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How To Calculate Deadweight Loss?

How To Calculate Deadweight Loss?

how to calculate deadweight loss

How to calculate deadweight loss?

In case you are searching for the answer to this question. I must say that you are into economics and dealing with the entire market. Although only performing deadweight loss is not going to give you a complete insight into the whole market, it is crucial.

When the market condition becomes inefficient, it is crucial to calculate the deadweight loss. And here, in this article, we will talk about that.

What Is Deadweight Loss?

When you are looking for “how to calculate the deadweight loss?” you might have a basic idea about deadweight loss. You might also not exactly know what it is, and you just need the formula to complete a given assignment.

When you actually need the formula to calculate deadweight loss, it will always be best to get a basic idea about deadweight loss so that you can perform the calculation properly.

The very term “deadweight loss” usually indicates the economic loss that takes place as a result of inefficient market conditions; for example, demand and supply are totally a mess in terms of equilibrium.

What Is Deadweight Loss

At the same time, deadweight loss also refers to the economic welfare of society when it is not at the optimum level of it. Several reasons are behind deadweight losses, and they are as follows.

  • Minimum wage or price floor.
  • Rent control or price ceiling.
  • Taxation.

How To Calculate Deadweight Loss?

The deadweight loss formula is expressed as the area of the triangle that too with base, which is equivalent to the difference between the following.

  • Prices of the new demand curve and the original demand curve at the new quality demanded.
  •  Height is equal to the gap between equilibrium quantities of the new demand curve and the original demand curve.

Here is the Deadweight Loss Formula.

Deadweight loss = ½ × Price Difference × Quantity Difference.

Geometrically, this particular deadweight loss formula is expressed as the area of the triangle IGF that is illustrated in the graph. It is bounded by the downward-sloping demand curve, upwards-sloping curve, and the vertical line that is drawn parallel to ordinate for price at the latest equilibrium point.

How Does Deadweight Loss Get Created?  

Living wage and minimum wage laws may help create a deadweight loss by causing employers to overpay their employees and preventing the workers who are low-skilled from securing a job. Price ceilings or rent controls may also result in a deadweight loss by discouraging production and lessening the supply of goods, services, and houses lower than what the consumers actually demand. Consumer experience producers and shortages earn marginally less than what they would otherwise.

Taxes are also responsible for creating a deadweight loss as they prevent people from getting engaged in purchases that they would otherwise make due to the product’s final price being higher than the equilibrium market price. If the taxes imposed on an item increase, the burden is usually split between the customer and the producer, which leads to the producer making less profit from an item for which the customer is paying a relatively high price. This results in less consumption of that item than it was consumed previously, which reduces the entire benefit that the consumer market could potentially receive while parallelly reducing the benefits that the company may have seen with regard to the profits.

Oligopolies and monopolies also result in deadweight loss as they can remove all the aspects that contribute to the perfect market, in which fair competition could accurately decide the price. Monopolies and oligopolies exercise control over the supply of a specific service or good, thereby unfairly increasing its price. This would eventually result in a comparatively lesser amount of goods or services that are sold.

Cause Of Deadweight Loss   

There are three major factors that contribute to creating deadweight loss within the economy. Let us now go through some of those factors.

Price Floors   

The price of a good or service can be set by the government itself. One of the most common examples of price floors would be minimum wage.

Price Ceilings   

The highest price margin of a product or service is also determined by the government. One of the most prominent examples of price ceilings would be rent control, where the government would set a limit on how high the landlord can charge the tenants.

Taxation   

It is the amount that the government charges over the selling price of a good or service. Cigarette tax, food tax, or any such tax that you may make up for an example of taxation.

How To Calculate Deadweight Loss On A Graph?

Now, we will learn about the graphical representation of the deadweight loss formula.

The above-mentioned graph, point I, represents the price that the consumer was ready to pay initially or, in other words, the original demand curve. At the same time, point G represents the price, that the consumer is ready to pay currently, or the new demand curve.

On the other hand, both points, A and B, represent the equilibrium quantities of the new and the original demand curve, respectively. That means, as per the above-mentioned graph, the deadweight loss formula can also be expressed as the following.

Deadweight loss = ½ ×  IG × HF.

So, now, I hope you get the knowledge of “how to calculate deadweight loss formulas?”

Deadweight Loss Formula: Examples

When it comes to any mathematical formula, it is a little tough to understand the entire concept only through mathematical terms. That is why we are going to discuss the deadweight loss formula with some examples.

These examples will help you understand the entire concept of “how to calculate deadweight loss with a price ceiling?” in a much better manner.

Deadweight Loss Formula:

Example 1

Let’s take the example of theater tickets to illustrate the calculation of deadweight loss. The theater tickets cost around $9, with 1,200 in a perfect market scenario. However, the government had imposed a price floor of around $12, and due to this very price range, the demand had declined to 800 from 1200.

That means 800 individuals would be attending the theaters only because the price went up to the range of $15 in the perfect market scenario. In the given scenario, we will calculate the deadweight loss of the movie theater.

Ticket PriceIndividuals Attending Movie
$91200
$12800
$15800
Rice Difference$3
Quantity Difference400

Now, we will calculate the deadweight loss for the above-mentioned scenario.

Here, the price difference = $3,

And the quantity difference = 400.

The deadweight loss = ½ × Price Difference × Quantity Difference.

= ½ × 3 × 400.

= $ 600. 

It means the calculated deadweight loss of the movie theater is $600 in this particular case.

Example 2

Let’s start with another example of “how to calculate deadweight loss” in order to get a much clearer understanding. Here, the original demand curve is always expressed by the particular equation (-0.08x + 80). The supply is represented by (0.08x).

Note: Here, the ‘x’ is the quantity demanded.

But, due to several external factors, the demand curve had shifted to (-0.08x + 60). Now, on the basis of the given condition, we will calculate the deadweight loss using the deadweight loss formula.

Now, we will first build a table for the given new and the original demand curves along with the supply curve.

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  • As per the original demand curve, at zero demand price = -0.08 × 0 +80 

= $80.

  • As per the new demand curve, at zero demand price = -0.08 × 0 +6
  • = $60.
  • As per the supply curve, at zero demand price = 0.08 × 0 

= $0.

And so forth,

(x)Quantity(-0.08x + 80) Original Demand Curve(-0.08x + 60)New Demand Curve(0.08x)Supply Curve
375$50$30$30
500$40$20$40

From this table, we find that the initial equilibrium quantity is 500, and on the other hand, the new equilibrium quantity is 375. At the same time, both the new and original prices at the new equilibrium are, respectively, $50 and $30.

That means the price difference = $50 – $30.

= $20.

Now, the quantity difference = 500 – 375.

= 125

Using the formula of “how to calculate the deadweight loss,” we will calculate the deadweight loss.

Deadweight loss = ½ × Price Difference × Quantity Difference

= ½ × $20 × 125

= $1,250.

Deadweight Loss Formula

Why Use Deadweight Loss Formula?

The entire concept of deadweight loss is crucial from an economic viewpoint because it really helps in the assessment of societal welfare along with understanding economic development.

Typically the deadweight loss formula measures the inefficiency of a market. For example, an increased value of deadweight loss represents a higher degree of inefficiency prevalent, like losses, are seen in a market that is also characterized by monopoly and oligopoly.

To Conclude

I believe after going through this article, now, you do not need to search “how to calculate deadweight loss” anymore. At the same time, I also understand it is really tough to digest so much complicated economic information at the same time. 

So, in case you have any further doubts or queries, feel free to reach us. I will be more than happy to help you. 

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