Deadweight Loss

A deadweight loss indicates the amount of economic welfare lost to the economy due to either (1) a market failure or (2) interference by government in an otherwise efficient marketplace. The deadweight loss comes at the expense of consumer or producer welfare, or both (in varying degrees).

A producer's monopolization of a market leads to a market failure when successful in restricting the quantity sold and raising the price per unit sold. This monopolization is a market failure because if the price could be lowered and the quantity sold increased this change would create a net benefit to society. In fact, the marginal (i.e., extra) benefit to consumers exceeds the marginal (i.e., extra) cost to the producer up to the point where the marginal social cost curve crosses the marginal social benefit curve. Simply put, this point is where supply equals demand. A market characterized by perfect competition would achieve that socially desirable result.

Figure 1 shows the standard model of a monopoly market. The deadweight loss from monopolization is the shaded triangle.

Figure 1 Deadweight Loss From Monopolization

In the upper panel, the monopolist uses the available degree of market power to set the price (PM) and quantity to be sold (QM), thus securing an economic profit (defined as above the competitive outcome) as shown by the shaded rectangle. This profit arises because the average revenue (AR) exceeds the average total cost (ATC) at the quantity sold. The lower panel takes this market and redefines it in economic welfare terms. By assuming there are no spillovers of this activity (i.e., externalities) into other markets, (1) the marginal cost (MC) will equal the marginal social cost (MSC) and (2) the demand (D) will equal the marginal social benefit (MSB). From this perspective, it can be seen that QM is characterized by MSBM exceeding MSCM, and this condition means that society would receive a net marginal benefit if further output could be produced. Of course, the monopolist has no incentive to lower economic profits by doing so. In fact, net marginal benefits occur up to a level of output equal to Q∗ (where MSB = MSC). The total of all the marginal benefits foregone because Q∗ is not produced at a price of P∗ is shown by the shaded deadweight loss triangle.

It may also be the case that the deadweight loss from monopolization could be significantly more than what the triangle indicates. If rent-seeking activity occurs before a producer can achieve market power, then both the monopolist and his rivals will be devoting funds to obtain a government license in order to dominate the market. Examples of this situation occur in the market for taxi medallions and television broadcasting licenses. Those rivals who spend money and yet ultimately lose the fight for the license have been encouraged by a regulatory environment in which the winning strategy is not clear. All resources spent in this inefficient process must be added to the deadweight loss triangle. In the extreme case, the entire economic profit rectangle could be dissipated because of destructive competition to achieve monopoly rights.

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