DEMERIT GOODS –

CORRECTING MARKET FAILURE

 WELFARE LOSS CAUSED BY NEGATIVE EXTERNALITIES IN CONSUMPTION
See the previous lesson for a discussion on the causes of welfare loss due to the external costs
associated with the consumption of demerit goods
POLICIES TO CORRECT MARKET FAILURE – A PER UNIT TAX.
ECONOMIC ANALYSIS
Private optimum level of consumption is at Q1,
where MSC=MPB
At Q1 MSC > MSB. On all units consumed
between Q* and Q1 there is a welfare loss.
The sum of the welfare loss on all these units is the
total welfare loss to society from the
overconsumption of the good.
It is represented by the shaded area in the diagram.
ECONOMIC ANALYSIS OF A PER-UNIT TAX
An indirect, per-unit tax is placed on
the good.
At each level of consumption the per-
unit tax increases the marginal social
cost by the monetary value of the tax.
The vertical distance between the two
curves is the monetary value of the tax.
In order to eliminate the welfare loss by
reducing consumption to the socially
optimal level of consumption, where
MSC=MSB, the value of the tax must
equal the value of the external costs of
consumption.
ECONOMIC ANALYSIS OF PER-UNIT TAX
After the tax is placed on the good the MSC curve shifts up to the left to
MSC+Tax
The vertical distance is the monetary value of the tax which is equal to the
marginal external costs.
The private optimum level of consumption before the tax was at Q1, where
MSC=MPB
The social optimum level of consumption is at Q*, where MSC=MSB
The private optimum level of consumption after the tax is at Q*, where
MSC+Tax = MPB
The private optimum level of consumption after the tax
is the same as the social optimum level of consumption
where MSC=MSB, both now at Q*
The price paid is now P2.
Total tax per unit is P2 – P*
Consumer burden of tax is P2 – P1
Producer burden is the remainder of the tax, P1-P*
ECONOMIC ANALYSIS
OF PER-UNIT TAX
Prise rises, from P1 to P2 thus quantity demanded
falls from Q1 to Q* (law of demand).
The consumers and producers (the burden of tax is
shared between them) now pay the external costs,
not third parties.
The tax has ‘internalised the externalities’ - the
external costs have been brought into the market.
 EVALUATION OF A PER-UNIT TAX
Government raises a lot of tax revenue from the imposition of this per-unit tax. This revenue can be used by
the government to further reduce consumption of the demerit good. For example through a negative
advertising campaign in the media.
The value of price elasticity of demand is relatively high for demerit goods such as tobacco and alcohol.
Demand is price inelastic.
PED = the percentage change in quantity demanded/ the percentage change in price.
The percentage change in price will be greater than the percentage change in quantity demanded.
In other words because consumption of alcohol and tobacco are addictive and habit forming when price
rises because of the tax consumption falls but a lower rate than price increases.
Therefore a relatively high tax will be required to reduce consumption to the socially optimal level of
consumption. There will be a substantial increase in price thus the consumer burden will be high.
Consumers will pay a greater proportion of the tax than producers.
A high tax will increase prices by a relatively high amount and therefore reduce consumer surplus. Thus
consumer welfare falls.
The tax that must be paid by consumers represents a higher proportion of the income earned by poor people
than that of higher income earners. Thus the tax might be regarded as inequitable.
 EVALUATION OF A PER-UNIT TAX
The idea of a tax is to reduce consumption and thereby reduce the external costs.
But a high tax will encourage consumers to expenditure switch away from the legal market
where tax is paid to the illegal/shadow/black market where tax is not paid.
The higher the tax the bigger the difference between prices in the two markets and the greater the
incentive to switch to buying in the black market.
Also as demand increases for black market goods the greater the profit there is available from
supplying black market goods. Thus a tax will encourage criminal activity.
This creates an opportunity cost. Government must spend tax payers money investigating black
market activity. There are costs associated with prosecuting and imprisoning those involved in
supplying the black market.
And very importantly if consumers expenditure switch from the legal to the black market
consumption does not fall and the external costs are still generated. And the government will not
receive the tax revenue from the legal sales of the good – a ‘double whammy’ so to speak
Also output falls thus firms lay off workers – profit falls in the industry and unemployment rises.
 POLICIES TO CORRECT MARKET FAILURE:
REGULATION BANNING CONSUMPTION
Prohibition of alcohol in the USA between 1920 and 1933 meant that the production, transportation and
consumption of alcohol was illegal.
But this did not eliminate demand. And ‘where there is demand supply will surely follow’.
Prohibition open up a huge black market.
Tax revenue gained from the sale of alcohol fell to zero.
BUT production continued. Production was not regulated so the quality of the product diminished and
consumption continued as of course did the external costs generated by consumption.
And the government incurred huge opportunity costs. Many scarce resources were used to prevent
production, transportation and consumption of alcohol but the policy failed to control the external costs.
So government experienced a loss of tax revenue and an increase in expenditure without reducing the
external costs. Thus welfare loss was not eliminated. Indeed the policy led to an increase in welfare loss. This
policy is an example of government failure – it occurs when the government acts to correct market failure but
by doing so fails to achieve its aims and even makes welfare loss higher.
Banning smoking in public places has reduced consumption of tobacco. Over the last few decades
government has made it illegal to smoke on public transport, in public houses, offices, factories, hospitals,
cinemas, indeed in all retail outlets. Some governments are considering extending the ban to cars, and even
private homes. Some argue that this is an infringement of our personal rights and liberties.
Also the government has banned the advertising and branding of tobacco.
POLICIES TO CORRECT MARKET FAILURE: NEGATIVE ADVERTISING
AND EDUCATION
In schools students are taught about the private costs, other than price, associated with
consumption of alcohol and tobacco. E.g. the health implications associated with the
consumption of the goods. It is argued that if people are aware of the true private costs
of consumption demand would fall.

Government funds negative advertisements and leaflets regarding the private costs of
consumption. The aim is to reduce demand for the product.

Negative advertising and education incur an opportunity cost. Resources are used in
both cases that therefore will mot be available for alternative uses. Remember
resources include land, labour and capital.

The effect of negative advertising and education is to reduce the perceived benefit
available from consumption and thereby reduce demand. The MPB curve (the demand
curve) will shift down and to the left. If it shifts by the amount of the external costs
then MPB will equal MSB at each level of consumption. Then the private optimum
level of consumption, where MSC=MPB, will be the same as the social optimum level
of consumption, where MSC = MSB and society’s welfare is maximised.

One more important evaluative point. A tax, regulation, negative advertising and
education will lead to a fall in consumption AND PRODUCTION. Therefore as output
falls firms profits fall and firms lay off workers so unemployment rises. So incomes
fall and government expenditure on unemployment benefits will rise.

When evaluating you might suggest, if appropriate, that to effectively achieve a

socially optimum level of consumption the government should use tax, regulation and
negative advertising and education to correct market failure.
CORRECTING MARKET FAILURE
Model sentence:
Left to the free market demerit goods will be overconsumed because consumers do
not take into account the external costs associated with consumption nor do they
know the full private costs of consumption. At the private optimum level of
consumption marginal social cost is greater than marginal social benefit leading to a
welfare loss, and the market fails to achieve an efficient allocation of resources.
Government can act to reduce consumption through the imposition of a per-unit tax,
through regulating the market and through negative advertising and education. All
these are aimed at reducing consumption and output and thereby reducing the
number of resources allocated to the production and consumption of the good.

DO NOT SIMPLY CUT CHUNKS FROM THE POWER POINT AND PASTE
THEM INTO YOUR ESSAYS
 HOMEWORK
Essay
Is the imposition of a per-unit tax the most effective policy that the government can implement to
correct market failure caused by the negative externalities associated with the consumption of
cigarettes? (15)
Explain why left to the free market the market will fail – draw a diagram showing welfare loss.
Explain how a per-unit tax might correct market failure – draw a diagram showing effect of a tax.
Evaluate the use of a tax – pros and cons.
Explain the potential benefits/drawbacks of implementing alternative policies such as regulation,
negative advertising and education – draw a diagram showing effect of negative advertising.
In the final paragraph weigh up the advantages and disadvantages and draw conclusions – in other
words answer the question.
You might argue that a combination of policies is best.
BE SUCCINCT/no repetition/do not define all terms used – a maximum of 2 sides
Read this topic in your text book – pages 144 and 145