Deadweight Loss

Deadweight loss refers to any insufficiency caused by ineffective distribution of resources. This is also known as excess burden or allocative insufficiency. These terms are used in economics.

Causes of Excess Burden

This situation can happen due to artificial scarcity brought about by monopoly pricing. Other reasons are subsidies, binding prices (floorings or ceilings) and externalities. When the term excess burden is used, it often refers to monopoly or taxation. Other factors can bring it about, but these are the most common.

Excess Burden Example 1

Suppose there is a market for screws each worth 10 cents. In this scenario, the demand reaches a high for free screws and zero for $1.25 screws. To understand deadweight loss, imagine this market is competitive. Manufacturers charge 10 cents. All customers with marginal benefits over 10 cents will have a screw.

But if there is monopoly in the market, they fix the price that yields the biggest profit. In this case, the manufacturer charges 60 cents. All customers without 60 cents are not included. The loss is the economic gain the customers would have if the pricing had been competitive.

Excess Burden Example 2

In this example the situation arises because consumers buy a product that costs a lot but with little benefit for them. Imagine there is a market for screws where they’re sold for 10 cents. The government provides a 3 cent subsidy per screw made.

To see how deadweight loss occurs, imagine the subsidy forces the prices to go down to 6 cents. Consumers purchase the 6 cent screws. The benefit is less than the actual cost of the 10 cents. The loss is generated by inadequate use of resources.

Excess Burden Example 3

Suppose a glass of whiskey and champagne both cost $4. The consumer buys the whiskey. If the government imposes a tax of $2 per whiskey glass, the consumer will choose to drink champagne. In this example, the excess burden of tax is utility loss for the consumer. Also note there is no tax generated from the consumer.

How to Calculate Deadweight Loss or Excess Burden

To determine the loss, you have to draw a chart for supply and demand. Next, determine the price and quantity as dictated by the market effectiveness. With the supply constant, figure the quantity demand and price after the tax or inadequacy has occurred.

To calculate the loss, use this formula: E.B. (excess burden) = 0.5 (change in price x change in quantity demanded). Assume the costs go up by 100 and demand down by 50. The equation would be E.B. = (0.5) (100 x 50) = (0.5) (5000) = 2500.

In most cases, the loss applies to tax, in particular sales tax. Sales tax is a source of revenue for governments. The source is the difference from the pre-tax cost which producers get and the after tax paid for by the consumer.

Deadweight loss can be brought about by pricing or taxation. Even though it can be a complex issue, knowing how it works can help you understand how the economy works.