How does one calculate deadweight loss?

Deadweight loss is the situation of market inefficiency resulting when the market is not in equilibrium condition.

Deadweight loss is the result of government regulations on price (price floor and price ceilings), tax, tariff, or artificial scarcity aroused from monopoly.

Let’s take an example of how taxation results in deadweight loss. For this let’s look at the graph shown below:

Here, in the graph above, the equilibrium price and quantity before imposition of tax is “Q0 and P0”.

Since tax is imposed on the producer’s, supply curve shift towards left from Supply0 to Supply1. This is because, producers want to supply less when he is imposed under tax. This results in in-equilibrium in the market.

If tax is imposed; regardless on whom it is imposed (i.e. either buyer or seller) both buyer and seller has to bear the tax burden (respective to the of demand and supply). Hence, after imposition of tax, the buyer’s price would increase to “P1” while supplier will receive fewer prices as it falls to “P2” from equilibrium price “P0”. The quantity demanded at these two prices are same i.e. “Q1”. Hence, at equilibrium quantity of “Q1” there is market in-efficiency.

Now, this situation results in creation of Deadweight loss represented by yellow and green triangle in graph above (DWL).

DWL is calculated as the area of the triangle: i.e ##color(red)(DWL)## = ##color(blue)(1/2)## *##color(yellow)((P2-P1))## * ##color(green)((Q0-Q1))##

In other words, Deadweight loss is equals to half of product of tax imposed with that of change in equilibrium quantity after imposition of tax.

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