What this lesson teaches
I can explain deadweight loss as society's lost net benefit when output is not at the social optimum.
Syllabus 8843, 2.2.1(c). Governments' Microeconomic Objectives: Deadweight loss results when the social optimum is not achieved; Deadweight loss can be explained as the reduction in net benefit to society when output level is not at the social optimum
Make a guess
A factory's pollution costs nearby residents $320 a week in total. Is the deadweight loss to society $320?
- No. It is only the loss from units that should not be produced.
- Yes. The deadweight loss is the total external cost.
- No. The deadweight loss is zero if the factory makes a profit.
Show the answer
No. It is only the loss from units that should not be produced.
Some output is worth producing even after its pollution cost. The deadweight loss comes only from the extra units beyond the efficient output.
Deadweight loss is the net benefit society loses when output is not at the efficient level.
Deadweight loss (DWL) measures how much worse off society is because output is at Qp instead of Qs.
With a negative externality, each unit between Qs and Qp costs society more than it is worth. The DWL is the sum of those excess costs: the triangle between MSC and MSB from Qs to Qp.
With a positive externality, each unit between Qp and Qs would have been worth more than it cost, but is not produced. The DWL is the benefit given up.
Deadweight loss is not the same as the total external cost. Some external cost is worth bearing, because the good is still worth producing up to Qs.
- DWL
- Net benefit lost from producing the wrong quantity.
- Not the same as
- Total external cost.
Worked example: Damage versus avoidable loss
In a market with a negative externality, the market produces 80 units, the efficient level is 60, and the marginal external cost is a constant $4 a unit.
- Total external cost at 80 units: 80 x $4 = $320.
- Deadweight loss: only the 20 excess units, 1/2 x 20 x $4 = $40.
- The other $280 of external cost comes from units worth producing, so it is not avoidable waste.
- Correcting the market removes the $40 deadweight loss, not all the external cost.
Watch out for this
Deadweight loss equals the total external cost.
DWL is only the net loss from producing the wrong quantity. The external cost of the efficient units is not a deadweight loss.
Check your understanding
A market with a negative externality moves from Qp to Qs. What happens?
- The external cost disappears, because output is now at the efficient level.
- The deadweight loss is removed, although the units still made cause some external cost.
- Deadweight loss increases, because firms produce less than before.
Show the answer
The deadweight loss is removed, although the units still made cause some external cost.
Right. At Qs, remaining external costs are outweighed by benefits.