Market failure caused by the over supply of demerit goods

Key terms:
Demerit good – spill over 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.

Negative externalities – the harmful effect to a third party from the consumption of 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 demerit good. An
example might be carbon taxes or excise duty on car fuel or tobacco products.

Activities:
1. Which of these goods do you think is the most dangerous for any society and which the
least dangerous – cigarettes, alcohol, cars, narcotics, fire arms?

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Most Dangerous Least Dangerous

Cigarettes Fire arms

Alcohol Cars

Narcotics
Activity 2

Complete the following table, which includes a list of goods that produce negative
externalities in your country. Divide these into those products which are considered so
dangerous that their production and sale is prohibited, goods which are legal but where their
consumption and sale is limited / restricted. Lastly, list the goods in your country which are
legal and can be sold without limits but are taxed by the government to limit their use.
Prohibited Limited Taxed
Tobacco ✔
Petrol ✔
Marijuana ✔
Hand guns ✔
Alcohol ✔
Hard narcotics ✔
Junk food ✔
Prescription drugs ✔

Activity 3: Applying market failure to 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

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The government decides to correct the
market failure via imposing a tax on petrol
sales, equal in size to the negative
externality.

(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. Illustrate this on a demand and supply
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 is traffic congestion, which reduces the
quality of life for many urban residents. Istanbul is 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.

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(a) Why is the absence of a comprehensive metro system an example of market failure?

 The absence of a more comprehensive metro system increase the number of car, taxi,
and bus journeys made in the city to a level beyond the equilibrium level.

(b) Explain how an electronic road pricing scheme might help reduce the externality caused
by excessive car consumption in the city?

 An electronic pricing system, as used in London or Singapore might help reduce the
volume of cars on the cities road closer to the socially optimal level.

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?

 (b) Through the interaction of demand and supply.

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) Use the diagram explain why

many governments believe that the most
effective way of reducing dependence on

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 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.

 One obvious solution would be to place a tax on polluting carbon based energy
sources as way of generating funds for the subsidy.

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 9: How do governments decide which goods to classify as demerit goods?

Activity 10: Links to TOK:

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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

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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:

Discussion point

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
decriminalised 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.

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]

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