A new partial-equilibrium approach to approximating the welfare effects of market power and taxes

Abstract

The traditional deadweight-loss (DWL) formula rests on a usually unstated, strong assumption: that all other markets are undistorted. We extend the DWL formula to cases where the surplus in other markets is non-zero. It involves an additional term of the same order of magnitude as the DWL; this term does not go to zero even when the directly affected market is small relative to the rest of the economy. In examples, we show that the DWL may get the sign of the surplus change wrong when a substantial share of the economy is monopolized or subject to commodity taxes.