Encyclonomic WEB*pedia: DEADWEIGHT LOSS

DEADWEIGHT LOSS:
The decrease in the sum of consumer surplus and producer surplus that results from the imposition of a tax. When a tax drives a wedge between demand price and supply price it disrupts what otherwise would be an efficient market equilibrium. Inefficiency arises because while a portion of the sum of consumer and producer surplus is merely transferred to government, a portion of this sum also disappears. The part that disappears is the deadweight loss and is an indicator of the inefficiency of the tax.
Taxes are mandatory payments made by members of society to government. The primary reason for such payments is to finance government operations, especially the provision of public goods. Taxes, though, usually have a secondary effect -- to change the allocation of resources. If the existing allocation is inefficient, such as what arises due to market failures, then taxes can correct the problems and promote efficiency.
However, if the existing allocation is efficient, then taxes can cause an inefficient allocation. This inefficiency can be seen by a difference in the demand price (the value of the good produced) and the supply price (the value of goods not produced). Because efficiency is achieved with equality between these two values, inequality means inefficiency.
Another indication of efficiency and inefficiency is seen through the combination of consumer surplus and producer surplus. Consumer surplus is the extra value buyers receive from a good over and above the price paid. Producer surplus is the extra value that sellers obtain over and above the cost of production. In an efficient market, the sum of consumer and producer surplus is maximized.
Levying a tax on an otherwise efficient market decreases the sum of consumer and producer surplus. A portion of the surplus is simply transfer to government as the tax payment. However, a portion of the surplus is also lost -- it vanishes. This decreased surplus is the deadweight loss of the tax.
A Lot of Surplus
Deadweight Loss

A market such as the one illustrated here is efficient not just because demand price is equal to supply price (and the value of the good produced is equal to the value of goods not produced) but also because the sum of consumer surplus and producer surplus is maximized.
Consumer Surplus: This is the difference between the maximum price buyers are willing to pay for a good and the price actually paid. Graphically, it is the area above the price and below the demand curve. To highlight the consumer surplus for this market, click the [Consumers Surplus] button.

Producer Surplus: This is the difference between the minimum price sellers are willing to accept for a good and the price actually received. Graphically, it is the area below the price and above the supply curve. To highlight the producer surplus for this market, click the [Producers Surplus] button.
This market is efficient because the sum of these areas is maximized. No other price-quantity pair would generate this maximum sum of surplus. A lower price might increase consumer surplus, but it would decrease producer surplus even more. Alternatively, a higher pricer would increase producer surplus, but this increase would be surpassed but the resulting decrease in consumer surplus.
Enter the Tax
For ease exposition, let's say that a $1 per unit tax is imposed on this market. This tax has the consequence of driving a wedge between the demand price and supply price. Imposing this tax on the market does two things.
First: A portion of consumer surplus and producer surplus is transferred to government as tax revenue. This is not necessarily inefficient, so long as government uses this revenue for valuable production. To illustrate this transfer of tax revenue, click the [Tax Revenue] button. This is the yellow rectangle given by the difference between the demand price and supply price, which is the $1 tax, and the new quantity exchanged, which is 3.75 in this case.

Second: A portion of consumer surplus and producer surplus is lost, it simply vanishes, ceases to exist. This is termed deadweight loss. To illustrate this loss, click the [Deadweight Loss] button. This is the small yellow triangle between the old and new equilibrium quantities and the demand and supply curves.
Given that the market was efficient before the tax, the market is not efficient after the tax. The tax causes a decrease in the surplus received by both consumers and producers. A portion of this surplus is transferred to government as the tax payment. However, the overall decline in the sum of consumer surplus and surplus exceeds that transferred to government. A portion of this surplus is also lost. It vanishes.
The disappearing amount is the deadweight loss. The deadweight loss triangle simply vanishes when a tax is imposed on the market. It is a loss incurred by society. Resources are not being used to generate the greatest possible satisfaction.
Check Out These Related Terms...
     | tax incidence | tax wedge | tax efficiency | taxation principles | taxation basics | tax effects | revenue effect | allocation effect | tax equity | ability-to-pay principle | benefit principle | horizontal equity | vertical equity | tax proportionality | proportional tax | progressive tax | regressive tax |
Or For A Little Background...
     | public finance | government functions | efficiency | inefficient | market equilibrium | market efficiency | consumer surplus | producer surplus | allocation |
And For Further Study...
     | public choice | good types | market failures | public goods: demand | public goods: efficiency | tax multiplier | personal tax and nontax payments | transfer payments |
Recommended Citation:
     DEADWEIGHT LOSS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: November 27, 2024].