Deadweight loss

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Definition

A deadweight loss is a loss that occurs because a potential market transaction (such as the purchase of a good or service) that would benefit all the parties involved in the transaction, does not occur.

Types of deadweight loss

Deadweight loss due to market power of sellers

Further information: Deadweight loss due to market power of sellers

The combination of a monopoly or near-monopoly (or a seller with significant market power) with the law of one price (which forces the seller to sell at the same price to all buyers) results in a deadweight loss.

Here, sellers are unwilling to sell goods at a profitable low price to certain buyers, because reducing the price for these buyers would also entail reducing the price for other high-paying customers, which would reduce the overall profit margin.

There are two remedies to this: increasing competition and reducing the market power of sellers, and allowing the sellers to practice price discrimination. The former remedy hurts the seller but benefits the buyers more. The latter remedy increases the total social surplus created but bulk of the surplus is gathered by the seller.

Deadweight loss due to external benefits

Further information: Deadweight loss due to external benefits

Certain potential market transactions may have positive external benefits for others who are not directly involved in the transaction. However, these transactions do not occur because they do not offer a net benefit to the parties involved in the transaction.

By allowing these other parties to pay the original parties in the transaction some money to compensate for the original benefits, it may be possible to carry out the original transaction in a manner that benefits all.

Deadweight loss due to taxation

Further information: Deadweight loss due to taxation

Here, a direct or indirect tax by a legal entity such as a government or an illegal entity such as an extortionist results in certain transactions that would have otherwise occurred to not occur.

This happens if the amount of the tax is greater than the social surplus generated by the transaction.