A deadweight loss, also known as excess burden or allocative inefficiency, is a loss of economic efficiency that can occur when equilibrium for a good or a service is not achieved. That can by caused by monopoly pricing in the case of artificial scarcity, an externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.
An example is if a market for nails has the cost of each nail is $0.10 and the demand linearly from a high demand for free nails to zero demand for nails at $1.10. If the market has perfect competition market, producers would have to charge a price of $0.10, and every customer whose marginal benefit exceeds $0.10 cents would have a nail. However, if there is one producer with a monopoly on the product, it will charge whatever price will yield the greatest profit. The producer would then charge $0.60 cents and thus exclude every customer who had less than $0.60 of marginal benefit. The deadweight loss would then be then the economic benefit foregone by such customers because of monopoly pricing.
Conversely, deadweight loss can come from consumers if they buy a product even if it costs more than it benefits them. To describe this, if the same nail market had the government giving a $0.03 cent subsidy to every nail produced, the subsidy would push the market price of each nail down to $0.07. Some consumers would then buy nails even though the benefit to them is less than the real cost of $0.10. That unneeded expense would then create a deadweight loss, with resources are not being used efficiently.
If the price of a glass of wine is $3.00 and the price of a glass of beer is $3.00, a consumer might prefer to drink wine. If the government decides to levy a wine tax of $3.00 per glass, the consumer might prefer to drink beer. The excess burden of taxation is the loss of utility to the consumer for drinking beer instead of wine since everything else remains unchanged.
Harberger's triangle, generally attributed to Arnold Harberger, refers to the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market. That can happen through price floors, caps, taxes, tariffs, or quotas. It also refers to the dead weight loss created by a government's failure to intervene in a market with externalities. In the case of a government tax, the amount of the tax drives a wedge between what consumers pay and what producers receive, and the filled-in wedge shape is equivalent to the deadweight loss from the tax.
The area represented by the triangle comes from the fact that the intersection of the supply and the demand curves are cut short so the consumer surplus and the producer surplus are also cut short. The loss of such surplus that not recouped, is the deadweight loss.
Some economists like James Tobin have argued that the triangles do not have a huge impact on the economy, but others like Martin Feldstein maintain that they can seriously affect long-term economic trends by pivoting the trend downwards and cause a magnification of losses in the long run.
Hicks vs. Marshall
An important distinction should be made between Hicksian (per John Hicks) and Marshallian (per Alfred Marshall) deadweight loss. After the consumer surplus is considered, it can be shown that the Marshallian deadweight loss is zero if demand is perfectly elastic or supply is perfectly inelastic. However, Hicks analyzed the situation through indifference curves and noted that when the Marshallian demand curve is perfectly inelastic, the policy or economic situation that caused a distortion in relative prices has a substitution effect, is a deadweight loss.
In modern economic literature, the most common measure of a taxpayer’s loss from a distortionary tax, such as a tax on bicycles, is the equivalent variation, the maximum amount that a taxpayer would be willing to forgo in a lump sum to avoid the distortionary tax. The deadweight loss can then be interpreted as the difference between the equivalent variation and the revenue raised by the tax. The difference is attributable to the behavioural changes induced by a distortionary tax that are measured by a substitution effect. However, that is not the only interpretation and Lind and Granqvist (2010) point out that Pigou did not use a lump sum tax as the point of reference to discuss deadweight loss (excess burden).
A comparable measure of loss is the compensating variation, which depends on Hicksian demand instead of Marshallian demand. In the context of a distortionary tax, the compensating variation is the minimum lump sum transfer that makes an individual indifferent between the lump sum transfer with tax and no lump sum transfer with no tax, the original situation. The deadweight loss can then be interpreted as the minimum lump sum.
- Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
- Hines, James R., Jr. (1999), "Three sides of Harberger Triangles" (PDF), Journal of Economic Perspectives, 13 (2): 167–188, doi:10.1257/jep.13.2.167.
- Lind, H. & R. Granqvist (2010) A Note on the Concept of Excess Burden. Economic Analysis and Policy 40:63-73.