Deadweight Loss

Instructor: Alex Tabarrok, George Mason University

Deadweight Loss : The ineconomic efficiency created when not all mutually profitable gains from trade are exploited and market equilibrium is not achieved. It is

Deadweight Loss: The ineconomic efficiency created when not all mutually profitable gains from trade are exploited and market equilibrium is not achieved. It is calculated by taking the sum of lost consumer surplus and producer surplus. This is from the video “Tax Revenue and Deadweight Loss” in the Principles of Microeconomics course.



We can show pretty much everything we need to show with a single diagram. So here is our initial equilibrium. The price with no tax is $2 and the quantity exchanged with no tax is 700 units. Now, let's recall that consumer surplus is the consumer's gain from exchange, and it's this green area here, the area underneath the demand curve and above the price, up to the quantity exchanged. So it's the area above the price of $2 and up to the quantity exchanged of 700 below the demand curve, this area right here. Producer surplus is the producer's gain from exchange, and it’s the area above the supply curve, up to the quantity exchanged and below the price, below the producer's price.

Now, you may also recall that a free market maximizes consumer plus producer surplus. What we're going to show is that when we have a tax, this is no longer true. The intervention into the free market means that consumer and producer surplus are not maximized.

Let's take a look. So suppose we have tax of $1, and using our wedge method, we can find what the new price is going to be for the buyers. It's going to be here. So the new price for the buyer is say, $2.50. Notice now, the consumer surplus is not this large green area since the price is now higher and the quantity exchanged has fallen. The quantity exchanged falls from 700 units to 500 units.

So, the consumer surplus with the tax is this smaller green area here. Again, it's the area above the buyer's price, up to the quantity exchanged, and below the demand. So exactly the definition hasn't changed, but because of the tax, the price to the buyer changes, and the quantity demanded exchanges, so the consumer surplus changes as well. In this case, it gets a lot smaller.

What about producer surplus? Well, again, the price which the sellers receive falls. So producer surplus is no longer this large blue area, but is now just this much smaller blue area. So the tax reduces consumer surplus and it reduces producer surplus.

Now, what about this area in the middle? Well, fortunately, that's not wasted. That, in fact, is tax revenues. So notice that the tax, the height of the tax here is $1, and there are 500 units exchanged, so the government gets $1 for each of those 500 units. So this revenue, tax revenue, is the area. It's the height of this box times the width, and the height is the tax, the width is the quantity exchanged. So this is tax revenue.

Now, what about this final bit over here? That used to be consumer and producer surplus, but now it's deadweight loss. Nobody gets that. That is lost gains from trade. So remember, people used to trade 700 units. Now they're only trading 500 units. Those units were benefitting people, but they're not anymore because these trades are not occurring.

I'm going to explain that in a little bit more detail in the next slide. For now, just be sure that you understand how to label these areas. So this is the new consumer surplus, tax revenues, the new producer surplus, and this area is deadweight loss.

Okay, let's explain deadweight loss in a little bit more detail.

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