SL/HL IB Economics (Google Slides) [4]

2.7 Market Failure— Externalities and Common Pool Resources

Negative Consumption Externalities (Types of Market Failure) - Notes

Kognity 2.8.4 (Online Textbook) - HL/ SL

IB Core Concept Standard Level and Higher Level Concept

Market failure After studying this section, you will be able to:

● I can define all the terms appearing in orange highlights in the text.

● I can explain the concepts of negative externalities of consumption, and

the welfare loss associated with the consumption of a good or service.

● I can draw a diagram illustrating negative externalities of consumption

and welfare loss.

● I can explain policies available to governments in response to negative

externalities of consumption.

● I can evaluate policies available to governments in response to negative

externalities of consumption.

● I can draw diagrams to illustrate the policies available to governments in

response to negative externalities of consumption.

WHAT IS A NEGATIVE CONSUMPTION EXTERNALITY?

● Negative Consumption Externality: Refers to a situation where the consumption of a good

or service generates a negative effect on a third party (or society), who were not factored into the
decision to consume that good.

➔ Note!: This usually happens when people consume goods and there is a negative impact
on the other people around. For example, when people consume goods like cigarettes
around other people, the non-smokers will be affected by the second-hand smoke, or
when people also drive cars that pollute the air for everyone, or any other negative
side-effects of consumption activities that spill over onto society and are not accounted
for in the private benefit for consumers.

Important!

When there is a negative consumption externality, the free market overallocates

resources to the production of the good, and too much of it is consumed and produced
relative to what is socially optimum. This is shown by the quantity Qm > Qopt and MSC
> MSB at Qm.

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WHAT IS AN EXAMPLE OF NEGATIVE CONSUMPTION EXTERNALITIES?

● Any negative effect of consumption on third parties that brings about negative benefits is
considered a negative consumption externality.

➔ To see how this works, take the example of consumers who smoke cigarettes in public
places. When consumers smoke in public places, there are external costs that spill over
onto society in the form of costs to non-smokers due to passive smoking. In addition,
smoking-related diseases result in higher than necessary health care costs that are an
additional burden upon society.

■ As shown in the diagram above, when this happens, the total benefit for society
(MSB) is lower than the private benefit (MPB), for every level of output. This is
because the demand for cigarettes does not take into consideration the negative
external effects it has on society as a whole, but only the benefits to the private
individual that consumes it.

■ Therefore, the vertical difference between MSB and MPB represents the negative
externality (negative effect on society – these can be thought of as ‘negative
benefits’). This includes the costs to non-smokers due to passive smoking,
including smoking-related diseases (lung cancer, bronchial illnesses, asthma, etc.)
and higher than necessary health care costs that are an additional burden upon
society.

■ In the example of cigarette consumption, society is consuming an amount Qm

while paying a price Pm. However, from society's point of view, the optimum
amount of cigarettes consumed and produced should be at the point where the
MSC curve intersects the MSB curve, at Qopt.

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 ■ Therefore, more resources are allocated to the production of cigarettes than what is
optimal for society (Qm > Qopt). The market over-allocates resources to the
production of cigarettes.

■ The yellow-shaded triangle shows a welfare loss – net ‘dollar’ value lost by society
from the consumption of units Qm being produced by the market even though
they should have been from society’s point of view. This area of loss is equal to the
difference between the MSB and MSC curves for the amount of output that is
overproduced relative to the social optimum (Qopt − Qm). It involves external
costs for society that are lost because too much of the good is produced. This is
why it is a market failure.

WHAT ARE DEMERIT GOODS AND WHY DO THEY RESULT IN MARKET FAILURE?

● Demerit Goods: Refers to goods that have negative effects when consumed and cause negative
externalities of consumption.

➔ Note!: ​Demerit goods are considered to be harmful for both the individual and society as
a whole, as in the cases of cigarettes and alcohol. As governments think that they should
be consumed to a lesser degree, or not consumed at all.

Important!

Demerit goods are overprovided by the market for two reasons: (i.) Demerit goods may
have negative externalities of consumption, in which case the market overallocated
resources to its consumption and production (Qm > Qopt). For example, cigarette
smoking imposes costs on non-smokers due to passive smoking, including
smoking-related diseases (lung cancer, bronchial illnesses, asthma, etc.) and higher
health care costs. And (ii.) people who consume demerit goods are either unaware of
the possible harm, or they ignore the possible risks. That is, consumers have imperfect
information about the potential costs to themselves, and to others (in which case
consumers may not be aware of the harmful effects upon others of their actions, or they
may not care).

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HOW CAN THE GOVERNMENT REDUCE OR ELIMINATE THE WELFARE LOSS RELATED
TO NEGATIVE EXTERNALITIES OF CONSUMPTION?

● To solve the problem caused by negative consumption externalities, the goal is to eliminate
welfare loss by reducing the quantity consumed of the good until Qm reaches Qopt. There are
several possible ways in which the government can intervene to achieve this outcome:

➔ Impose a Pigovian (indirect) tax – The government could impose a Pigovian

(indirect) tax on consumption activities that contribute to external costs being imposed
onto third parties. This may include the government imposing a specific tax, which is a
fixed amount of money added to the price of each pack of cigarettes, regardless of the
brand or type. The purpose of this policy is to internalize the external costs by raising the
price of cigarettes to reflect the full social cost of their consumption, including healthcare
expenses borne by society, environmental damage from cigarette waste, and productivity
losses due to smoking-related illnesses. This is intended to discourage cigarette
consumption, ultimately leading to a more socially optimal level of consumption and
mitigating the negative impacts on public health and associated costs.

Figure 1. Figure 2.

■ As shown in Figure 1, an indirect (Pigovian) tax has the effect of shifting the supply
curve vertically upwards from S = MPC = MSC to S2 (= MPC + tax).

■ The new market equilibrium is determined by the demand curve D = MPB and the
new supply curve S2 (= MPC + tax), so the price paid by consumers for a pack of
cigarettes increases to Pc.

■ At the higher price (Pc), cigarettes are now less affordable, so consumers are
incentivized to decrease the quantity of cigarettes demanded to quantity Qopt.

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■ If the tax equals the external cost, the S2 (= MPC + tax) curve intersects MPB at the
socially optimum level of output, with production/ consumption occurring at
Qopt, reflecting allocative efficiency.

■ Whereas a Pigovian (indirect) tax is intended to achieve particular objectives, it

does not always work as expected:

Table 1. The limitations of an Pigovian (indirect) tax:

Limitations (of policy)

‒ Accurately measuring the full range of external costs from cigarette

smoking is complex and prone to debate. This includes the economic
burden on healthcare systems, lost productivity due to smoking-related
illness, and the intangible costs of secondhand smoke exposure.
Additionally, secondhand smoke presents particular challenges. Assessing
the impact on various individuals and quantifying the associated health
risks and reduced quality of life involve complex epidemiological and
economic calculations. Thus, setting a tax rate that is equal to the full
external cost may not be achieved. An underestimation will fail to deter
smoking and internalize the costs, while an overestimation could harm the
industry and consumers without achieving the desired reduction in
smoking.

‒ Additionally, when the good is addictive, such as cigarettes (and other

demerit goods), its demand tends to be price inelastic, which means the
consumers are relatively unresponsive to changes in price. Thus, to achieve
the social optimum level of consumption, a high tax rate will need to be
imposed.

‒ High cigarette taxes can incentivize cross-border shopping where

consumers purchase cigarettes in neighboring jurisdictions with lower
taxes. This reduces the tax revenue the government hoped to gain and
undermines the intended reduction in consumption within its own
borders.

‒ Additionally, high tax rates can also fuel the growth of a black market for
cigarettes, offering cheaper alternatives outside the reach of regulation and
taxation. This further undermines the effectiveness of the Pigovian tax and
can introduce safety risks due to unregulated production and distribution.

‒ Furthermore, high cigarette taxes may also incentivize consumers to switch

to lower-taxed or alternative nicotine products, including e-cigarettes,

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 which might raise new public health concerns. The reason is that there are
very many different types (e-cigarettes, chewing tobacco, loose tobacco,
etc.) and for each type there are very many different brands and qualities
that differ dramatically in price. Thus, if, say, 20% tax is imposed on each
pack of cigarettes then a ‘chain of substitutions’ may start with many
poorer addicted individuals just switching to lower priced and lower
quality tobacco substitutes so that overall consumption decreases very
little.

‒ Pigovian taxes can have disproportionate impacts on low-income

consumers who may lack the resources to switch to healthier alternatives
or travel to cheaper sources. This is because higher-income and
lower-income people pay the same amount of tax, but this takes up a larger
proportion of income from lower-income people. This raises concerns
about regressive taxation and potentially exacerbating existing inequalities.

Important!

In practice, given the limitations above for all the various policies it is only
possible to move the economy in a direction towards correction of the
externality, rather than achieving a precise allocation of resources where Qopt is
produced and consumed.

➔ Government regulation – The government could pass laws to limit the consumption
activities that impose external costs onto third parties. This may include legal restrictions
on activities like smoking in public places or age restrictions forcing sellers to do business
only with adults, or laws about cigarette packaging (plain or graphic packaging), or laws
about advertising tobacco products. These regulations primarily target consumer behavior
by directly influencing their purchasing decisions, exposure to cigarette marketing, and
smoking habits in public spaces. The purpose of this policy is to address the specific
activities that result in negative externalities by imposing rules and laws that limit or
prevent their consumption and use.

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■ As shown in the diagram above, government regulations have the effect of shifting
the D1 = MPB curve (due to a change in consumer preferences or fewer buyers in
the market) towards the MSB curve until D2 overlaps with MSB.

■ If the regulation is effective, the D2 (= MPB) curve intersects the MPC curve at the
socially optimum level of output, with production and consumption occurring at
Qopt, reflecting allocative efficiency.

■ Whereas a regulation is intended to achieve particular objectives, it does not

always work as expected:

Table 2. The limitations of a regulation:

Limitations (of policy)

‒ Regulations may also be difficult to enforce. For example, bans on smoking

in public places require extensive enforcement efforts and may face
pushback from businesses relying on customers who smoke. Setting
minimum age limits might be ineffective without robust age verification
systems, while restrictions on advertising could raise concerns about
censorship and stifle competition within the industry. Due to this,
non-compliance may persist despite regulations, especially in
hard-to-monitor areas, leading to limited impact on actual consumption.
This may impose an additional cost on the government.

‒ Regulations can be seen as infringing upon individual freedom of choice

regarding personal habits like smoking. This can lead to public opposition
and resistance to the implementation or enforcement of regulations, which
could negatively affect the government's future elections as consumers are

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 also voters, making it less likely that governments will choose this option.

‒ Regulations alone might not effectively address the core issue of cigarette
addiction, which drives continued consumption even under restrictions.

‒ The tobacco industry wields significant political and economic influence,

potentially lobbying against stricter regulations or hindering their effective
implementation. Political considerations surrounding voter backlash and
potential losses in campaign contributions can make governments hesitant
to pursue strong regulatory measures.

Important!

In practice, given the limitations above for all the various policies it is only
possible to move the economy in a direction towards correction of the
externality, rather than achieving a precise allocation of resources where Qopt is
produced and consumed.

➔ Advertising/ education – The government could create awareness about the risks and
dangers that consuming these harmful goods creates for others, or for the consumer
themselves. These campaigns target youth, adult smokers, and non-smokers alike through
various channels like media messages, community outreach programs, and school
education, fostering informed choices and a culture of smoke-free spaces. The purpose of
this policy is to equip consumers with the knowledge and resources necessary to make
informed decisions that minimize external costs associated with certain cigarette
consumption, particularly its impact on individual and societal health costs,
environmental pollution, and secondhand smoke exposure.

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■ As shown in the diagram above, negative advertising has the effect of shifting the
D1 = MPB curve (due to a change in consumer preferences) towards the MSB curve
until D2 overlaps with MSB.

■ If the advertisement campaign is effective, the D2 (= MPB) curve intersects the

MPC curve at the socially optimal level of output, with production and
consumption occurring at Qopt, reflecting allocative efficiency.

■ Whereas advertising/ education is intended to achieve particular objectives, it does

not always work as expected:

Table 3. The limitations of advertising/ education:

Limitations (of policy)

‒ Educational campaigns are a long-term approach that requires significant

investment from the government. This means there are less funds available
for use elsewhere in the economy (there are opportunity costs).

‒ Additionally, there is always a level of doubt about how effective

advertising is at reducing demand, especially in cases such as cigarette
consumption within certain age groups. Many studies show that
advertising does not have a great effect on teenagers in reducing cigarette
consumption. This is because many teenagers may be aware of the
potential risks, but manage to convince themselves that they will not be
affected. Or, they reason that the consequence will be felt too far in the
future to worry about it. Additionally, long-term smokers often have deeply
ingrained habits that may result in educational campaigns to be an
insufficient method to reduce smoking.

‒ The tobacco industry and other interested groups can engage in

counter-messaging campaigns, promoting misleading information or
minimizing the health risks of smoking. This can undermine the
effectiveness of genuine educational efforts and confuse the public.

Important!

In practice, given the limitations above for all the various policies it is only
possible to move the economy in a direction towards correction of the
externality, rather than achieving a precise allocation of resources where Qopt is
produced and consumed.

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