How to Calculate Deadweight Loss: Deadweight Loss refers to the decrease in potential revenue for individuals and businesses as taxes and price controls impact business expansion and hiring ability. Explore examples of causes, and learn the formula behind calculating deadweight loss.
What is Deadweight Loss?
Alice is the owner of the Daily Grind, a very successful coffee shop. Alice has plans to open a second location because she is so successful.
She needs to hire another employee, so she doesn’t have to be in the shop every day if she wants to open a second location.
She examines her financial situation and concludes that she can afford to pay a new employee $9 per hour. Alice is then informed by her state government that the state minimum wage has been raised to $12 per hour.
Alice realizes she cannot afford an employee at $12 per hour and is forced to abandon her expansion plans.
This represents a loss for Alice because she will be unable to expand her business, a loss for the employee who could have been hired at $9 per hour, and a loss for her city, which will not benefit from the addition of another Daily Grind location.
Economists refer to this loss as a deadweight loss. The loss to society caused by price controls and taxes is referred to as deadweight loss.
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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.
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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 affecting a good’s supply and demand through price manipulation. More people will want to live in a rent-controlled building than there are apartments available (demand is greater than the supply).
How to Calculate Deadweight Loss
To calculate deadweight loss, you’ll need to know the change in price and the change in the quantity of a product or service. Use the following formula:
deadweight loss = ((Pn − Po) × (Qo − Qn)) / 2
where:
Po = the product’s original price
Pn = the product’s new price after taxes, price ceiling, and/or price floor is accounted for
Qo = the product’s quantity that was originally requested
Qn = the product’s quantity that was requested after taxes, price ceiling, and/or price floor is introduced
Use the following steps to calculate deadweight loss:
‣ Determine the original price of the product or service.
‣ Determine the new price of the product or service.
‣ Find out the product’s originally requested quantity.
‣ Find out the product’s new quantity.
‣ Calculate the deadweight loss.
Unemployment will result from a minimum wage because there will be some unemployed workers 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 raising the price of a product and lowering demand for that product.
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