If you’ve taken economics, you’ve probably heard the term “deadweight loss” thrown around as something that is generally “bad.” But what does deadweight loss even mean, and why do economists try to avoid it? Let’s find out.
To understand deadweight loss, we first need to understand how economists think about welfare. Economists think about welfare as the total value created from transactions in the economy. So, for example, let’s consider a simple economy where there are only two people: Mary and John. if Mary (the consumer) is willing to pay $20 or less for a new pair of jeans and John (the producer) is willing to sell a new pair of jeans at $15 or more, then the total value created (i.e. welfare gain) from that transaction is $5. That welfare gain might accrue to Mary if she can buy the pair of jeans at $15 even though she was willing to pay $20; this would mean $5 in consumer welfare and $0 in producer welfare. Alternatively, the welfare gain could accrue to John if he can sell the jeans for $20 instead of accepting $15; this would mean $5 in producer welfare and $0 in consumer welfare. But as long as the transaction occurs, the total welfare gain is $5 split in some way between the consumer and the producer.
Deadweight loss occurs when somehow the transaction between Mary and John doesn’t happen, even though one or both parties would benefit from it. In the simplest case, let’s say a government banned the purchase or sale of jeans. This would create $5 in deadweight loss because Mary and John cannot engage in a trade for jeans that creates $5 in value. Similarly, if the government set a price ceiling of $12 on jeans, there would also be a deadweight loss of $5. This is because John would not be willing to sell the jeans at all at $12, so the trade doesn’t happen. The total deadweight loss is the sum of all such transactions that don’t happen as a result of some policy or market condition, but would have happened if individuals could transact freely, if markets were perfectly competitive, and if consumers and suppliers had perfect information.
There are a lot of situations in markets that cause deadweight loss. Deadweight loss often happens when the government introduces taxes or subsidies, or regulates prices or wages. It can also happen without any government intervention in certain markets that don’t meet economists’ criteria for perfect competition and perfect information, such as monopolies and many insurance markets.
Deadweight loss is a tricky concept because it is invisible in many ways. It is understandably unintuitive to think about the harm that comes from transactions that never happen. But that lost potential (or opportunity cost) of transactions that don’t occur is very real and is critical for evaluating economic policy. If you can master this concept, you’ll be well on your way to understanding the economy better than most.
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