What Is a Deadweight Loss?
A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. 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. With a reduced level of trade, the allocation of resources in a society may also become inefficient.
What is Deadweight Loss?
Understanding Deadweight Loss
Deadweight loss occurs when supply and demand are not in equilibrium, which leads to market inefficiency. Market inefficiency occurs when goods within the market are either overvalued or undervalued. While certain members of society may benefit from the imbalance, others will be negatively impacted by a shift from 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.
For example, overvalued prices may lead to higher profit margins for a company, but it negatively affects 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 that market sector to compensate or be priced out of the market entirely.
Undervalued products may be desirable for consumers but may prevent a producer from recuperating their production costs. If the product remains undervalued for a substantial period, producers will either choose to no longer sell that product, up the price to equilibrium or may be forced out of the market entirely.
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 also 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. 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.