What’s Deadweight Loss?

A brief explainer

Many people who read this blog may not have a background in economics. Some of the terms I use might be unfamiliar, or even entirely novel. I shall explain some of the big ones, in coming columns, but we shall start with deadweight loss. What is it? Why does it arise? Why is it bad?

Let’s imagine a world of perfect competition. There are many firms who are all price-takers. If they were to sell more or fewer goods, the price would remain the same. The price is determined by the total market supply and demand.

In all worlds, firms produce until the point that marginal cost equals marginal revenue. “Marginal” simply means what you bring in “on the margin” — what is the cost or benefit of selling one additional unit. The important thing here is that the demand curve for an individual firm is horizontal — it has a slope of zero and is called “perfectly elastic”. If you raise your price above, your sales will drop from something to nothing at all.

Now let’s suppose the demand curve facing the firm has a slope greater than zero. This is what we may find in the case of a monopoly, when there is only one seller. If someone wishes to lower their price to sell one more unit, they must drop their prices for everyone in the market. Thus, marginal revenue is not the same as the demand curve, and the marginal cost curve will cross marginal revenue sooner. To maximize profit, one produces at that quantity, and prices it at the demand curve.

Deadweight loss, then, is what could have been made — and would have been made efficiently — but which never was. Another example of deadweight loss comes from taxes. If you tax a good, it will push some of the units into unprofitability, and they will never get made at all. Thus, taxes on imports reduce what we can consume. 

This has been a short post; please let me know if you want to see more short explainers of this sort.