Deadweight Loss

A dead-weight loss or net welfare loss is also known as excess burden or excess burden of monopoly or the excess burden of taxation or allocation inefficiency. It is a loss of economic efficiency that can occur when the free market equilibrium for a good or a service is not achieved. That can be caused by monopoly pricing in the case of artificial scarcity, an externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.

In the above figure, $AD$ is demand curve, $BS$ is supply curve, $OQ_1$ is market quantity with price ceiling, $OQ_2$ is equilibrium quantity, $OP_1$ is price ceiling, $OP_2$ is market price at equilibrium, $P_1E'CA$ is consumer's surplus, $BE'P_1$ is producer's surplus, $E'EC$ is dead-weight loss.  Dead-weight loss can occur when equilibrium for a good or service is not Pareto optimal. In other words, (i) Either people who would have more marginal benefit than marginal cost are not buying the good or service (no revenue). Thus dead-weight loss is  the economic benefit forgone by these customers due to the monopoly pricing. (ii) Or people who would have more marginal cost than marginal benefit are buying the products (un-needed expenses). This unneeded expense then creates the dead-weight loss. There are two important concepts of dead-weight loss due to Hicks and Marshall with a distinction. The latter is related to the concept of consumer surplus, such that it can be shown that the Marshallian dead-weight loss is zero where demand is perfectly elastic or supply is perfectly inelastic. On the other hand, Hicks analysed the situation through indifference curves, the policy or economic situation which caused a distortion in relative prices will have an income effect and that this income effect is a dead-weight loss. Dead-weight loss is zero if commodity demand is perfectly inelastic.