Methods to Correct Negative

Consumption Externalities
Unit 5 - Lesson 7
Learning Outcomes
● Explain government intervention to correct negative consumption
externalities (AO2)
○ Indirect (Pigouvian Taxes)
○ Legislation and Regulation
○ Education and Awareness creation
○ Nudges
● Draw a diagram to illustrate the above government responses. (AO4)
● Discuss the strengths and limitations of the above government policies with
respect to: (AO3)
○ Difficulties measuring the size of the externality.
○ Degree of effectiveness.
○ Consequences to stakeholders.
Market Based Policies to Correct Negative Consumption
Externality.
Indirect (Pigouvian) Tax
● Indirect taxes are placed on the
demerit goods where the private
consumption has negative spillover
costs to a 3rd party/society.
○ Examples include cigarettes and
petrol/diesel.
● As we know from chapter 2, a tax is a
non-price determinant of supply.
● A tax increases the cost of
production resulting in a decrease
(shift left) in MPC from MPC to MPC
+ tax
Market Based Policies to Correct Negative Consumption
Externality.
● If the tax equals the external costs to
society (vertical distance between A -
B) the MPC + tax curve intersects
the MPB curve at Qso.
● A tax results in a decrease in
quantity demanded from Qfm to
Qso and an increase in price from
Pfm to P-tax.
● If the tax is equal to the external cost
the market will produce the socially
optimal quantity (Qso) and be
allocatively efficient.
Advantages of Market Based Policies
● Economist prefer market based
policies when addressing the
negative external costs created by
the consumption of a demerit good.
● Market Based Policies internalize
the externality.
○ Internalize means the external
costs that arise from the private
transactions are now paid for by
the consumer and producer of
the demerit good and not
society.
○ Consumer and producer burden.
Advantages of Market Based Policies
● The government receives revenue
of (p-tax minus Pso) times Qso.
○ This revenue generated can be
used on educational programs
aimed at reducing the
consumption of demerit goods
or used to promote other merit
goods - goods that have
positive spillover benefits.
● The effectiveness of the tax to
reduce the quantity in the free
market (Qfm) to the socially optimal
quantity (Qso) depends on the price
elasticity of demand.
Advantages of Market Based Policies
PED is less than one - consumers are less
sensitive to the change in rice caused by the
introduction of the tax.
● % increase in price is greater than the
% decrease in quantity demanded.
● Consumer is burdened more by the
introduction of the tax than the
producer.
● If demand is inelastic a tax will likely not
reduce the Qfm to Qso.
● Tax will reduce the size of the external
costs and total welfare loss but not
eliminate it.
● The government would need to increase
the tax significantly to incentivize the
consumer to change habits.
Advantages of Market Based Policies
PED is greater than 1 - consumers are
more sensitive to the change in price
caused by the introduction of the tax.
● % increase in price is less than the %
decrease in quantity demanded.
● Consumer is burdened less by the
the tax than the producer.
● If demand is elastic a tax will likely
have greater impact on reducing
consumption from Qfm to Qso.
● With demand elastic it would have a
greater impact on incentivizing the
consumer to reduce their
consumption.
Limitations of Market Based Policies
Limitations:
● Measuring the value of the external costs that the consumption has on society.
○ Difficult to ensure that there is not too much or little tax imposed on the
good.
● Many technical difficulties in measuring who and what is impacted by the
consumption of the demerit good.
Summary:
Market based policies such as Pigouvian taxes work by incentivizing the
consumer to consume less by increasing the price. The degree to which the
market based policy is successful at reducing the consumption of demerit
goods depends on the price elasticity of demand - sensitivity of consumers to a
change in price.
Government Legislation and Regulation
● Regulations are used to prevent or
limit the activities of the consumer that
result in external costs to society.
○ Examples include:
■ No smoking in restaurants
■ No sale of cigarettes or alcohol
to persons under 18.
■ No advertising of cigarettes or
alcohol in magazines,
television or newspapers.
● Government regulations and
legislation lead to a decrease (shift
left) in MPB moving it closer to MSB
resulting in a decrease in quantity from
Qfm to Qso.
Advantage and Limitations of Regulation and Legislation
Some regulations are very effective at reducing the external costs associated
with the consumption of a demerit good.

For example, restriction of smoking in public places, the restrictions on cars

For activities like these regulation and legislation is very effective.

However, for certain activities regulation is not as effective.

For example, regulating petrol consumption is not easily done and indirect taxes
would be more effective at reducing the consumption though consideration of
price elasticity of demand is needed.
 Education and Awareness Creation
● Education and public awareness by
the government can be used to try
and persuade the consumers of
demerit good to consume less.
○ Examples include anti-smoking
campaigns, raise awareness
about the consumption of
unhealthy foods, educational
campaign about the impact of
fossil fuels on the environment.
If the campaigns are successful it will
result in a decrease in MPB moving it
closer to MSB resulting in a decrease in
quantity from Qfm to Qso.
 Advantage and Limitations of Education Awareness

Education has the advantage that it is simpler to implement than market based
policies and regulation.

However, educational awareness does have some limitations.

The cost of these educational programs are paid for by the government and thus
the cost of the educational program results in an opportunity cost to the
government. The government could spend that money elsewhere to benefit
society.

There is also the question of the relationship between the cost to fund the
educational program and the impact it has at decreasing the consumption of
the demerit good.
 Nudges
In chapter 2 we talked about Nudges when
exploring Behavioural Economics.
● Nudges are designed to try and influence
individuals to make choices that are
deemed socially desirable.
○ Examples include keeping cigarette
packs out of view of the consumer in a
store, the creation of bike lanes and
graphic photos on cigarette packaging.
If nudges work influencing consumers to make
socially desirable choices it will result in a
decrease in MPB moving it closer to MSB
resulting in a decrease in quantity from Qfm to
Qso.
 Advantage and Limitations of Nudges
There may be difficulties in designing Nudges to effectively influence
consumers of demerit goods to make socially desirable choices.

Behavioural Economics and Nudges are relatively new so knowing how

Also, Nudges may not have the same effect across income and cultural groups
thus reducing the effect.

In summary, the correction of a negative consumption externality through