What is dead weight loss?
A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of balance. Mainly used in economics, the dead loss can be applied to any deficiency caused by an inefficient allocation of resources. Price ceilings, such as price controls and rent controls; floor prices, such as minimum wage and living wage laws; and taxation can potentially create deadweight losses. With a reduced level of trade, the allocation of resources in a society can also become ineffective.
What is dead weight loss?
Understanding dead weight loss
A deadweight loss occurs when supply and demand are not in equilibrium, which leads to market inefficiency. Market inefficiency occurs when goods on the market are overvalued or undervalued. While some members of society may benefit from the imbalance, others will be negatively affected by a change in balance.
When consumers do not think the price of a good or service is justified relative to the perceived utility, they are less likely to buy the item.
For example, overvalued prices can lead to higher profit margins for a business, but this negatively affects consumers of the product. For non-elastic products – which means that demand does not change for that particular good or service when the price increases or decreases – rising costs can prevent consumers from making purchases in other sectors of the market. In addition, some consumers may purchase a lower quantity of the item when possible. For elastic products – that is, sellers and buyers quickly adjust their demand for this good or service if the price changes – consumers can reduce spending in this sector of the market to compensate for or be totally excluded from market.
Undervalued products may be desirable for consumers but may prevent a producer from recovering production costs. If the product remains undervalued for a substantial period of time, producers will choose to stop selling the product, increase the break-even price, or be forced to exit the market entirely.
Examples of dead weight loss
Minimum wage and living wage laws can create a deadweight loss by forcing employers to overpay for employees and preventing low-skilled workers from finding employment. Price caps and rent controls can also create a deadweight loss by discouraging production and reducing the supply of goods, services or housing below what consumers actually demand. Consumers are experiencing shortages and producers are earning less than they would otherwise.
Taxes also create a deadweight loss because they prevent people from making purchases that they would otherwise make because the final price of the product is higher than the market equilibrium price. If the taxes on an item increase, the burden is often shared between the producer and the consumer, resulting in the producer receiving less profit from the item and the customer paying a higher price. This results in a lower consumption of the article than before, which reduces the overall benefits that the consumer market could have received while simultaneously reducing the advantage that the company can see in terms of profits.