Deadweight Loss and Excess Burden
Deadweight loss or excess burden is a loss of economic efficiency when the equilibrium of goods or services is not achieved. The deadweight loss is caused by the pricing of monopoly in case of artificial scarcity, binding price or tax, and subsidy. The presumption about the elasticity of demand for monopoly goods is very low. Harberger assumed it to low as to 1.[1] The author envisaged that the substitution of goods is not the substitute for a single firm. The substitution is the great aggregate products against other products. The assumption of elasticity is made of the excess amount of excess profit measures the number of resources that must be called into an industry in order to bring its profit into line.[2] Resources mean the aggregate value of labor, capital, and materials bought by the industry.
Monopoly, Resource Allocation, and Welfare Cost
The rates of total profit to total capital for seventy-three manufacturing industries with total capital defined as book capital plus bonded indebtedness and total profit defined as book profit plus interest on the indebtedness.[3] 1924-28 periods is used to do this research on welfare cost of manufacturing unit. To get rid of the variations of a short period in rates of return five year average of rates are taken as rate. The excess profit is created by the difference of return from the monopoly and the opportunity cost of capital. While the return is 20% and an average cost of capital is 10% the excess profit is 10%.
The negative values of column 2 In Table 1 shows that the capital losses of the industry due to the divergence from the average return on capital. The welfare cost represents the divested capital because the unattained return from the industry assuming that the elasticity of the demand for the industry is unity. A monopoly industry can achieve equilibrium in the long run. Some firm may experience losses while other firms can gain profit due to different marginal cost. Epstein’s study included 2046 corporations which account for 45% of total sales and capital in a manufacturing industry. The misallocation of the resources in the period of 1924-28 could have been eliminated by the transfer of 4% resources in the manufacturing industry. Arnold Harberger used the research of Professor Ralph C. Epstein.
The Calculation of Deadweight Loss
Assuming the price elasticity of demand 1 the welfare loss is equal to ½ r2 q. At Q’ the production is suboptimal that is why the DWL occurred. If the production can be shifted from Q’ to Q welfare gain can occur being the fiscal adjustment makes the marginal utility of money same. Half is taken into consideration because of the average change of price and quantity. The unity of the elasticity comes from the assumption that all the firms produce similar goods and services. The Formula for the welfare loss =(X1×X3)/2. The calculated deadweight loss in manufacturing is 2.33%. Arnold Harberger concluded that monopoly doesn’t seem to affect the aggregate welfare very seriously but it has very serious effects on resource allocation. [4]The assumptions of price elasticity, the equal marginal utility of money and constant rate of capital make the estimate of deadweight loss conservative.
The Impact on Manufacturing Industry
The whole manufacturing industry can’t have more than average return on capital. The normal rate of return is 8% while Epstein’s research shows that the average return is 10.4% because of the sampling of highly profitable firms. The aggregate loss is 2.33% of total sales. It is possible to get the total sales from table-1 (column 3). The comparison in manufacturing is not more accurate from the extrapolation to the whole national income. For an inverse demand curve, the coefficient of the price equation will be 0. If there is a positive value in the coefficient, the price of the demanded goods or services can be negative. The price of any product or services cannot be negative so bs=0 is assumed. From the equation ad, bd and cd are constants.
Conclusion
The linear demand unity refers that the price change in the monopoly industry will proportionately change the demand. The elasticity of demand is 1. In the long run equilibrium, the firms in the industry will remain profitable and no firm will want to enter the industry and leave the industry thus there will be no significant change in price and quantity production and demanded 8% increase in price may cause .1% increase in deadweight loss. If the price is 100, the deadweight loss is 2.33. If the price is 150 the deadweight loss is 3.495. 108 results in 2.53 deadweight loss which 1/10 of the percent of total sales. The deadweight loss, when the monopoly price is 25% higher, is 2.91% of total sales. When the sales are 6% higher the deadweight loss is 2.46. When As is 1 Ad is 2.86.
Bibliography
Garella, Paolo G. "Monopoly and Incentives to Cost-Reducing R"D". SSRN Electronic Journal, 2010. doi:10.2139/ssrn.1581456.
Harberger, Arnold C. 1988. "The Changing Resources Picture". Challenge 4 (4): 15-18. doi:10.1080/05775132.1956.11468197.
Pustay, Michael W. "The Social Costs of Monopoly and Regulation: An Empirical Evaluation". Southern Economic Journal 45, no. 2 (1978): 583. Doi: 10.2307/1057686.
Tabarrok, Alexander, and Tyler Cowen. 1998. "Who Benefits From Progress?” Kyklos 51 (3): 379-398. doi:10.1111/1467-6435.00056.
[1] Arnold C. Harberger, "The Changing Resources Picture", Challenge 4, no. 4 (1956): 15-18, doi:10.1080/05775132.1956.11468197.
[2] Paolo G. Garella, "Monopoly And Incentives To Cost-Reducing R"D", SSRN Electronic Journal, 2010, doi:10.2139/ssrn.1581456.
[3] Michael W. Pustay, "The Social Costs of Monopoly and Regulation: An Empirical Evaluation", Southern Economic Journal 45, no. 2 (1978): 583, doi: 10.2307/1057686.
[4] Alexander Tabarrok and Tyler Cowen, "Who Benefits From Progress?” Kyklos 51, no. 3 (1998): 379-398, doi:10.1111/1467-6435.00056.
