What is a deadweight loss?

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“Deadweight loss” is a term from economics that describes an overall economic or societal loss due to market inefficiencies.

Imagine a situation where what buyers are willing to pay for a product differs from what sellers are willing to sell it for. This mismatch leads to a loss that no one benefits from. The lost value that could've been enjoyed if the supply and demand were in equilibrium is the deadweight loss.


Key insights

  • Deadweight loss is when society overall loses due to market inefficiencies.
  • Deadweight taxation loss is the overall economic loss caused by a new tax on a product or service.
  • Deadweight loss is mainly caused by the inefficient allocation of resources created by taxes, price ceilings, price floors and other legal interventions.

Understanding deadweight loss of taxation

Taxes are the primary source of revenue for the government, which uses these funds to meet  citizens' needs by supporting public programs and projects such as social services, infrastructure and economic aid. When the government doesn't have enough funds for projects, one way to increase its revenue is by raising taxes.

While this sounds like a good idea on paper, sometimes it backfires and no one benefits, including the government. This is called deadweight loss of taxation.

Theoretically, when the government raises taxes for certain goods and services, it then collects more tax, which becomes its additional revenue. However, increased taxes can result in an increased cost of production and, subsequently, a higher purchase price for the consumer.

When this happens, production and consumption can drop. This leads to an increase in cost and lower demand for goods and services, ultimately lowering revenue for the government. The difference between the taxed and tax-free volumes is the deadweight loss.

"Tax increases can play a major role in increasing deadweight loss for the economy. Higher business taxes are transferred to consumers via higher prices for goods and services. If customers cannot pay the higher prices, businesses can be left with reduced demand, while the economy suffers from lower levels of activity." said Noah Yosif, chief economist at the American Staffing Association.

» MORE: Best tax software and services

Causes of deadweight loss

Causes of deadweight loss are mostly factors that affect the supply and demand equilibrium.

Price ceiling

A price ceiling is a type of price control set by the law. Set by the government, it's the maximum amount a seller is allowed to price a product or service. Price ceilings are applied to food, energy and other staples when they become unaffordable to regular customers. All sellers must sell their products at a price equal to or below that amount.

A price ceiling creates excess demand coupled with low supply, causing market inefficiency.

Price floors

A price floor is the lowest legal price that can be paid for a service or a product. A good example is the minimum wage, set to ensure that a person working full time can afford a basic standard of living.

Taxes

Tax is the amount the government charges above the selling price of goods or services. Whether a tax is imposed on the consumer or the seller affects the surplus of a commodity in the market.

Subsidies

A subsidy is a form of payment the government provides to a business entity or individual to promote an economic policy or social good. Subsidies can be direct (such as cash payments) or indirect (such as tax relief). In most cases, subsidies reduce the production cost, resulting in a surplus in supply and demand.

Deadweight loss and government policies

Government policies and regulations can cause deadweight loss if they impact the supply and demand of a product or service.

Here is an example of deadweight loss:

A company launches a new skincare product and sells it for $40. Buyers perceive the value of this skincare product to be $45, so they consider $40 a friendly price. The government then imposes a sales tax on the ingredients used to produce the skin care product. To compensate for the change in production cost, the seller increases the product's price to $50.

At $50, buyers consider the skin care product overvalued and are no longer willing to purchase it. The company sees a decrease in demand and its revenue decreases. In this case, the deadweight loss is the unsold skincare product as a result of the new increased cost.

Consumers miss out on buying the product, the company loses revenue and the government collects less or no tax.

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    FAQ

    Why is understanding deadweight loss important?

    Understanding deadweight loss can help increase customer retention by providing other incentives. As a consumer, it helps you understand why your favorite brand can no longer offer you its formerly friendly prices.

    Can deadweight loss be minimized or avoided?

    Deadweight can be minimized by setting tax policies with the elasticity of demand and supply in mind. This includes designing reasonable tax rates and minimizing compliance costs.

    How is deadweight loss calculated?

    Deadweight is as calculated as:  ((P2 - P1) x (Q1 - Q2)) ÷ 2. Here is a breakdown of the variables:

    P2: Original price

    P: New price

    Q1: Original quantity

    Q2: New quantity

    Bottom line

    Deadweight loss is a loss of economic efficiency for society at large. It's a disadvantage to producers, consumers and the government.

    However, deadweight loss isn't black and white. Sometimes, the policy causing deadweight loss can be for societal good – a great example is minimum wage. It all comes down to whether the benefit of the policy outweighs the costs associated with the deadweight loss.

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