How to calculate deadweight loss? Someone requested me to write about this. I tell him, no problem my friend I will definitely write to you.
Here I just try to explain a few things that really need to know to understand about deadweight loss.
You should Understand:
- Deadweight Loss is a reduction in consumer surplus (Consumer Surplus) and surplus producers that occur when the output of a product is limited so that it is lower than the optimum efficiency level.
- Deadweight Loss is a loss of economic efficiency for consumers/producers because the efficiency of resource allocation is not achieved.
- DWL is created due to market inefficiency.
- DWL occurs when supply and demand are not at the equilibrium point.
If a tax is levied on the producer for each unit of goods he sells, then the price balance will change higher. Then part of the burden will be passed on to the consumer.
If the consumer feels that the price of a good does not match / higher than the perceived benefit, then they are less likely to buy the item. With reduced levels of trade, resource allocations become inefficient, which can lead to reduced overall wellbeing in a society.
Causes of Deadweight Loss:
- The base price is the minimum price level applied.
For example, if the government sets a floor price of Rp 700 per kilogram of rice, then buyers should buy grain from farmers with prices as low as Rp 700 per kilogram.
Another example, if the government sets a minimum wage of Rp 15,000 per day, the employer must pay the workforce at least Rp 15,000 per day
- If the base price is above the equilibrium point, it will affect demand and supply.
- The Minimum Wage may cause employers to pay higher wages to workers.
This makes the company even tighter in selecting workers, thus preventing workers with low skills to find work.
- The graph above is an example of applying the base price on the market.
- The base price above the equilibrium point will cause the bidding to rise. In the above chart, the offer goes up to 700,000 tonnes.
- While demand fell to 200,000 tons.
- Triangle A and B are DWL.
- The lost consumer surplus is the size of the triangle A.
- The lost Manufacturer’s surplus is the size of a triangle B.
- On the curve above the labor market balance occurs at the price of Rp 2,500 / day, with employment of 5,000 workers/month.
- When the government sets a minimum wage above the equilibrium price in the market, the demand for labor declines, but labor supply rises.
- Companies are even tighter in choosing workers, even reducing their workers for higher salaries.
- On the other hand, people are attracted to higher salaries, causing labor supply to rise.
- This causes unemployment of 5000 people/month (7000-2000).
- DWL is as big as A and B triangles.
- The highest price (ceiling price) is the maximum limit of the sales price by the manufacturer.
- The purpose of the highest price determination is so that the price of the product can be affordable for consumers whose purchasing power is less.
- The highest price below the equilibrium price can cause DWL.
- Companies that have been set for a product price per unit below the price will usually shrink its production or reduce the supply of goods below that is actually requested by consumers.
This causes consumers to experience a shortage of needs and producers earn revenue lower than usual.
- In the graph above, the balance occurs at the instant noodle price level of Rp 1,000 per pack, with the amount of 15 million packs per month.
- At the highest price of Rp 750 per pack, bidding fell to 10 million, while demand rose to 16.25 million.
- This led to an excess demand of 6.25 million (16.25 million – 10 million) packs per month.
- DWL or lost economic surplus is the size of triangle A and B.
- Quotas or production restrictions are government policies to limit the amount of production of goods or services sold in the market.
- Quota aims to influence and keep the price level.
- Without government intervention, the balance of the corn market in the above curve occurs at point E1 with the amount of corn Qo and the price of Po.
- If the government wants to keep the corn price at least P1, then the production amount should be limited by Q1 only.
- The supply curve becomes S1, and the price rises to P1.
- This causes the loss of a consumer surplus of A + B.
- Manufacturers lose C surplus but get an additional surplus of A.
- DWL is an area of triangle B and C.
Nb: for corn producers to reduce their production to Q1 level, financial incentives must be provided at least as large as B + C + F.
- Taxes are used as a means of economic stabilization.
- Taxes can cause DWL because it can prevent people from making purchases they are supposed to make.
- The final price of the product becomes more expensive because it is taxed so it can cause people are reluctant to buy.
- If a goods tax rises, the tax burden will be shared with producers and consumers.
- Manufacturers get less profit from the goods because of taxes, while consumers have to pay higher prices.
This causes the consumption of goods is lower than before.
- On the curve above, the imposition of a tax to the producer causes the supply curve to shift to the left. (So to S1)
- The equilibrium price becomes P1, and the sum of equilibrium becomes Q1.
- This causes consumers to lose a surplus of A + B.
- Manufacturers lose a surplus of F + C.
- The government earns an income of A + F. (0Q1 * (P1-P2))
- DWL is a triangle B + C.
- The gray box is the amount of tax revenue.
- DWL is a triangular area made up of gray boxes of tax receipts, initial supply curves, and demand curves.
- The triangle is also known as the Harberger Triangle (Harberger’s Triangle).
I hope you understand that How to calculate deadweight loss? It really helpful informative article.