Wednesday, February 15, 2006


NP - Klimt 1918 - Dopoguerra

Yesterday while I was walking home, on the side of the road I saw...a brain. Yep, a brain, all pink and wrinkled and, well, rather naked. It was interesting; something different from the usual twigs and leaves and litter. I actually stopped to get a closer look. Obviously it wasn't a real brain: plastic, looked like one of those fake brains they have in schools to teach schoolkids anatomy. It was pretty cool though; should have take a picture, but I didn't think of it at the time.

Anyway I've had this question on my mind for a while now. Its an Economics thing, but its very basic (for those of you who aren't interested, thats you're que to stop reading!).

We're taught that having an infinite number of firms in the market, each of whom is small and has no market power, is good. With such a large number of small firms, each one is a price taker, i.e. they dont affect the price of the good. Price is determined by costs, so that, in a perfectly competitive market, the price equals the marginal cost. Firms thus make zero profits. This maximises consumer surplus and minimises producer surplus. Total welfare is maximised, with zero deadweight loss.

Consider the other extreme, a monopoly. The monopolist can set whatever price he chooses - to maximise profit, he sets his price so that marginal cost equals marginal revenue. This creates profits for him, and so there is a producer surplus. Consumer surplus falls , and - this is the important bit - total welfare falls, as this creates a deadweight loss.

We aren't told, in real terms, what a deadweight loss is. We're taught that its a drop in welfare. Theoretically, this works. But I try to figure it out in real terms. What is a 'loss in welfare'? If we look at welfare strictly as money, well, in a closed economy (an economy with no international trade), the money isnt going anywhere. It stays within the country. Lets look at deadweight loss due to taxes and large government regulation and that. Without getting into details, this causes a deadweight loss, because we (consumers) are paying more of our money in taxes to the government. But this money isnt 'lost'. It goes to pay the lawyers, judges, civil servants, etc. The people who work in the courts to administer this rules, the people who work in the regulating bodies in order to enforce fairness of trade, etc. The money is being redistributed, isnt it? In the case of a monopoly causing deadweight loss, well, lets say a firm is ' inefficient', that is to say, its costs are not as low as they may be. It spends more on wages, equipment, etc., and thus the price of its product(s) is higher. This money isn't lost - its being redistributed. Suppliers to that firm are getting more money, those the firm relies on in order to continue its operations are making increased profits. These profits in turn get redistributed to employees of those firms (as well as to the owners).

My point is that money isnt actually lost, is it? So why is deadweight loss strictly bad? Perhaps I'm missing so simple and basic, and yet it must be fundamental, because this is such a pillar in economics it seems, that deadweight loss is bad (unless offset by efficiency gains somewhere else). I feel pretty stupid asking my lecturers this question, because I'm afraid I've missed something basic. Can anyoe help me out here?

Posted by illogicist at 4:04 AM


  1. Blogger Arabian Princess posted at 2/18/2006 12:23:00 AM  
    Woow your post sent me few years back, I miss economics!!

    I am not sure if I understand it well, but redistributing the money could be a deadweight loss. I mean it could mean that the resources are concentrated on one segment of the society so there would not be effective distribution of the the resources (when the rich gets richer, and poor gets poorer?)

    not sure if I got it right .. I guess its best to ask your lecturer even if you think it sounded silly.. who knows maybe you came up with a new theory :)
  2. Blogger Sree posted at 2/20/2006 06:12:00 AM  
    I did think of the 'deadweight' loss part a bit too, but unlike AP here Economics wasn't my forte at school - actually God alone knows why I made good grades in those classes.

    Anyways, after reading AP's post, if that is why its a 'deadweight' loss then I think it is justified to a certain extent. But, Z also mentions about taxation and deadweight loss - which I'm still confused on. Can anyone explain it to me once again please?
  3. Blogger Per Your Request posted at 2/20/2006 06:12:00 AM  
    In regards to deadweight loss, it is due to the fact that society is not operating at its highest point on the production possibility frontier. Therefore the resources are not utilized efficiently and consumers/individuals are unable to maximize their benefit given the available resources. Thus a deadweight loss in terms of utility.
    On your point about taxes, economics assumes that each individual has their own indifference curve, and individual decides about what to consume given their budget constraint. If government interferes and adjusts each individual’s budget constraint by t, then society as a whole is not maximizing its allocation of the goods of their choice. I don’t know about you, but I think I can spend my money better than anyone else can!
    Ive been stopping by for a while, and I have enjoyed your blog. Finally got the chance to comment.My blog is brand new, but the plan is for it to be economics based. Stop by.
  4. Blogger illogicist posted at 2/21/2006 02:40:00 AM  
    thanks for your comment PYR, and the compliment. Your blog doesnt load for me right now, but I'll try again soon. But an economics-based blog sounds cool.

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