What is deadweight loss?

Economic surplus refers to the sum of consumer surplus and producer surplus in a market. Consumer surplus represents the difference between what consumers are willing to pay for a good and what they actually pay. Producer surplus represents the difference between what producers are willing to accept for a good and the price they actually receive.

In a competitive market, the equilibrium is determined at the intersection of supply and demand curves, where the quantity demanded by consumers equals the quantity supplied by producers. At this point, the market is efficient, and the total economic surplus is maximized.

Deadweight loss occurs when market conditions prevent competitive equilibrium, and the economic surplus is not maximized. This can be due to market failures like monopolies, externalities, taxes, or subsidies. In these situations, there is a misallocation of resources, causing the quantity demanded to be different from the quantity supplied.

a) Monopoly: In a monopoly, there is only one seller controlling the market. The monopolist maximizes their profit by producing less quantity than what would be produced in a competitive market, and selling at a higher price. This results in a deadweight loss, as the economic surplus is not maximized. b) Taxation: When a tax is imposed on a good, it increases the cost of production for suppliers, causing them to produce less and charge higher prices. The increased price reduces the quantity demanded by consumers. The reduction in quantity exchanged leads to a drop in economic surplus and creates a deadweight loss. c) Externalities: A negative externality occurs when the actions of a producer or consumer have adverse effects on others who are not involved in the market transaction. For instance, pollution is a negative externality. If the market does not price the cost of pollution, more of the polluting goods are produced than what would be socially optimal. This results in a deadweight loss as the economic surplus is not maximized.

Deadweight loss can be visualized and calculated using a supply and demand graph. In the case of monopoly or taxation, draw the supply, demand, and marginal cost curves on a graph. The area between the initial equilibrium point and the new equilibrium (following the introduction of a market distortion) is the deadweight loss. This area represents the portion of the economic surplus not allocated under the new market condition.