Dead weight loss - Definition and Overview

In economics, a deadweight loss is a permanent loss of well being to society that can occur when equilibrium for a good or service is not Pareto optimal, (that at least one individual could be made better off without others being made worse off). Deadweight loss can be thought of destroying a given quantity of a good or service in question, and in many cases natural waste in a system (like leakage from water pipes) is equivalent to and is also called deadweight loss.

Deadweight loss can be caused by monopoly pricing (or even pricing in markets with high fixed costs), externalities or taxes or subsidies. The term deadweight loss may also be referred to as the 'excess burden of monopoly' or 'taxation'.

An important distinction should be drawn between Hicksian and Marshallian dead weight loss. The latter is related to the concept of consumer surplus, such that it can be shown that the Marshallian dead weight loss is zero where demand or supply is perfectly elastic or inelastic. Hicks analysed the situation through indifference curves and noted that even in the absence of a substitution effect (perfect inelasticity) a policy or economic situation which causes a distortion in relative prices will have an income effect and that this income effect is a dead weight loss.