Economics
Deadweight Loss
Deadweight loss refers to the inefficiency that occurs when the quantity of a good or service traded in a market is below the equilibrium level. This results in a loss of potential economic welfare that could have been generated if the market was operating at its equilibrium. Deadweight loss is often associated with market distortions such as taxes, subsidies, or price controls.
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3 Key excerpts on "Deadweight Loss"
- William K. Jaeger(Author)
- 2012(Publication Date)
- Island Press(Publisher)
Deadweight Loss. Deadweight Loss is the difference between the net benefits actually achieved and the maximum net benefits possible with an efficient allocation (at Q*).Let’s take a simple example where government limits, say, the amount of steel that can be produced to Qmax . In figure 3.10 we see that this amount falls short of the amount that would be supplied at the competitive market equilibrium. At the Pareto optimum the total net benefit would equal the areas A + B, but with the supply restriction the net benefit is only equal to the area A. The Deadweight Loss, therefore, is equal to B, the shaded area.Let’s take another example, say, where government subsidizes milk production by paying farmers a direct subsidy, S, for every gallon produced. The supply curve shifts down by the amount of the subsidy because the marginal private cost (MPC), which includes the subsidy, is lower than the marginal social cost (MSC), which is the “true” cost to society, including the cost to taxpayers who ultimately pay the subsidy. This is described in figure 3.11 .Notice that the change in market price from P1 to P2 is less than the amount of the subsidy (P1 –S is below P2 ). If demand were fixed at Q1 , the price might decline by the full amount of the subsidy and consumers would reap their entire benefit. This would occur only if the demand curve were vertical. Because the lower price encourages higher demand, and this increased demand puts upward pressure on prices, the new market equilibrium occurs at Q2 where supply increased to meet that demand. As a result, some of the benefits of the subsidy end up being transferred to producers because of the market adjustments that lead to a new equilibrium price at P2 . So who gets the subsidy? Both producers and consumers get a part of it, and the shares depend on the relative slopes of the demand and supply curves. Economists will refer to the “incidence” of a subsidy when they talk about who actually ends up benefiting from it. The same concept and term is used for taxes to recognize that even though a tax may be levied on producers (or consumers), markets will adjust in response to the shift in supply (or demand) caused by the tax, and these market adjustments will determine the “incidence of the tax,” meaning who really
eBook - ePubIndustrial Organization
Competition, Growth and Structural Change
- Kenneth George, Caroline Joll, E L Lynk(Authors)
- 2005(Publication Date)
- Routledge(Publisher)
In the extreme case of perfectly contestable markets (see), there can be no deadweight welfare loss because incumbents have to charge competitive prices and can earn only a competitive return. The other extreme would be the case of a monopolist which can protect its position indefinitely. Clearly the rate at which monopoly positions decay (see Chapter 6) is of crucial importance. Schmalensee (1982) has shown, assuming a market for a homogeneous product, that the effect of the rate of decay of monopoly power on the deadweight welfare loss is as follows: where: r = rate of discount used to capitalise future welfare losses DW S and DW L = short- and long-run deadweight welfare losses, respectively γ = the annual fractional reduction in the gap between DW S and DW L ; i.e. the rate of decay of market power. For the case of perfect contestability, γ = ∞ and DW l = 0, so welfare loss is zero. Where, on the other hand, market power is preserved indefinitely, γ = 0 and DW S = DW L. Consequently welfare loss equals the present discounted value of the short-run welfare loss, i.e. l/ r (DW). Empirical evidence finds no support for either extreme. Market power does tend to decay, but the rate of decay varies substantially and in some cases may be at a snail’s pace. So far we have concentrated on the possible allocative losses associated with monopoly power. In the next two sections we broaden the concept of welfare losses of monopoly and look at arguments that suggest that the static allocative loss from monopoly is only one element, and not necessarily the most important element, of the total costs involved. 12.4 X-INEFFICIENCY Measurement of the welfare costs of monopoly by the triangular Deadweight Loss area BCF of Figure 12.1 rests on the assumption that the costs of the industry will be the same under monopoly as under perfect competition
eBook - PDFIntermediate Microeconomics
An Intuitive Approach with Calculus
- Thomas Nechyba(Author)
- 2018(Publication Date)
- Cengage Learning EMEA(Publisher)
As a result, whether one can see it or not in a picture of market equilibrium in the labour market, wage taxes will have Deadweight Losses as long as there is any substitutability at all between leisure and consumption, which there almost certainly is. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 552 CHAPTER 19 DISTORTIONARY TAXES AND SUBSIDIES Illustrate, using an analogous set of steps to those just used as we worked our way through Graph 19.6, how wage subsidies are inefficient even when workers are completely unresponsive to changes in wages. Exercise 19A.8* 19A.2.3 Deadweight Losses From Subsidies in Labour or Capital Markets We can show a similar error that may arise when we use the uncompensated savings–interest rate relationship, which represents the sup-ply curve for financial capital, to predict the welfare effect of savings subsidies. Consider the case where individuals are completely unresponsive to changes in the rate of return on savings – they always put the same amount into the savings account regardless of the interest rate. This gives a perfectly inelastic supply curve for capital as presented in panel (a) of Graph 19.7. When a subsidy for saving is now introduced, the entire benefit of the subsidy accrues to savers as their rate of return jumps from the initial equilibrium interest rate r* to the new interest rate ( r* 1 s ) that includes the per-unit subsidy s .
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