Introducing Supply and Demand
Introduction to Deadweight Loss
Define deadweight loss
- Deadweight loss can be caused by monopolies, binding price controls, taxes, subsidies, and externalities.
- When deadweight loss occurs, it comes at the expense of consumer surplus and/or producer surplus.
- Deadweight loss can be visually represented on supply and demand graphs as a figure known as Harberger's triangle.
- Pareto optimal: Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.
- deadweight loss: A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.
Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced and produced at its pareto optimal level. When output is at its pareto optimal point, the price, production, and consumption of a good cannot be altered for one person's benefit without making at least one other worse off. In a perfectly competitive market, products are priced at the pareto optimal point.
When deadweight loss occurs, it comes at the expense of either the consumer economic surplus or the producer's economic surplus. Consumer surplus is the gain that consumers receive when they are able to purchase a product for less than the price they are willing to pay; producer surplus is the benefit producers receive when the sell a product for more than they are willing to sell for. While price controls, subsidies and other forms of market intervention might increase consumer or producer surplus, economic theory states that any gain would be outweighed by the losses sustained by the other side. This net harm is what causes deadweight loss.
Deadweight loss can be visually represented on supply and demand graphs. Known as Harberger's triangle, the deadweight loss equals the area within the following three points:
Deadweight loss: This chart illustrates the deadweight loss created when a price floor is instituted on the market for a good. The amount of deadweight loss is shown by the triangle highlighted in yellow. This area is known as Harberger's triangle.
- where the supply and demand curve intersect, otherwise known as the free market equilibrium;
- the point on the supply curve where the y-coordinate equals the non-pareto optimal price;
- the point on the demand curve where the y-coordinate equals the non-pareto optimal price.