Whenever consumers do not buy goods or services because of changes in price, there is a so-called deadweight loss. This is the case in several different industries. Determining the deadweight loss helps to see how much money a company is missing based on new taxes, price ceilings, or changes in the base price.
In this article, we define what deadweight loss is, what causes it, how to calculate it, as well as examples of cases.
Contents
What is Deadweight Loss?
Deadweight loss refers to a loss or expense that stems from economic inadequacy where allocations are unequal. In other words, it is a loss that occurs from market inefficiencies, such as unbalanced supply vs. demand.
When a deadweight loss occurs, some people may benefit while others may not. If consumers feel as though the value of a good or service does not exceed its cost, they are less likely to make a purchase. This results in a loss because consumers do not feel the costs are justified.
Causes of Deadweight Loss?
There are three main causes of deadweight loss, and many are unavoidable:
1. Tax
These financial costs are created by the government and are unavoidable. An example of a tax is a sales tax levied on products or goods.
2. Price ceiling
A price ceiling refers to the maximum price the government says a good or service can charge. The government does this to prevent certain companies from selling goods or services at a higher price. An example of a price ceiling is a lease control where the price is set as the highest amount of rent a landlord can collect.
3. Base price
Finally, the floor price refers to the minimum price that the government thinks a good or service can sell for. This is the opposite of the price ceiling. An example is the minimum wage.
It is important to note that external factors have the potential to influence the supply and demand for goods or services.
How to Calculate Deadweight Loss
To calculate deadweight loss, you must know the change in price and the change in the quantity of the product or service. Use the following formula:
Deadweight loss = ((Pn – Po) × (Qo – Qn)) / 2
where:
Po = original price of the product
Pn = new product price after tax, price ceiling and/or base price are taken into account
Qo = quantity of product originally demanded
Qn = quantity of product demanded after-tax, price limit and/or base price introduced
Use the following steps to calculate deadweight loss:
1. Determine the original price of the product or service
The first step in calculating deadweight loss is to determine the original price of the product or service in question. For example, if you want to buy a concert ticket, the original price could be 50,000.
2. Determine the new price of the product or service
Next, determine the new price for the product or service after taxes, price ceilings, and/or base prices have been included. Using the example above, if the government imposed a 100% tax on concert tickets, this would create a concert ticket that you would buy 100,000 compared to the original 50,000.
3. Find out the quantity of the product originally demanded and the new quantity
Decide how many products you initially want to buy. In the example above, you want one concert ticket. Let’s say you budgeted 60,000 for concert tickets. Instead of being able to buy one concert ticket, you can’t buy it anymore as it costs 100,000 now due to government taxes compared to the original price of 50,000. Therefore, the original quantity is one and the new quantity is zero.
4. Calculate deadweight loss
Now that you have determined the above values, use the formula to calculate the deadweight loss
Deadweight loss = ((Pn Po) × (Qo Qn)) / 2
((100,000 – 50,000) × (1 – 0)) / 2 = 25
In the example above, your loss is 25,000.
More Examples of Calculating Deadweight Loss
Consider the following deadweight loss example:
Example 1
Let’s say you are planning a vacation to Bali. A plane ticket will cost you 300,000 and you value the trip with 500,000. In this case, the value of the trip (500,000) exceeds the cost of the airfare (300,000).
With this information, you decide to go on a trip. The net worth you get from this trip to Bali is 200,000 because 500,000 minus 300,000 is 200,000.
However, before you travel, the government imposes a 100% tax on air tickets. This will increase the price of your airfare from 300,000 to 600,000.
This means the costs now exceed the benefits or value you set for your trip. This is because you will now pay 600,000 for a plane ticket to Bali where you only get a value of 500,000.
If this is the case, you will not travel. Also, because you don’t travel, the government won’t get taxes from you. The deadweight loss in this scenario is the value of the airfare not purchased due to the new tax.
Example 2
Say you want to go to a concert of your favorite band. You determine that a concert ticket will cost you 80,000, however, you value the concert at 100,000. In this example, the value or benefit (100,000) exceeds the cost of the concert ticket (80,000), so you determine that it is a worthy investment and decide to walk away. The net worth of this concert is 20,000 because 100,000 minus 80,000 is 20,000.
Before you attend a concert, the government decides to impose a 50% tax on concert tickets. This means that the original cost of the ticket will increase by 50% to 120,000. This means the cost of the concert ticket now exceeds the value you set as you will now pay 120,000 for the concert ticket that you originally valued at 100,000.
Therefore, you decide to cancel the concert and the deadweight loss will be the value of the concert tickets that were not purchased due to the new government tax.
Conclusion
That’s a discussion about deadweight loss and examples in everyday life. This loss can also occur if you are a business owner. So make sure you are aware of any costs you incur and the value of each of your assets and investments.
To make this easier, you can use accounting software such as Accurate Online with the most complete features and the most affordable prices.