Concept of Deadweight Loss
In economics, deadweight loss (excess burden) is a term used to describe the loss caused to the society due to market inefficiencies.
It occurs when equilibrium for goods and services is not attained. In other words, it occurs when supply curve of a commodity does not intersect the demand curve at the free market equilibrium point.
In a graph, deadweight loss is represented by the area between supply curve and demand curve, bound by initial quantity demanded and new quantity demanded.
Figure: graphical representation of price ceiling and dead weight loss
In the above graph, SS is a supply curve and DD is a demand curve. They intersect at free market equilibrium point E where Q1 amount of commodity is supplied at price P1.
Let us suppose P2 is the price ceiling of the commodity. As price ceiling is lesser than the equilibrium price, consumers’ demand for the commodity increases. However, producers are not willing to offer goods at such low price and therefore cut off their supply, making Q2 the new supplied in the market.
Thus, the area in the graph bounded by supply curve, demand curve, initial quantity supplied (Q1) and final quantity supplied (Q2) gives the measure of deadweight loss.
Causes of deadweight loss
Government’s intervening activities such as price ceiling, price flooring and taxation are the major reasons of deadweight loss. These activities cause inefficient allocation of resources in the market creating imbalance between supply and demand of the commodity.
Price ceiling is a measure of price control imposed by the government on particular commodities in order to prevent consumers from being charged high prices.
As mentioned above, price ceiling creates deadweight loss if it is set below equilibrium price. It is because fall in price increases demand of consumers and decreases supply from producers simultaneously, creating imbalance in the free market equilibrium.
Likewise, price floor is another measure of price control on how low a price can be charged for a commodity.
When price floor is set above the free market equilibrium price, there is excessive supply of the commodity but significantly low demand. The goods and services will no longer be sold in quantities they would have otherwise and the imbalance in demand and supply results in deadweight loss.
Imposing taxes on goods and services increases the price of commodity which is followed by decrease in demand for that commodity.
Once again, commodity fails to make as much sales as it would have made without taxes and cause imbalances in the free market equilibrium.