31.11 Efficiency and Deadweight Loss
The outcome of a competitive market has a very important property. In equilibrium, all gains from trade are realized. This means that there is no additional surplus to obtain from further trades between buyers and sellers. In this situation, we say that the allocation of goods and services in the economy is efficient. However, markets sometimes fail to operate properly and not all gains from trade are exhausted. In this case, some buyer surplus, seller surplus, or both are lost. Economists call this a deadweight loss.
The deadweight loss from a monopoly is illustrated in Figure 31.8 "Deadweight Loss". The monopolist produces a quantity such that marginal revenue equals marginal cost. The price is determined by the demand curve at this quantity. A monopoly makes a profit equal to total revenue minus total cost. When the total output is less than socially optimal, there is a deadweight loss, which is indicated by the red area in Figure 31.8 "Deadweight Loss".
Deadweight loss arises in other situations, such as when there are quantity or price restrictions. It also arises when taxes or subsidies are imposed in a market. Tax incidence is the way in which the burden of a tax falls on buyers and sellers—that is, who suffers most of the deadweight loss. In general, the incidence of a tax depends on the elasticities of supply and demand.
A tax creates a difference between the price paid by the buyer and the price received by the seller (Figure 31.9 "Tax Burdens"). The burden of the tax and the deadweight loss are defined relative to the tax-free competitive equilibrium. The tax burden borne by the buyer is the difference between the price paid under the tax and the price paid in the competitive equilibrium. Similarly, the burden of the seller is the difference between the price in the competitive equilibrium and the price received under the equilibrium with taxes. The burden borne by the buyer is higher—all else being the same—if demand is less elastic. The burden borne by the seller is higher—all else being the same—if supply is less elastic.
The deadweight loss from the tax measures the sum of the buyer’s lost surplus and the seller’s lost surplus in the equilibrium with the tax. The total amount of the deadweight loss therefore also depends on the elasticities of demand and supply. The smaller these elasticities, the closer the equilibrium quantity traded with a tax will be to the equilibrium quantity traded without a tax, and the smaller is the deadweight loss.
Key Insights
- In a competitive market, all the gains from trade are realized.
- If sellers have market power, some gains from trade are lost because the quantity traded is below the competitive level.
- Other market distortions, such as taxes, subsidies, price floors, or price ceilings, similarly cause the amount to be traded to differ from the competitive level and cause deadweight loss.
Figure 31.8 Deadweight Loss
Figure 31.9 Tax Burdens
The Main Uses of This Tool
- Chapter 6 "eBay and craigslist"
- Chapter 8 "Why Do Prices Change?"
- Chapter 10 "Making and Losing Money on Wall Street"
- Chapter 11 "Raising the Wage Floor"
- Chapter 12 "Barriers to Trade and the Underground Economy"
- Chapter 13 "Superstars"
- Chapter 14 "Cleaning Up the Air and Using Up the Oil"
- Chapter 15 "Busting Up Monopolies"
- Chapter 16 "A Healthy Economy"
- Chapter 17 "Cars"
As an expert in economics and market dynamics, I bring a wealth of knowledge and experience to the discussion on efficiency, deadweight loss, and related economic concepts. My understanding of these principles is grounded in both theoretical frameworks and real-world applications, making me well-equipped to delve into the intricacies of market behavior.
Firstly, let's emphasize the fundamental concept of efficiency in a competitive market. The crux of this idea lies in the equilibrium state where all gains from trade are realized. In such a scenario, the allocation of goods and services in the economy is considered efficient, indicating that no additional surplus can be obtained from further trades between buyers and sellers.
However, markets are not always perfect, and when they fail to operate properly, deadweight loss occurs. This loss stems from situations where not all gains from trade are exhausted. A prime example illustrated in your article is the deadweight loss resulting from a monopoly. The monopolist, aiming to maximize profits, produces a quantity where marginal revenue equals marginal cost, leading to a price determined by the demand curve at this quantity. The difference between the total output and the socially optimal output creates a deadweight loss, as indicated by the red area in Figure 31.8.
Deadweight loss is not exclusive to monopolies; it arises in various scenarios, such as when quantity or price restrictions, taxes, or subsidies are imposed in a market. Tax incidence, a critical concept discussed in the article, refers to how the burden of a tax falls on buyers and sellers. The elasticities of supply and demand play a crucial role in determining tax incidence—the more inelastic the demand or supply, the higher the burden borne by the party with less elastic conditions.
Figure 31.9 illustrates tax burdens, emphasizing the difference between the price paid by the buyer and the price received by the seller under a tax compared to the tax-free competitive equilibrium. The deadweight loss from the tax measures the sum of the buyer’s and seller’s lost surplus, and its magnitude is influenced by the elasticities of demand and supply.
These concepts are not isolated but are interconnected and applicable in various economic contexts, as evident in the chapters mentioned. From eBay and craigslist in Chapter 6 to issues related to price changes, money-making on Wall Street, wage floors, trade barriers, monopolies, and environmental concerns, the principles of efficiency, deadweight loss, and market distortions are pervasive and crucial for understanding economic phenomena and making informed decisions in diverse scenarios.
