Deadweight Loss: Taxes, Monopoly, Regulation

Deadweight Loss: taxes, monopoly, regulation

Deadweight loss (DWL) is the net welfare loss that no one receives. This is the price of market inefficiency or inefficient intervention.

Sources of DWL

Taxes:

• Wedge between buyer and seller price
• Some transactions do not occur
• DWL = ½ × t × ΔQ

Monopoly:

• $P > MC \to Q$
• Transactions profitable at $P = MC$ do not occur

Price controls:

• Price ceiling below equilibrium → shortage, DWL
• Price floor above equilibrium → surplus, DWL

Subsidies:

• $Q >$ efficient
• Units are produced whose costs exceed value

Calculating DWL

Graphically: a triangle between the demand and supply curves, from the distorted to the efficient quantity.

Formula (for small changes): $ DWL \approx \frac{1}{2} \times |\Delta P| \times |\Delta Q| $

Dependence on elasticity: the more elastic demand and supply are, the greater the DWL for the same distortion.

DWL of taxes in detail

DWL grows with the square of the tax rate: doubling the tax quadruples the DWL.

Consequence:

• Many small taxes are better than one large one
• A broad tax base with low rates is more efficient

Laffer curve: at sufficiently high rates DWL is so great that tax revenues fall.

Comparison of policies

Welfare analysis: comparison of $\Delta CS + \Delta PS + \Delta$ Gov Revenue $- DWL$.

Example — tax:

• CS falls
• PS falls
• The government receives revenue
• But CS + PS falls by more than the government receives — the difference = DWL

For the investor

Inefficient markets = potential: if DWL can be eliminated (deregulation, technology), growth is possible.

Regulatory costs: assessment of the real impact of regulation on the industry.