In economics, a deadweight loss (also known as excess burden) is a permanent loss of well being to society that can occur when equilibrium for a good or service is not Pareto optimal (at least one individual could be made better off without others being made worse off). Deadweight loss can be thought of destroying a given quantity of a good or service in question, and in many cases natural waste in a system (like leakage from water pipes) is equivalent to, and is also called, deadweight loss.

Deadweight loss can be caused (though not necessarily) by monopoly pricing (or even pricing in markets with high fixed costs), externalities or taxes or subsidies. (Case and Fair, 1999: 442). The term deadweight loss may also be referred to as the "excess burden of monopoly" or the "excess burden of taxation".

To illustrate: imagine there is a monopoly on nails. Suppose that the marginal cost of a nail is 10 cents. Suppose that demand for nails is uniformly distributed between 0 and $1.10. The monopolist can sustainably sell nails for any price between $0.10 and $1.10. Their profit is greatest at a price of $0.60, so they choose that. But none of the people who were willing to pay less than 60 cents get nails. Those with valuations between $0.10 and $0.60 could at least theoretically have bought nails and obtained a surplus without making the monopolist or anyone else worse off, so the situation is Pareto inefficient.

An important distinction should be drawn between Hicksian and Marshallian deadweight loss. The latter is related to the concept of consumer surplus, such that it can be shown that the Marshallian deadweight loss is zero where demand or supply is perfectly elastic or inelastic. Hicks analysed the situation through indifference curves and noted that when the Marshallian Demand Curve exhibits perfect inelasticity (this happens when the good is inferior and its income effect counterbalances its substitution effect), a policy or economic situation which causes a distortion in relative prices will have an income effect and that this income effect is a deadweight loss.

References

• Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.

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