Deadweight loss describes the loss to an economy as a result of market inefficiencies. Market inefficiencies occur as a result of not allowing the free market to set where the supply and demand curves intersect.
Deadweight loss occurs when supply and demand are not in equilibrium. When suppliers can not make a large enough profit on a good or service, they are less likely to produce the item. When consumers feel the price of a good or service is too high, they are less likely to buy the item. The reduced level of trade between suppliers and consumers results in deadweight loss in an economy.
How Taxes Create Deadweight Loss
In a market without taxation, we will say that a package of socks will sell at a fair market price of $14. This $14 equilibrium price is set where the supply and demand curves cross.
When taxes hit the package of socks, the buyer pays a higher price of $15.40, and the seller receives a lower price of $11. Taxation lowers demand to d1 because buyers have to pay a higher price for socks. The seller is also taxed, and so he receives less profit for his package of socks. If there’s less profit, the supplier will supply fewer socks at a level of s1.
The amount that the government receives in taxes is equal to the buyer’s price minus the seller’s price, multiplied by the quantity of the transaction, whether for goods or services. The area of the light red rectangle is the tax revenue collected by the government. The area of the dark red triangle is equal to the economic value that is lost to taxation.
This loss of economic value consists of buyers who will either buy less or not at all because the price is higher than what they can afford so they decide to do without. Likewise, some suppliers will not produce the product because they are not receiving a high enough price to cover their costs. The benefit that these buyers and sellers would have added to the economy if it were not for taxation is called the deadweight loss of taxation. Because these buyers and sellers do not participate in the market, they do not contribute to the tax. Instead, the taxes are paid by the buyers and sellers who continue to participate in the market. The tax burden falls on the fewer buyers and sellers who continue to participate in the market. A vicious taxation loop can start where a government raises taxes more to offset lower tax revenues caused by rising deadweight loss.
Demand and Supply Elasticity
Demand elasticity is the change in quantity demanded at a particular price. If a large change in price results in little change in the quantity demanded, then demand is considered inelastic. If a small change in price results in large changes in the quantity demanded, then demand is considered elastic.
Products that have good substitutes have a high elasticity of demand, since if the price of one substitute increases, buyers can switch to another substitute. For example, if the price of beef increases, then people will buy more chicken, ham, pork, or some other meat. Beef is considered an elastic product.
Products that have fewer or no substitutes have a high inelasticity of demand since if the price increases, there are no substitute products buyers can switch to. For example, if gasoline and oil prices increase, buyers have to pay the higher price because there are no close substitutes.
Supply elasticity is the change in supply costs at a particular price. If the supply changes little with a change in price, then supplies are considered inelastic. Supply is elastic if there are large changes in supply for a small change in price.
For example, the supply of land is inelastic because no one is making any more of it. By contrast, the supply of software is fairly elastic since it costs very little to make and distribute copies of software over the internet.
Deadweight Loss Varies with Elasticity
The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is small, because the quantity bought or sold does not vary much with the price.
Demand Inelasticity and Deadweight Loss
Buyers need to have the product and so changing the price through taxation is not going to change that. For example, buyers need gasoline to operate their automobile. Gasoline is inelastic as there are no substitutes. Raising taxes on gasoline will result in a lower deadweight loss.
Supply Inelasticity and Deadweight Loss
Sellers want to sell land, and so the tax rate is not going to heavily influence the supply of land for sale. The supply of land is inelastic because, as Will Rogers once said, they’re not making any more of the stuff. Raising taxes on land sales will result in a lower deadweight loss.
Deadweight loss increases proportionately to the elasticity of either supply or demand.
Higher Taxes and Deadweight Loss
Balancing the tax rate which gives the most tax revenue with the least amount of deadweight loss is impossible. The tax rate that worked during the Bill Clinton Administration did not work during the Obama Administration. An endless amount of factors come into play when determining a moderate tax rate with the most yield versus minimal deadweight loss. What we do know is that when the tax rate is small, there is less deadweight loss and conversely, when the tax rate is high, there is more deadweight loss as illustrated in the two graphs below.
As can be seen from the graph below, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax. Likewise, tax revenue increases at first but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate.
How Rent Control Creates Deadweight Loss
In a free, non-rent controlled market, the price of rent is established by the market where the supply and demand curves cross.
Look at what happens when rent control is introduced into a free market.
The red horizontal line represents rent control, or the maximum price landlords can charge for rent. The lower price of rent increases demand to “B.” However, since suppliers (owners) cannot charge the same rent that a free market would support, they choose to supply less rental units to the market at point “A.”
The gap between market demand and market supply is a shortage shown as a red shaded area. This shortage of rental units means that the competition for rental units becomes increasingly stiff and even well-qualified prospective tenants will find it difficult to find adequate housing in rent controlled cities. Worse, setting a price ceiling in cities like San Franciso and New York that have high property taxes and high maintenance costs means landlords would make hardly any profit and perhaps even lose money on rental properties. In other words, through rent control, the government has provided a strong disincentive for landlords to provide sufficient supply to meet a growing cities’ demand.
Rent control hurts local tax revenues as well because owners are bringing in less taxable income from their properties. Look at where the blue line intersects the demand curve at “D.” Point “D” represents the price renters would be willing to pay at the lower supply landlords provide under rent control. In other words, there are fewer rental units to tax (as supply contracts) and lower income tax paid by owners (because owners are making less). That’s a contraction in a local real estate market of both supply and lower tax revenues brought on by rent control. The local government must raise some other tax to offset what was lost from rent control, thereby increasing deadweight loss from taxation.
The blue shaded area represents a deadweight loss to a local economy from rent control. Deadweight loss is a loss of economic efficiency caused by rent control because more landlords could be leasing and thus more renters who could be renting (because of greater supply) if it were not for the price ceiling.<< Back to Glossary Index