What is Deadweight Loss?
A deadweight loss is a cost to society created by market inefficiency. Mainly used in economics, deadweight loss can be applied to any deficiency caused by an inefficient allocation of resources. Price ceilings, such as price controls and rent controls; price floors, such as minimum wage and living wage laws; and taxation can all potentially create deadweight losses.
What is Deadweight Loss?
Breaking Down Deadweight Loss
Deadweight loss occurs when supply and demand are not in equilibrium. When consumers do not feel the price of a good or service is justified when compared to the perceived utility, they are less likely to purchase the item. With the reduced level of trade, the allocation of resources may become inefficient, which can lead to a reduction in overall welfare within a society.
Examples of Deadweight Loss
Minimum wage and living wage laws can create a deadweight loss by causing employers to overpay for employees and preventing low-skilled workers from securing jobs. Price ceilings and rent controls can also create deadweight loss by discouraging production and decreasing the supply of goods, services or housing below what consumers truly demand. Consumers experience shortages and producers earn less than they would otherwise.
Taxes are also said to create a deadweight loss because they prevent people from engaging in purchases they would otherwise make because the final price of the product is above the equilibrium market price.
For example, if taxes on an item rise, the burden is often split between the producer and the consumer, leading to the producer receiving less profit from the item and the customer paying a higher price. This results in lower consumption of the item than previously, which reduces the overall benefits the consumer market could have received while simultaneously reducing the benefit the company may see in regard to profits.
Market inefficiency occurs when goods within the market are either overvalued or undervalued. While certain members of society may benefit from the imbalance, others suffer consequences in regard to their welfare.
For example, overvalued prices may lead to higher profit margins but negatively affect consumers of the product. For inelastic goods - meaning demand does not change for that particular good or service when the price goes up or down - the increased cost may prevent consumers from making purchases in other market sectors. In addition, some consumers may purchase a lower quantity of the item when possible. For elastic goods - meaning sellers and buyers quickly adjust their demand for that good or service if the price changes - consumers may reduce spending in the category to compensate or be priced out of the market entirely.
Undervalued products may be desirable for consumers but may prevent a producer from recuperating production costs. If the product remains undervalued for a substantial period, some producers may be forced out of the market.