite the cost of doing so being larger than the benefit, or additional goods are not being produced despite the fact that the benefits of their production would be larger than the costs. The deadweight loss is the net benefit that is missed out on. While losses to one entity often lead to gains for another, deadweight loss represents the loss that is not regained by anyone else. This loss is therefore attributed to both producers and consumers.
Deadweight loss can also be a measure of lost economic efficiency when the socially optimal quantity of a good or a service is not produced. Non-optimal production can be caused by monopoly pricing in the case of artificial scarcity, a positive or negative externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.
Assume a market for nails where the cost of each nail is $0.10. Demand decreases linearly; there is a high demand for free nails and zero demand for nails at a price per nail of $1.10 or higher. The price of $0.10 per nail represents the point of economic equilibrium in a competitive market.
If market conditions are perfect competition, producers would charge a price of $0.10, and every customer whose marginal benefit exceeds $0.10 would buy a nail. A monopoly producer of this product would typically charge whatever price will yield the greatest profit for themselves, regardless of lost efficiency for the economy as a whole. In this example, the monopoly producer charges $0.60 per nail, thus excluding every customer from the market with a marginal benefit less than $0.60. The deadweight loss due to monopoly pricing would then be the economic benefit foregone by customers with a marginal benefit of between $0.10 and $0.60 per nail. The monopolist has "priced them out of the market", even though their benefit exceeds the true cost per nail.
Conversely, deadweight loss can also arise from consumers buying more of a product than they otherwise would based on their marginal benefit and the cost of production. For example, if in the same nail market the government provided a $0.03 subsidy for every nail produced, the subsidy would reduce the market price of each nail to $0.07, even though production actually still costs $0.10 per nail. Consumers with a marginal benefit of between $0.07 and $0.10 per nail would then buy nails, even though their benefit is less than the real production cost of $0.10. The difference between the cost of production and the purchase price then creates the "deadweight loss" to society.
A tax has the opposite effect of a subsidy. Whereas a subsidy entices consumers to buy a product that would otherwise be too expensive for them in light of their marginal benefit (price is lowered to artificially increase demand), a tax dissuades consumers from a purchase (price is increased to artificially lower demand). This excess burden of taxation represents the lost utility for the consumer. A common example of this is the so-called sin tax, a tax levied against goods deemed harmful to society and individuals. For example, "sin taxes" levied against alcohol and tobacco are intended to artificially lower demand for these goods; some would-be users are priced out of the market, i.e. total smoking and drinking are reduced. Products such as alcohol and tobacco have historically been highly taxed and incur excise duties which are one of the categories of indirect tax. Indirect tax (VAT), weighs on the consumer, is not a cause of loss of surplus for the producer, but affects consumer utility and leads to deadweight loss for consumers. Indirect taxes are usually paid by large entities such as corporations or manufacturers but are partially shifted towards the consumer. Furthermore, indirect taxes can be charged based on the unit price of a said commodity or can be calculated based on a percentage of the final retail price. Additionally, indirect taxes can either be collected at one stage of the production and retail process or alternatively can be charged and collected at multiple stages of the overall production process of a commodity.
Harberger's triangle, generally attributed to Arnold Harberger, shows the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market. Mechanisms for this intervention include price floors, caps, taxes, tariffs, or quotas. It also refers to the deadweight loss created by a government's failure to intervene in a market with externalities.
In the case of a government tax, the amount of the tax drives a wedge between what consumers pay and what producers receive, and the area of this wedge shape is equivalent to the deadweight loss caused by the tax.
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Deadweight loss
In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit (to society) does not equal marginal cost (to society). In other words, there are either goods being produced despite the cost of doing so being larger than the benefit, or additional goods are not being produced despite the fact that the benefits of their production would be larger than the costs. The deadweight loss is the net benefit that is missed out on. While losses to one entity often lead to gains for another, deadweight loss represents the loss that is not regained by anyone else. This loss is therefore attributed to both producers and consumers.
Deadweight loss can also be a measure of lost economic efficiency when the socially optimal quantity of a good or a service is not produced. Non-optimal production can be caused by monopoly pricing in the case of artificial scarcity, a positive or negative externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.
Assume a market for nails where the cost of each nail is $0.10. Demand decreases linearly; there is a high demand for free nails and zero demand for nails at a price per nail of $1.10 or higher. The price of $0.10 per nail represents the point of economic equilibrium in a competitive market.
If market conditions are perfect competition, producers would charge a price of $0.10, and every customer whose marginal benefit exceeds $0.10 would buy a nail. A monopoly producer of this product would typically charge whatever price will yield the greatest profit for themselves, regardless of lost efficiency for the economy as a whole. In this example, the monopoly producer charges $0.60 per nail, thus excluding every customer from the market with a marginal benefit less than $0.60. The deadweight loss due to monopoly pricing would then be the economic benefit foregone by customers with a marginal benefit of between $0.10 and $0.60 per nail. The monopolist has "priced them out of the market", even though their benefit exceeds the true cost per nail.
Conversely, deadweight loss can also arise from consumers buying more of a product than they otherwise would based on their marginal benefit and the cost of production. For example, if in the same nail market the government provided a $0.03 subsidy for every nail produced, the subsidy would reduce the market price of each nail to $0.07, even though production actually still costs $0.10 per nail. Consumers with a marginal benefit of between $0.07 and $0.10 per nail would then buy nails, even though their benefit is less than the real production cost of $0.10. The difference between the cost of production and the purchase price then creates the "deadweight loss" to society.
A tax has the opposite effect of a subsidy. Whereas a subsidy entices consumers to buy a product that would otherwise be too expensive for them in light of their marginal benefit (price is lowered to artificially increase demand), a tax dissuades consumers from a purchase (price is increased to artificially lower demand). This excess burden of taxation represents the lost utility for the consumer. A common example of this is the so-called sin tax, a tax levied against goods deemed harmful to society and individuals. For example, "sin taxes" levied against alcohol and tobacco are intended to artificially lower demand for these goods; some would-be users are priced out of the market, i.e. total smoking and drinking are reduced. Products such as alcohol and tobacco have historically been highly taxed and incur excise duties which are one of the categories of indirect tax. Indirect tax (VAT), weighs on the consumer, is not a cause of loss of surplus for the producer, but affects consumer utility and leads to deadweight loss for consumers. Indirect taxes are usually paid by large entities such as corporations or manufacturers but are partially shifted towards the consumer. Furthermore, indirect taxes can be charged based on the unit price of a said commodity or can be calculated based on a percentage of the final retail price. Additionally, indirect taxes can either be collected at one stage of the production and retail process or alternatively can be charged and collected at multiple stages of the overall production process of a commodity.
Harberger's triangle, generally attributed to Arnold Harberger, shows the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market. Mechanisms for this intervention include price floors, caps, taxes, tariffs, or quotas. It also refers to the deadweight loss created by a government's failure to intervene in a market with externalities.
In the case of a government tax, the amount of the tax drives a wedge between what consumers pay and what producers receive, and the area of this wedge shape is equivalent to the deadweight loss caused by the tax.