Unit 2.8: Demerit goods
This page focuses on another cause of market failure, the negative spillover costs associated with the consumption of demerit goods and some of the policies that governments can use to reduce the negative spillover costs. While IB students will generally understand the concept of external costs they will often struggle with the appropriate diagrams.
Why might the provision of some goods e.g. cigarettes and alcohol be over provided by the market. What measures can a government take to reduce the negative externalities caused by the production and consumption of certain products.
Lesson time: 90 minutes
Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.
Explain that demerit goods are goods whose consumption creates external costs.
Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government
regulations, to the problem of negative externalities of production and consumption.
Beginning activityWhich of the following demerit goods, in your opinion, should be considered harmful to society - guns, narcotics, alcohol, cars. Which of these do you think is the most dangerous for any society and which the least dangerous?
Demerit good - can be defined as one that produces negative externalities when consumed. They are generally over consumed in a free market, relative to the socially optimum level of output and provide another example of market failure.
Negative externalities – spillover costs to a third party caused by the production, or consumption of a good (or service). They occur when MSC is greater than MSB in the market for a good or service.
Marginal private benefit - the additional benefit obtained by the consumer or producer from the consumption or production of one additional unit of a product.
Marginal social benefit - equal to the private marginal benefit a good provides plus any external benefits it creates. MSB measures the total marginal benefit of the good to society as a whole.
Marginal private cost - the additional cost incurred by the user or producer of one additional unit of a good or service.
Marginal social cost - the total cost to society as a whole when one more unit of a good or service is consumed or produced.
Socially optimum level of output - where the MSB for a good or service is equal to MSC.
Tradable pollution permits - sometimes called a cap and trade scheme. This policy provides an economic solution to the problem of negative spillover costs, caused by excessive pollution. Under the scheme each company is given a legal right to pollute a certain amount per fixed time span. Firms that pollute less can then sell their leftover pollution permits to firms that pollute more.
Indirect (pigouvian) taxes - a tax on any market activity that compensates for the negative externalities created by the consumption / production of a de-merit good. An example might be carbon taxes or excise duty on car fuel or tobacco products.
The activities on this page are available as a PDF file at: Demerit goods
Activity 2: Different government approaches to demerit goods
Complete the following table, which includes a list of demerit goods available in your country. Divide these into those demerit goods which are considered so dangerous that there production and sale is prohibited, demerit goods which are legal but where their consumption and sale is limited / restricted. Lastly, list the demerit goods in your country which are legal and can be sold without limits but are taxed by the government to limit their use.
Illustrating market failure on a diagram
Watch the following video which explains how economists illustrate market failure before completing the activities which follow. The video uses cigarettes as an example of a demerit good but the theory can be applied to all demerit goods.
Activity 3: Market failure in the market for private cars
The diagram to the right illustrates the market for petrol in an unregulated market.
(a) Explain why the consumption of petrol is above the socially optimum level of Qso.
(b) Explain why in an unregulated market the market for fuel will also represent a market failure?
(c) Explain why some third parties suffer as a result of the purchase.
Activity 4: Correcting market failure through taxation
The government decides to try and correct the market failure by imposing a tax on petrol sales, equal in size to the negative externality, in the hope that car owners may use their cars less often.
(a) Draw the impact of the tax on a demand and supply diagram and illustrate the following points:
i. The new equilibrium price and output
ii. The level of tax revenue collected for the government.
(b) The government also decides as part of its commitment reduce the number of private cars on the roads, to invest in a government education campaign. They hope that this will encourage consumers to leave their cars at home and instead use public transport. How would this be illustrated on a supply and demand diagram? Is this policy likely to be effective?
Activity 5: Traffic congestion in a fast growing LEDC
One of the more obvious examples of market failure caused by traffic congestion exists in Istanbul. Rapid urbanisation has made Istanbul one of the most congested cities in Europe, with traffic costing the city more than 5 billion Turkish Liras per year ($ 2bn) in lost revenue. This is caused by a loss of labour and excess fuel consumption, according to Kasım Kutlu, the general manager of the Istanbul Municipality - Affiliated Intelligent Transportation Systems (İSBAK).
Watch the following short video and then answer the following question.
1. Why is the absence of a comprehensive metro system an example of market failure?
2. Explain how an electronic road pricing scheme might help reduce the externality caused by excessive car consumption in the city?
Activity 6: Limiting market failure with enforceable limits and tradable permits
The diagram to the right illustrates the level of pollution in an unregulated market. The government decides to implement an system of agreed pollution limits and tradable permits.
(a) Complete the diagram by adding a tradable quota, at the socially optimum level of output.
(b) How will the market price of permits be derived?
Activity 7: The market for renewable and clean energy
The diagram to the left illustrates the market for renewable energy, with a government subsidy.
(a) Using the diagram explain why many governments believe that the most effective way of reducing dependence on carbon based energy sources is to provide subsidies for alternative products e.g. clean energy sources.
(b) Suggest how the government might fund the subsidy on cleaner / renewable energy sources.
Activity 8: Taxation or legislation, which is more effective?
The following short video is taken from a question and answer session given by Milton Freedman during his visit to Rochester University. Milton Freedman is one of the worlds most prominent free market economists. During his career he has consistently promoted the notion that governments should intervene only in the most extreme of circumstances.
After watching the following video discuss the merits and weaknesses of Freeman's assertion that governments should use taxation rather than legislation (prohibiting actions) to correct market failure.
Activity 10: Links to TOK:
Governments use a range of methods to restrict consumption of demerit goods such as cigarettes, alcohol and narcotics. Why do governments use taxation to restrict consumption of some goods while prohibiting the sale of others?
Activity 11: What represents a safe level of alcohol consumption
Watch the following short video and then answer the questions: 'Is there a safe limit for alcohol consumption' and how should governments respond to the problems caused by the over consumption of alcoholic beverages?
Activity 12: Should cannabis be legalised?
The consumption of cannabis / marijuana is considered a demerit good, just as the consumption of cigarettes and alcohol are considered demerit goods. The difference being that while most nations impose a blanket ban on the sale of all narcotics including cannabis; consumption of tobacco and alcohol products remain legal - though both goods are taxed to reduce consumption levels. As a point of comparison the number of deaths in the USA in 2015 from all illegal narcotics was 17,000, of which 0 where related to the consumption of cannabis. By contrast deaths from tobacco related products stood at 480,000 deaths, or 1 in every 5 deaths in the country. Of course such a comparison is unfair because rates of tobacco consumption are far greater than levels of drug consumption.
Watch the following video and complete the discussion point which follows:
In the USA the legality of the recreational drug cannabis is determined by individual states. As the diagram to the right identifies different states have very different laws on its use.
At one end of the spectrum, those shaded have fully legalised the recreational drug. Here the drug is still considered a demerit good and the production is subject to a tax to discourage its use. The states shaded have kept the drug illegal but have de-criminalised its use. In the other states shaded , , cannabis remains illegal and consumers face prosecution for its use.
Outline the arguments for an against a state government legalising the drug. Consider the following stakeholders in your decisions:
- the state tax collection service
- occasional users of the drug for recreational purposes
- non users of the drug
- the criminal gangs running the illegal trade
- the drug and law enforcement agencies.
Further reading on this topic can be accessed at: Marijuana
Activity 13: Link to the paper 1 examination
(a) Explain with a diagram how the government imposition of a specific tax could reduce pollution levels in a city. [10 marks]
(b) Using real world examples, evaluate the effectiveness of indirect taxes in reducing the consumption levels of demerit goods such as tobacco, petrol and alcohol products? [15 marks]
In the paper three examination candidates may be required to suggest possible government options to correct market failure and / or illustrate the impact of such policies on a diagram. They may also be required to calculate the impact of any tax and or subsidy from the data provided.