What is meant by deadweight loss? Why does tax create deadweight loss? What determines the size of the loss?
Deadweight loss refers to the loss of economic efficiency that occurs when the equilibrium quantity of a good or service is not being produced or consumed. This occurs when the market is not operating at its optimal level, leading to a loss of overall welfare in the economy.
Taxes create deadweight loss because they distort the market equilibrium by altering the prices of goods and services. Taxes increase the cost of production or consumption, leading to a decrease in quantity traded and a loss of consumer and producer surplus.
The size of the deadweight loss created by a tax is determined by the elasticity of demand and supply for the good or service being taxed. The more elastic the demand and supply curves are, the larger the deadweight loss will be, as consumers and producers are more sensitive to changes in price. Additionally, the size of the deadweight loss also depends on the size of the tax itself – the higher the tax rate, the larger the deadweight loss will be.