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Deadweight Loss in Economics: Definition, Formula & Example

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  • 0:00 What Is Deadweight Loss?
  • 1:10 Causes Of Deadweight Loss
  • 2:36 How To Calculate…
  • 5:38 Lesson Summary
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Lesson Transcript
Instructor: Adam Gifford

Adam holds an MBA and a MS in Human Resources

In this lesson we will discuss the concept of deadweight loss. We will first define it, then apply the formula needed to calculate it, and cite examples.

What Is Deadweight Loss?

Alice is the owner of a very successful coffee shop called the Daily Grind. Alice is so successful that she has plans to open a second location. In order for her to open a second location, she needs to hire another employee so that she doesn't have to be in the shop every day. She looks at her financials and determines that she can afford to pay a new employee $9 per hour. Alice then learns that her state government just increased the state minimum wage to $12 per hour.

Alice realizes that she cannot afford an employee at $12 per hour, so she is forced to cancel her plans of expanding her business. This represents a loss to Alice because she can no longer expand her business, a loss to the employee that she could have hired at $9 per hour, and a loss to her city which will not gain the benefit of another Daily Grind location. This loss is referred to as deadweight loss by economists. Deadweight loss is defined as the loss to society that is caused by price controls and taxes.

Causes Of Deadweight Loss

There are three main causes of deadweight loss:

Price ceilings - These are government sanctioned price controls that prohibit a seller from charging above a set amount for a good or service. An example of a price ceiling is rent control. This occurs when the government sets a maximum amount of money that a landlord can charge for rent.

Price floors - These are government sanctioned price controls that prohibit a seller from charging below a set amount for a good or service. An example of a price floor is minimum wage. This occurs when the government sets a minimum amount of money that a person can sell their hourly labor for.

Taxes - This is the money that the government charges above the selling price of a good or service. An example of this would be the sales tax that some states charge on the sale of certain goods.

Price ceilings, price floors and taxes all cause deadweight loss by altering the supply and demand of a good through price manipulation. A rent-controlled building will have more people who want to live there than apartments available (demand is greater than the supply). A minimum wage will create unemployment because there will be some unemployed workers who are willing to work for a certain wage, and employers who need employees but cannot afford to pay the minimum wage. Taxes cause deadweight loss by increasing the price of a product which in turn decreases the demand for that product.

How To Calculate Deadweight Loss

In order to calculate deadweight loss, you are going to need to know four pieces of information:

  1. The original price of the product being measured. We will call this P1.
  2. The new price of the product after the price ceiling, price floor or tax is imposed. We will call this P2.
  3. The original quantity demanded of the product being measured. We will call this Q1.
  4. The new quantity demanded of the product after the price ceiling, price floor or tax is imposed. We will call this Q2.

The formula to determine deadweight loss is as follows:

Deadweight Loss = .5 * (P2 - P1) * (Q1 - Q2)

So, let's use this formula to see another way that Alice has experienced deadweight loss at Daily Grind.

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