Deadweight Loss
What is Deadweight Loss?
Deadweight loss is the loss of total surplus that occurs when a market is not at its efficient competitive equilibrium.
It measures mutually beneficial trades that fail to occur because of a price control, tax, monopoly, or externality. On a supply-and-demand graph it is the triangular area between the demand and supply curves over the units no longer traded. A market is allocatively efficient when deadweight loss is zero.
Deadweight Loss: a worked example
Take a market with demand P = 20 − Q and supply P = 2 + 0.5Q, which clears at Q = 12 and P = $8. A $3 per-unit excise tax on sellers shifts the supply curve up by $3 to P = 5 + 0.5Q, so quantity traded falls to 10 units, buyers pay $10 and sellers keep $7. The government collects $3 × 10 = $30, which is transferred rather than destroyed, while the 2 units that are no longer traded create a deadweight loss of ½ × 2 × $3 = $3.
The mistake students make with deadweight loss
On a binding price ceiling, students draw the deadweight loss triangle using the shortage, quantity demanded minus quantity supplied, as its base. The base is instead the drop in units actually traded, from the free-market equilibrium quantity down to the quantity supplied at the ceiling, because only trades that never happen at all destroy surplus; the buyers left queuing were never going to be served by units that were never produced.
Deadweight Loss questions
How do you calculate deadweight loss from a tax?
Deadweight loss from a per-unit tax equals ½ × the tax per unit × the fall in quantity traded. A $3 per-unit tax that cuts quantity from 12 units to 10 units creates a deadweight loss of ½ × $3 × 2 = $3.
Does every tax create deadweight loss?
A tax creates deadweight loss only when it changes the quantity traded, so a tax on a good with perfectly inelastic supply or perfectly inelastic demand raises revenue with zero deadweight loss. A corrective tax on a good with a negative externality can even reduce total deadweight loss, by pushing output toward the socially efficient quantity.
Is deadweight loss the same as tax revenue?
Deadweight loss and tax revenue are different areas: tax revenue is money moved from buyers and sellers to the government and is still surplus for society, while deadweight loss is surplus nobody receives because mutually beneficial trades stop happening. On the graph, revenue is the rectangle between the price buyers pay and the price sellers keep over the units still traded, and deadweight loss is the triangle immediately to the right of it.
Formula / Example
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Related terms
Common comparisons
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