Deadweight loss

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Deadweight loss created by a binding price ceiling. Producer surplus is necessarily decreased, while consumer surplus may or may not increase; however the decrease in producer surplus must be greater than the increase (if any) in consumer surplus.

In economics, a deadweight loss (also known as excess burden) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal. In other words, either people who would have more marginal benefit than marginal cost are not buying the good or service or people who would have more marginal cost than marginal benefit are buying the product.

Causes of deadweight loss can include monopoly pricing (see artificial scarcity), externalities, taxes or subsidies (Case and Fair, 1999: 442), and binding price ceilings or floors. The term deadweight loss may also be referred to as the "excess burden of monopoly" or the "excess burden of taxation".

[edit] Example

For example, consider a market for nails where the cost of each nail is 10 cents and that the demand will decrease linearly from a high demand for free nails to zero demand for nails at $1.10. In a perfectly competitive market, producers would have to charge a price of 10 cents and every customer whose marginal benefit exceeds 10 cents would have a nail. However, if only one producer has a monopoly on the product, then they will charge whichever price will yield the highest profit. For this market, the producer would charge 60 cents and thus exclude every customer who had less than 60 cents of marginal benefit. The deadweight loss is then the economic benefit forgone by these customers due to the monopoly pricing.

Conversely, deadweight loss can also come from consumers buying a product even if it costs more than it benefits them. To see this, let's use the same nail market, but instead it will be perfectly competitive with the government giving a 3 cent subsidy to every nail produced. This 3 cent subsidy will push the market price of each nail down to 7 cents. Some consumers then buy nails even though the benefit to them is less than the cost of 10 cents. This unneeded expense then creates the deadweight loss.

[edit] Hicks vs. Marshall

Also, an important distinction should be drawn between Hicksian and Marshallian deadweight loss. The latter is related to the concept of consumer surplus, such that it can be shown that the Marshallian deadweight loss is zero where demand is perfectly elastic or supply is perfectly inelastic. On the other hand, Hicks analysed the situation through indifference curves and noted that when the Marshallian Demand Curve exhibits perfect inelasticity, the policy or economic situation which caused a distortion in relative prices will have an income effect and that this income effect is a deadweight loss.