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17.11 Efficiency and Deadweight Loss
The outcome of a competitive market has a very important property. In equilibrium, all gains from trade are realized. This means that there is no additional surplus to obtain from further trades between buyers and sellers. In this situation, we say that the allocation of goods and services in the economy is efficient. However, markets sometimes fail to operate properly and not all gains from trade are exhausted. In this case, some buyer surplus, seller surplus, or both are lost. Economists call this a deadweight loss.
The deadweight loss from a monopoly is illustrated in Figure 17.8 "Deadweight Loss". The monopolist produces a quantity such that marginal revenue equals marginal cost. The price is determined by the demand curve at this quantity. A monopoly makes a profit equal to total revenue minus total cost. When the total output is less than socially optimal, there is a deadweight loss, which is indicated by the red area in Figure 17.8 "Deadweight Loss".
Deadweight loss arises in other situations, such as when there are quantity or price restrictions. It also arises when taxes or subsidies are imposed in a market. Tax incidence is the way in which the burden of a tax falls on buyers and sellers—that is, who suffers most of the deadweight loss. In general, the incidence of a tax depends on the elasticities of supply and demand.
A tax creates a difference between the price paid by the buyer and the price received by the seller (Figure 17.9 "Tax Burdens"). The burden of the tax and the deadweight loss are defined relative to the tax-free competitive equilibrium. The tax burden borne by the buyer is the difference between the price paid under the tax and the price paid in the competitive equilibrium. Similarly, the burden of the seller is the difference between the price in the competitive equilibrium and the price received under the equilibrium with taxes. The burden borne by the buyer is higher—all else being the same—if demand is less elastic. The burden borne by the seller is higher—all else being the same—if supply is less elastic.
The deadweight loss from the tax measures the sum of the buyer’s lost surplus and the seller’s lost surplus in the equilibrium with the tax. The total amount of the deadweight loss therefore also depends on the elasticities of demand and supply. The smaller these elasticities, the closer the equilibrium quantity traded with a tax will be to the equilibrium quantity traded without a tax, and the smaller is the deadweight loss.
- In a competitive market, all the gains from trade are realized.
- If sellers have market power, some gains from trade are lost because the quantity traded is below the competitive level.
- Other market distortions, such as taxes, subsidies, price floors, or price ceilings, similarly cause the amount to be traded to differ from the competitive level and cause deadweight loss.
Figure 17.8 Deadweight Loss
Figure 17.9 Tax Burdens
The Main Uses of This Tool
- Chapter 5 "eBay and craigslist"
- Chapter 7 "Why Do Prices Change?"
- Chapter 9 "Making and Losing Money on Wall Street"
- Chapter 10 "Raising the Wage Floor"
- Chapter 11 "Barriers to Trade and the Underground Economy"
- Chapter 12 "Superstars"
- Chapter 13 "Cleaning Up the Air and Using Up the Oil"
- Chapter 14 "Busting Up Monopolies"
- Chapter 15 "A Healthy Economy"
- Chapter 16 "Cars"