Deadweight loss in economics refers to a loss in total welfare among market participants. In economic markets, deadweight loss occurs when the supply and demand forces are stopped from interacting to produce an equilibrium price and quantity. Two recent news items provide good examples of the concept at work: one from a pure economics perspective; the other from a political economy perspective.
To understand deadweight loss one must first understand the basics of supply and demand, and how each curve produces a point of equilibrium. The two primary agents in any competitive market are producers and consumers. Each has its own curve that reveals a series of price/quantity combinations they would be willing to agree to. For consumers, it is a demand curve, and for producers, it is a supply curve. Neither of these curves exists in isolation, and hence interact to produce market equilibrium: the point where demand and supply meet. All of the points on the supply and demand curves prior to that equilibrium combine to create economic welfare, or total welfare (TW). That is, at any price/quantity combination before equilibrium on their respective curves, both producers and consumers will be maximizing their welfare. Consumers (demanders) will be maximizing their welfare because any price prior to equilibrium is a higher price they would have been willing to pay but now do not have to since equilibrium price is lower on the demand curve, according to the law of demand. Now that the market is in equilibrium with a lower price, they have more money left to consume other products they need or want. Hence, their welfare is being maximized.
So too are producers maximizing their welfare: any point on a supply curve represents a price/quantity combination that we can safely assume results in a profit for the producer. Though producers would prefer to produce more of a good or service at higher prices (law of supply), their concerns for profit limit them to produce at the point where the demand curve crosses their supply curve. Therefore, one can understand any point on a supply curve prior to equilibrium as one the producer would have been willing to produce at but now does not have to be limited to since equilibrium is higher (and hence profits will be higher).
Graphically, market equilibrium and total welfare look like this, with equilibrium being represented by the dot in the middle, and TW being represented by the area prior to equilibrium, below the demand curve, and above the supply curve:
Deadweight loss occurs when there is a mismatch between these curves, resulting in a surplus of welfare for the consumer and producer, and hence a loss of total welfare. For example, assume a producer was limited to charging $40 dollars for their product represented by the market above. Limiting producers to charging $40 would encourage them to produce a quantity below equilibrium – say, 400 gallons. In other words, though they could be producing 100 more gallons to be sold at a higher cost, they are not being allowed to. Hence, their welfare has been limited. But so too has the consumer’s welfare been limited. At $40 consumers are demanding more milk – say 600 gallons. Because they cannot obtain that milk at that price, their welfare has also been limited. Both losses of welfare slow an economy down – weigh it down – by misallocating resources (more milk could be produced if the price were allowed to rise, more money could be spent if producers were allowed to raise the price). That loss to the economy is deadweight loss.
A good example of this occurring in the real world is in the labor market for construction. As is noted by the New York Times today, a construction executive revealed to Congress in March that their industry was short approximately 100,000 workers in spite of business being similar to their market in 2007. In other words, though demand for construction labor is as high as it was prior to the Great Recession’s onset – which should translate to higher labor prices (i.e., wages) for construction firms in order to attract labor in order to meet that supply -, the supply of labor to that industry has fallen short of what it should be. Being in disequilibrium, total welfare is not being maximized. For construction firms are willing to hire – demanding – up to 100,000 more workers (consumer surplus), which would lead to more construction (quantity), and hence to more profit. If that could happen, their welfare would be maximized. For suppliers of labor – workers – their welfare is not being maximized as well: the labor market is willing to supply a higher quantity of labor it cannot currently (producer surplus). If it could supply that labor, the price of all labor would rise (through forces of competition), thus maximizing the total welfare of all current and future labor suppliers in the labor market.
A less obvious example of deadweight loss, but no less important, comes from the political economy perspective. Former Greek Finance Minister Yanis Varoufakis offered this week his own prescription for mending the political ailments of the West’s contemporary political economy. According to Varoufakis, the cause of these ailments is something akin to deadweight loss in the political sphere. The introduction of previously outsider ideas and politicians into mainstream (read: more centrist, less extreme) politics is “the result [of] a situation in which the political establishment’s once unassailable authority has died, but before any credible replacement has been born. The cloud of uncertainty and volatility that envelops us today is the product of this gap.”
The gap Varoufakis refers to may be understood as deadweight loss. According to his analysis, the supply of a governing authority with enough legitimacy among the necessary parties concerned so as to be considered “unassailable” has been lower than the demand by concerned parties for them. For whatever reason, unassailable ideas (i.e., centrist ideas), or politicians beholding these ideas that are electable, has not been supplied to the electorate by those arenas typically producing these ideas and/or politicians in spite of a demand for them. This has lead to a situation where voters and other concerned parties are therefore instead willing to pay a higher price (a broader constituency of voters) for candidates with less popular appeal. The welfare for political demanders (i.e., voters), and political suppliers (i.e., ideas and politicians) has both been sacrificed, leading to a loss in total welfare, and the rise of “extremist” candidates and ideas.
But don’t bother explaining these concepts to Energy Secretary Rick Perry; he clearly needs a lot more help on the basics of economics, energy, education,…