Deadweight loss is something that occurs in the economy when total society welfare is not maximized. Under certain conditions, the welfare of a society (meaning consumer and producer surplus) will be at its maximum, meaning that the economy as a whole cannot be better off. Keep in mind that a society achieving its maximum welfare doesn’t necessarily mean that the welfare is distributed equally or fairly, it simply means that TOTAL (consumer plus producer) welfare is at its highest possible amount.
The conditions that must hold for societal welfare to be maximized (and thus have no deadweight loss) are:
1) Perfectly competitive markets. This means there are lots of buyers and sellers for a product, and no single buyer or seller has influence over the price. In this case we prefer perfect competition to monopolies, monopolistic competition, and oligopolies.
2) No externalities in the market. This assumes that no externalities from production or consumption occur, such as pollution. This ensures that the market price reacts to the true marginal benefits and marginal costs to society.
3) No government intervention. Government policies such as quotas, taxes, and price ceilings or floors will create a deadweight loss if conditions 1 and 2 hold.
We will now go through some examples, showing how if these conditions are violated, a deadweight loss will arise.
Not having a perfectly competitive market. Let’s assume that we have a monopoly, in this case a monopoly choose to produce where marginal revenue equals marginal cost, instead of where society’s marginal benefit equals marginal cost.
Point A shows us where the monopoly decides to produce, where point B shows us where production would take place under perfectly competitive conditions. The difference between the marginal benefits and marginal costs between these two points (the area of a triangle), shows us the deadweight loss caused by the monopoly.
Next, let’s consider the effect of a negative externality such as pollution. Here we will have a private marginal cost curve, and a social marginal cost curve. The private firm produces where private marginal cost equals marginal benefit, but society will want it to produce where social marginal cost equals marginal benefit.
Private firms will produce at point A, but society will have maximum benefits if equilibrium occurs at point B. The total difference between SMC (social marginal cost) and marginal benefit between these two points will give us the deadweight loss that occurs for this situation.
Finally let’s consider one form of government intervention, a quota.
Point A shows where the economy will produce with the quota. However, under ideal circumstances the economy would like to produce at point B. Again, the difference between marginal benefits and marginal costs between these two quantities shows us the deadweight loss that occurs in the economy.
Remember: Economists hate deadweight loss, they prefer efficient outcomes. Whenever a policy results in a deadweight loss, economists try to find a way recapture the losses from the deadweight loss. Sometimes if conditions 1 or 2 don’t hold, then government intervention may be necessary in order to alleviate an economy of a deadweight loss.