Q.
What is Deadweight Loss? Explain with a diagram and with some examples.
A.
.
In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal.
Read further on consumers' surplus and producers' surplus here. They are very much related to deadweight loss.
Causes:
Read further on consumers' surplus and producers' surplus here. They are very much related to deadweight loss.
Causes:
Causes of deadweight loss can include monopoly pricing (in the case of artificial scarcity), externalities, taxes or subsidies, and binding price ceilings or floors(including minimum wages). The term deadweight loss may also be referred to as the "excess burden" of monopoly or taxation.
Example:
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.
[Hence, in simple terms, as long as the economy is not at equilibrium, or Pareto Efficiency, there is a un-utilized energy of productivity which is lost. This is created with less than optimal production quantity, eg. by imposing tax on price so that actual price is higher, or limiting the resource to produce - quota system on sales. Like high tax on car, hence less people have cars. Or, only buy from one cement producer with limited quota per month. Therefore, the industry has to produce less due to limited demand for expensive cars or limited cement supply. The energy or capacity lost, eg. labour is limited to less hours, machineries not operating at maximum level, finally results in the DEADWEIGHT LOSS.]
[Hence, in simple terms, as long as the economy is not at equilibrium, or Pareto Efficiency, there is a un-utilized energy of productivity which is lost. This is created with less than optimal production quantity, eg. by imposing tax on price so that actual price is higher, or limiting the resource to produce - quota system on sales. Like high tax on car, hence less people have cars. Or, only buy from one cement producer with limited quota per month. Therefore, the industry has to produce less due to limited demand for expensive cars or limited cement supply. The energy or capacity lost, eg. labour is limited to less hours, machineries not operating at maximum level, finally results in the DEADWEIGHT LOSS.]
Ref:
Wikipedia from http://en.wikipedia.org/wiki/Deadweight_loss
[Own account]