Estimating Dead Weight Loss Due to Imperfectly Competitive Market Structures
Estimating Dead Weight Loss Due to Imperfectly Competitive Market Structures
Economists are naturally interested in estimating the size of dead weight losses (DWLs) resulting from allocative inefficiency. Estimating DWL is difficult because the investigator will not normally know the true value of marginal cost. Hence, DWL must be estimated indirectly.
Harburger's approach
Arnold Harburger. "Monopoly and Resource Allocation," American Economic Review, Dec. 1965: 77-87
The A-E-B dead weight triangle can
be approximated by
the following equation:
DWL = 1/2(PM - PC)(QC
- QM) [1]
Let P* denote the price charged by
the firm and Q* is the resulting quantity sold. We can do some algebra
to show that:
DWL = 1/2h d 2P*Q* [2]
Where d is the price-cost
margin, that is,
d = (P*
- PC)/P*. h
is elasticity of demand. Specifically:
h = ô
(D Q/Q)/(D P/P)ô
= %D Q / %D P
To estimate d,
Harburger measured the difference between
rate of return for the industry and the average rate of return for all
industries. Harburger assumed that, for all industries, h
= 1.
Harburger's results
Based on data for U.S. industries in the 1920s, Harburger estimated the DWL due to monopoly to be equal to 1/10 of 1 percent of GNP. Hence, the welfare loss due to pricing above marginal cost is very small and would hardly justify the allocation of substantial resources for antitrust enforcement.
The Cowling and Mueller contribution
Keith Cowling and Dennis Mueller. "The Social Costs of Monopoly Power," Economic Journal, December 1978: 727-48.
Equation [2] above reveals that estimates
of DWL are sensitive to assumptions made about elasticity of demand (h
)Cowling and Mueller made adjustments to the methodology used by Harburger
and , using a sample of 734 U.S. firms for 1963-66, reached radically different
conclusions as regards the magnitude of welfare losses.
Cowling and Mueller changed a key assumption of Harburger; namely, that for across all industries, h = 1. They took advantage of the following relationship for a profit maximizing firm (where P* is the profit-maximizing price).
P*/(P* - MC) = h [equation 4.2 on p. 86]
By substituting and rearranging, we
arrive at the following:
DWL @ 1/2 (P* - MC)Q* [3]
If MC is constant, then MC = ATC. Let B denote profits. [3] can be rewritten:
DWL @ 1/2 (P* - ATC)Q* = 1/2 p * [4]
Hence dead weight losses are equal to approximately one-half of economic profits realized by firms.
Cowling and Mueller's results
Assuming that 12 percent is a "normal" rate of return on capital, Cowling and Mueller produced 2 estimates of DWL in the U.S. economy:
 | The low estimate, which does not include advertising expenditures as a component of the dead weight loss, was 4 percent of GNP (about $330 billion in 1997). |
| The high estimate, which reckoned advertising expenditures as "wasted resources," was 13 percent of GNP (about $1.073 trillion in 1997). |