NEGATIVE

EXTERNALITIES OF Demerit goods

CONSUMPTION
 NEGATIVE EXTERNALITIES OF CONSUMPTION AND
WELFARE LOSS
Consumers gain a private benefit from the consumption of goods.
But the consumption of some goods create negative spill over effects.
There are costs associated with the negative spill over effects – these are the external costs
and are paid for not by the consumer of the good but by third parties, often the tax payer.
For example the consumption of alcohol leads to violence, vandalism, accidents, and
absenteeism from work.
The consumption of tobacco leads to health problems that are treated by health services an
external cost paid for by third parties
The over consumption of fatty foods and sugar again can lead to diabetes and obesity. There
are significant external costs generated by the prevalence of these diseases.
The use of cars leads to air pollution and consequential rise in respiratory diseases. These
have to be treated.
With all of the above there are less obvious external costs such as the negative impact on the
economy of higher mortality rates, absenteeism rates, the negative impact on productivity,
the impact on expenditure by government on sickness and unemployment benefits.
 PRIVATE OPTIMUM LEVEL OF CONSUMPTION
A good that when consumed generates external cost/negative externalities is called a demerit
good. Left to the free market it is under-priced and overconsumed, as far as achieving a socially
optimum level of consumption is concerned.
As we know the consumer only considers the private cost and the private benefit when making
decisions on how much of a good to consume.
A buyer will consume up to the point where the marginal private cost equals the marginal
private benefit. This is the point where the consumer’s welfare is maximised. It is the private
optimum level of consumption.
The consumer considers the price, which is the marginal private cost, and considers the
additional benefit gained from the consumption of the good. The consumer DOES NOT TAKE
INTO ACCOUNT THE EXTERNAL COSTS.
If the extra benefit is greater than the price – the extra private cost, the consumer will buy the
good because by doing so private welfare will increase.
If the MPC > MPB then the consumer will not buy the good because the cost outweighs the
benefit and there will be a welfare loss.
Logically, therefore, the consumer will maximise welfare where MPC=MPB. Any other level
of consumption will lead to a loss of welfare for the individual consumer.
 MARGINAL SOCIAL BENEFIT

Consumption of demerit goods generates private benefit for

the consumer but also external costs that are paid by third
parties.
Therefore, it is argued that the total private benefit gained
from consumption of the good by the consumers in the
market is greater than the total benefit gained by society.
Therefore on all units of the demerit good consumed
marginal social benefit is less than marginal private benefit.
That is the additional benefit to society from the next unit
consumed is less than the additional benefit enjoyed by the
consumers of that next unit consumed.
PRIVATE OPTIMUM LEVEL OF CONSUMPTION OF THE DEMERIT GOOD
MSB is less than MPB at all levels of quantity consumed therefore the MSB curve
therefore lies above the MPB curve at all levels of quantity consumed.
The vertical distance between the MPB curve and the MSB curve is the monetary
value of the external cost/negative externality generated by consumption of the
marginal unit consumed.
As we know the private optimum level of consumption, that is the level of
consumption at which consumers in the market maximise their welfare is at the
equilibrium P1,Q1where MPC = MPB (Please note that MSC = MPC).
Consumers in the market do not take into account the external costs associated with
the consumption of this demerit good when deciding on the amount they want to
consume.
WELFARE LOSS LEFT TO THE FREE MARKET
However, at the quantity consumed, Q1, we note that marginal
social cost exceeds marginal social benefit. This means that the
additional cost to society from the consumption and production of
the next or marginal unit is greater than the additional benefit
society enjoys from its production and consumption. The costs
outweigh the benefits.
WELFARE LOSS LEFT TO THE FREE MARKET
The social optimum level of consumption is at the equilibrium P*,Q* which is where
society maximises its welfare. At Q* MSC=MSB.
But, in a free market the equilibrium is determined solely by the forces of supply and
demand. At P1,Q1 MSC>MSB. And MSC > MSB on all units consumed between
Q* and Q1. The monetary value of the external cost for each unit between Q* and
Q1 is the welfare loss on each of the units. The sum of the external costs incurred on
each of these units is represented by the shaded area in the diagram – the welfare
loss
 WELFARE LOSS LEFT TO THE FREE MARKET
Left to the free market the market for a demerit good will fail to achieve a socially efficient
outcome.
Consumption creates negative spill over effects – external costs ARE NOT TAKEN INTO
ACCOUNT WHEN LEFT TO THE FREE MARKET.
Consumption is too high – too many resources have been allocated to the consumption and
production of the good. There is an inefficient allocation of resources.
CORRECTING MARKET FAILURE – DEMERIT GOODS
Left to the free flowing forces of supply and demand the market fails to realise the
social optimum level of consumption and production.
To correct market failure, and thereby eliminate the welfare loss, the government
must intervene in the market.
In our next lesson we will examine policies government can employ to reduce
consumption of demerit goods and thereby reduce the external costs.
.