The term ‘deadweight loss’ refers to the economic loss due to market inefficiency. Here’s How to Calculate DeadWeight Loss. It is a condition in which the ‘supply’ and ‘demand’ are not in equilibrium. Market inefficiency occurs when the product is either undervalued or overvalued. The deadweight loss indicates the economic welfare of society is not optimum. This imbalance in the market values can be beneficial for some while a negative shift to others. Whenever a consumer decides to buy a product but back out due to the fraction of price, it causes a deadweight loss.
Steps to Learn How to Calculate DeadWeight Loss
Because the consumer doesn’t feel the cost is justified. In general, the cause of deadweight loss is unusual government policies such as price floors, price ceilings, taxes and subsidies. Let us learn the causes of deadweight loss in depth.
It refers to the minimum amount that the government has decided for a certain product or service. Usually, the minimum price of a product decreases the market value. This results in sellers either choosing to not sell that product or it is completely driven out of the market.
It refers to the maximum amount that the government has decided for a certain product or service. It prevents the seller from collecting a huge sum of money for their products because overvalued products may lead to higher profits for sellers but it negatively affects the consumer.
Taxes are the unavoidable financial charges implied by the government. They are added to the final price of the product which in total exceed the equilibrium of the market price.
It is the price paid by the government to the sellers in order to reduce the final price of the product for the consumers. It is the opposite of taxes and assumed to increase the demand of a product due to its reduced price.
People often get confused about deadweight loss calculation and the question remains unanswered as to how to calculate deadweight loss. Deadweight loss can be derived using simple steps
- Determine the original demand price of the product or service that can be stated as P1.
- Determine the new demand price of the product or service that can be stated as P2.
- Find the original requested quantity of the product that can be stated as Q1.
- Find the new quantity of the product that can be stated as Q2.
- Calculate the deadweight loss by using the formula
Deadweight Loss = 1/2 * (P2 – P1) * (Q2 – Q1)
Geometrically, the formula of deadweight loss can be expressed as the area of triangle in which the base is equivalent to the difference in original price and new price of the product or service and height is equivalent to the difference in quantity of product.
Deadweight loss is important from an economic point of view as it assists in the welfare of the society. Imagine a scenario in which the Government has imposed taxes which affects the production and consumption of a product. In consequence, government tax revenue reduces. In this case, the government can judge the market condition by calculating deadweight loss. Higher value of deadweight loss shows a greater degree of inefficiency in equilibrium of the market.