What is Deadweight Loss?
A loss in economic efficiency is the loss of deadweight. This refers to the eventuality that the equilibrium outcome will not be achieved or can not be reached. It is also the price society pays for market inefficiency.
Video explanation of deadweight loss
Here is a video tutorial explaining what deadweight loss looks like, the causes, and an example calculation.
What causes weight loss?
- Prices floors:The government establishes a ceiling on the price a service or good can be sold for. A price floor is an example.Minimum wage.
- Prices ceilingsThe government establishes a maximum price that can be charged for goods or services. Rent control is an example of a price limit. It limits the amount that landlords can collect in rent.
- TaxationThe government charging more than the selling price of a product or service. A cigarette tax is an example of taxation.
Imperfect competition and deadweight loss
Imperfect competition, such as oligopolies or monopolies, can also lead to weight loss. Companies restrict supply in imperfect markets to raise prices above their average total costs. Consumers are less likely to enjoy the goods if they have higher prices. This can lead to a loss of weight.
Example of Deadweight Loss
Imagine you are planning a trip to Vancouver. You can get a bus ticket to Vancouver for $20 and the trip is worth $35. This situation means that the trip’s value ($35) is greater than the cost ($20), and you would therefore choose to take the trip. This trip has a net value of $35-$20 (benefit-cost) = $15
The government decides to impose an immediate 100% tax on bus tickets before you buy a ticket for Vancouver. This would increase the cost of bus tickets to Vancouver from $20 to $40. The cost of a bus ticket is $40, but you get $35 in value.
This scenario would mean that the trip would be cancelled and that the government would not get any tax revenue. The government imposes a tax that is equal to the deadweight loss. This refers to the value of trips to Vancouver which do not occur.
How to calculate your deadweight loss
You will need to know how much a product or service has changed in price. The following formula can be used:
Deadweight loss = (Pn – Po) x Qo – Qn) / 2.
Po = Original price of the product
Pn is the new product price after taxes, price ceiling or floor are accounted for
Qo = The product’s original quantity
Qn is the product’s total quantity after taxes, price ceiling or floor are applied.
These steps will help you calculate your deadweight loss.
- Find out the original price of the product/service.
- Calculate the new price for the product or service.
- Determine the original quantity of the product.
- Learn the new quantity of your product.
- Calculate your deadweight loss.
1. 1. Determine the original price for the product/service
To calculate the deadweight loss, the first step is to determine the original price of the product/service in question. If you want to purchase a concert ticket, for example, the original price might be $50.
2. 2. Determine the new price for the product/service
Next, calculate the new price of your product or service, after prices have been adjusted for taxes, price ceilings, and/or price floors. If the government places a 100 percent tax on concert tickets, it would make the ticket $100 instead of the $50 originally purchased.
3. 3. Determine the original quantity requested and the new quantity required.
Calculate how much product you actually intended to buy. As an example, one concert ticket is what you want. Let’s suppose you have $60 to spend on a concert ticket. Instead of being able purchase one concert ticket, the price has increased to $100 because of the tax paid by the government. This is in contrast to the $50 original price. The original quantity was 1 and the new quantity is 0.
4. Calculate your deadweight loss
Once you have determined the above values, use this formula to calculate your deadweight loss.
Deadweight loss = (Pn – Po) x Qo – Qn) / 2.
((100-50) x (1-0)) / 25
The deadweight loss in the above example is $25.
Similar: Learn More About Becoming a Financial Analyst
Examples of deadweight loss
These are some examples of deadweight loss:
Let’s suppose you are planning a vacation in Hawaii. You will need to pay $300 for a plane ticket and $500 for the trip. The trip’s value ($500) is greater than the flight ticket’s ($300). This information is enough to convince you to book the trip. This trip to Hawaii will net you $200. $300 is subtracted from $500 and the result is $200.
The government has imposed a 100% tax upon plane tickets before you can take off. The cost of your plane ticket would go up from $300 to $600. This would result in the price of your plane ticket exceeding the benefit or value that you have assigned to it. This is because you would now have to pay $600 for a flight to Hawaii, where you get only a $500 value. You wouldn’t travel on this trip if that were the case. You wouldn’t have to pay any taxes if you didn’t travel on the trip. In this case, the deadweight is the difference in the price of the ticket that wasn’t purchased due to the new tax.
Let’s suppose you are interested in attending a concert by your favorite band. The concert ticket costs you $80. However, the concert is worth $100. This example shows that the benefit or value ($100) is greater than the ticket price ($80). You decide to invest in the concert and decide it’s worth the investment. This concert has a net worth of $20, which is $100 minus $80.
The government places a 50% tax on concert tickets before you go. The original price of the ticket will increase by 50%, making it $120. The concert ticket’s cost will now be higher than the original value. You would now pay $120 for a $100 concert ticket. You decide to cancel the concert. The deadweight loss, which is the difference in the price of the concert ticket not purchased due to the new tax from the government, would be $120.