The Effects of Deadweight Loss
Table of Contents
Deadweight loss is a macroeconomic term that refers to the total value of lost trades, caused by a mismatch between supply and demand. Deadweight loss can be the result of taxation, price restrictions, the impact of monopolies, and other factors.
Deadweight loss isn’t limited to a single company, but rather describes the impacts on the overall economy of certain policies, which can trickle down and have an effect on the markets.
Key Points
• Deadweight loss refers to the value of all the trades or transactions that did not occur owing to a market inefficiency.
• These inefficiencies are the result of a market distortion, or mismatch, such as what occurs when a tax or minimum wage is imposed.
• These factors can impact production costs and pricing, which can cause a disequilibrium in both supply and demand, leading to deadweight loss.
• Deadweight loss generally plays out in terms of larger societal and/or economic trends, and as such can impact markets as well.
What Is Deadweight Loss?
Deadweight loss refers to inefficiencies created by a misallocation or inefficient allocation of resources, and is an important economic concept. Deadweight loss is often due to government interventions such as price floors or ceilings, or inefficiencies within a tax system that effectively reduce trades or transactions by interfering with supply and demand equilibrium.
To understand more fully, it can be helpful to think about how government interventions can impact the equilibrium between supply and demand.
First: Calculate Surplus
In order to know how to calculate deadweight loss, we must first be able to calculate surplus.
Typically, a business will only sell something if they can do so at a price that’s greater than what they paid for it themselves, and a consumer will only buy something if it’s at or less than the price they want to pay for it — the same principle as generating a stock profit.
Scenario A — The Equilibrium: Let’s imagine Store X sells comic books for $10 each. The store buys the comic books from the wholesaler for $5 and sells them for $10, pocketing $5 of “producer surplus.”
Before the Store X opened, consumers traveled to another store to buy comic books for $15. This $5 difference between the price they were willing to pay and the newly available price is the “consumer surplus”.
In this case, let’s say Store X is able to sell 1,000 comic books, that means the combined producer and consumer surplus is $10,000.
Breakdown:
• P1 = Producer’s Cost of a Comic Book = $5
• P2 = Producer’s Price to Sell a Comic Book = $10
• P3 = Price the Consumer Pays = $10
• P4 = Price the Consumer Is Willing to Pay = $15
• Units Sold = 1,000
• Producer Surplus = (P2 – P1) * Units Sold = ($10 – $5) * 1,000 = $5,000
• Consumer Surplus = (P4 – P3) * Units Sold = ($15 – $10) * 1,000 = $5,000
• Total Surplus 1 = Producer Surplus + Consumer Surplus = $5,000 + $5,000 = $10,000
In this theoretical example, there is no deadweight loss because supply and demand are in balance. That would change if another factor entered the picture that caused a market distortion that caused a loss in the number of purchases. Deadweight loss being the value of the trades or transactions that did not occur, owing to a market inefficiency.
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Common Causes of Deadweight Loss
There can be several causes of deadweight loss, but some of the most common are government-mandated changes to markets. Examples include price floors, such as a minimum wage, which can create some inefficiencies in the labor market (there may be workers who would be willing to work for less than minimum wage).
Price ceilings, also can create deadweight loss — an example could be rent control. Finally, taxes can create deadweight loss, too.
How to Calculate Deadweight Loss
To properly calculate deadweight loss, you need to be able to represent the supply and demand of the goods being sold graphically in order to determine prices. According to the laws of supply and demand, the higher a price goes, the fewer of that item will get sold; and vice versa.
Example of Deadweight Loss
Let’s go back to our comic book example and imagine that the town’s government imposes a $2 tax on comic books.
Scenario B — The Impact of Taxes
What happens to the price of comic books and the surplus generated by the sales of comic books? Theoretically, Store X could simply bump up prices $2 and sell 1,000 comic books for $12 each, maintaining a $5 producer surplus on each comic book sold, with $2 going to the government, and consumer surplus of $3.
In this case the combined consumer and producer surplus is lower — $5 × 1,000 + $3 × 1,000 = $8,000. So there’s a missing $2,000 of what economics call “gains from trade.” But, the government is collecting $2,000, so the money does not disappear from the economy.
In other words, the government is collecting $2,000, with which it can buy things, hire people, and literally send money to people via economic stimulus measures. Thus, the tax revenue does not disappear from the economy.
But in reality, if Store X were to increase the price to $12, thus passing on the tax to customers, they may not be able to sell enough comic books to maintain the revenue needed to keep the store open.
If they lower the price to $11, splitting the cost of the tax between the store and consumers, it’s likely fewer consumers would buy comic books: let’s say Store X would now sell 600 comic books instead of 1,000.
The combined consumer and producer surplus is $4,800 ($4 × 600 + 600 × $4) with $1,200 of tax collected (600 × $2) meaning there’s a total of $6,000 of consumer surplus, producer surplus, and government revenue. In this case the deadweight loss is $4,000.
Breakdown:
• P1 = Producer’s Cost of a Comic Book = $5
• P2 = Producer’s Price to Sell a Comic Book = $9
• P3 = Price the Consumer Pays = $11
• P4 = Price the Consumer Is Willing to Pay = $15
• Units Sold = 600
• Tax = $2/Comic Book
• Producer Surplus = (P2 – P1) * Units Sold = ($9 – $5) * 600 = $2,400
• Consumer Surplus = (P4 – P3) * Units Sold = ($15 – $11) * 600 = $2,400
• Gains From Trade (Tax) = $2 * 600 = $1,200
• Total Surplus 2 = Producer Surplus + Consumer Surplus + Gains From Trade = $6,000
• Deadweight Loss = Total Surplus1 – Total Surplus2 = $10,000 – $6,000 = $4,000
The higher price, created through taxation, has impacted the equilibrium between supply and demand and created a deadweight loss — the number of sales that evaporated due to fewer transactions happening between the comic book seller and the readers.
While this is a rather extreme example of what happens when taxes force up prices, it’s a good way of thinking about how deadweight losses are more than just items getting more expensive. Rather, the deadweight loss formula can illustrate the evaporation of mutually beneficial economic transactions due to different types of taxes and other policies.
A similar impact can occur when a government imposes price floors or ceilings on items.
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Why Investors Should Care About Deadweight Loss
Deadweight loss can affect investors in a number of ways, and it’s important to consider it when looking at different types of investments. One of the most debated issues in economics is the effects that the tax system has on income, investment, and economic growth in the short and long run.
Some argue that income taxes, payroll taxes (the flat taxes on wages that fund Social Security and Medicare) and capital gains taxes work like the comic book tax described above, preventing otherwise beneficial transactions from happening and reducing the economic gains available to all sides. There’s evidence on all sides of this debate, and the effects of tax rates on overall economic growth are, at best, unclear.
As an investor, deadweight loss might matter when it comes to companies or sectors impacted by specific taxes, such as sales taxes or excise taxes on alcohol or cigarettes.
Deadweight loss shows how taxes on specific items can not only reduce profitability by increasing a company’s tax bill, but also affect revenue by reducing overall sales or driving down prices that businesses can charge or receive from buyers. As an investor, this knowledge and insight can be useful when allocating capital between companies, sectors, or types of assets.
The Takeaway
Deadweight loss is the result of economic inefficiencies, and it can affect an investor’s portfolio if it results in slower sales and revenues for businesses. It’s a large economic concept, and may not have a day-to-day direct impact on the stock market. But it’s still good for investors to know the basics of deadweight loss and how it applies to them.
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FAQ
Why does a monopoly cause a deadweight loss?
A monopoly can cause deadweight loss because competitive markets create competition and fairer prices. A monopoly distorts prices, leading to inefficiencies.
Can deadweight loss be a negative value?
No, deadweight loss cannot be a negative value, but it can be zero. Zero deadweight loss would mean that demand is perfectly elastic or supply is perfectly inelastic.
Is deadweight loss market failure?
Deadweight loss is not a market failure, but rather, the societal costs of inefficiencies within a market. Market failures can, however, create deadweight loss.
Photo credit: iStock/akinbostanci
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