Negative Externalities and Demerit Goods

Demerit goods are goods and services that are over-consumed in a free market because consumers either fail to fully appreciate their long-term negative consequences or are influenced by factors such as addiction, peer pressure, or misleading advertising. Unlike merit goods, which generate positive externalities, demerit goods create negative externalities, meaning their consumption imposes costs on society. Common examples include tobacco, alcohol, recreational drugs, and unhealthy processed foods.

Characteristics of Demerit Goods

Negative Externalities: The consumption of demerit goods leads to costs that extend beyond the individual consumer. For instance, smoking increases public healthcare costs due to smoking-related illnesses, while excessive alcohol consumption contributes to crime, traffic accidents, and lost productivity.
Imperfect Information: Many individuals focus on short-term pleasure or gratification while underestimating the long-term consequences of consuming demerit goods. For example, teenagers may ignore the risks of smoking or excessive sugar consumption due to peer influence and lack of awareness.
Social Costs and Market Failure: Overconsumption of demerit goods can place a significant burden on public services, such as healthcare and law enforcement, leading to higher taxes and lower economic productivity. The presence of negative externalities results in market failure, as private individuals do not account for the broader societal harm of their consumption.

Negative Externalities

What are negative externalities?

Negative Ext of Production.mov

This video will look into what negative externalities of production are and how they can occur in the free market.

Remember, the externality occurs due to the spillover costs from the production, causing the Marginal Social Cost (to society) to be higher than the Marginal Private Costs to firms to produce. Therefore, this causes an overproduction and overconsumption of the good in the free market, meaning an overall overallocation of resources and therefore market failure.

Market Based Methods to Correct Negative Externalities

This video will explore the Market Based Policies governments can use to correct negative externalities of production. These include:

Pigovian Tax
Carbon Tax
Tradable Permits/Cap and Trade System

These policies are referred to as "Market Based" as they aim to encourage changes in the market through market forces and actors i.e. consumers and producers responding to changes in the price in the market. All of the above will increase the cost of production for firms, resulting in higher prices and therefore falling quantity demanded. Carbon taxes and Tradable Permits may also encourage firms to invest in greener technologies in order to avoid having to pay the additional costs. This is because the overall levels of carbon emissions will be lower and therefore the tax or need for permits will be lower for these firms using greener technologies, increasing a firms profitability.

Neg Ext - Market Based Methods.mov

Pro's of Market Based Policies

Internalising the externality (external cost). This means that costs to society are now paid for by consumers and producers, who are the parties of the transaction
Carbon taxes which tax the emissions rather than a tax on output, can encourage firms to invest in greener technologies in order to avoid having to pay the tax. This can cause a long run shift downward in the MSC. (A tax on output on the other hand, will simply decrease output and firms will keep the same production methods.)
This incentive will also encourage firms to use materials that pollute less or use the current materials more efficiently. Those firms that can't will have to pay the tax and so will produce less, whilst those more efficient firms will produce more, lowering the external costs to society overall.
Similarly, if firms know in time that the number of tradable permits will be reduced (and therefore it will become more expensive to pollute in the future, firms can plan ahead to invest to reduce their pollution in order to avoid paying the higher price for the permits, thus reducing the external costs of production.

Con's of Market Based Policies

Taxation

Different production methods produce different pollutants so therefore governments must decide what pollutants does the policy aim to reduce.
It is difficult for governments to determine the value of the harm to society. Therefore it is difficult for governments to determine a value of the external cost and therefore determine the value of the resulting tax.
Any form of indirect taxation is considered regressive. That is to say, as the value of the tax is the same regardless of income, those on lower incomes will ultimately be worse off as the % of their income spent on the tax is higher than those on higher incomes. Therefore it is considered inequitable or unfair.

Tradable Permits

As with carbon taxes, it is difficult to determine the value of the external cost and therefore issue the sufficient number of permits to correct the external cost. Issue to many permits and the cost of polluting is low, therefore making the policy ineffective. Issue too few and the price of polluting will be too high, even for efficient firms and may cause additional hardship or even force firms to shut down.
Tradable Permits focus on only specific pollutants (CO2, SO2)
Distribution of permits may present problems of political favouritism as governments give preferential treatment to specific supporters.

Regulation and Legislation

Unlike market based policies, command and control policies aim specifically to control the outcomes in a market. For example, banning firms from releasing certain emissions, or enforcing permits or licenses to control the levels of pollution etc.

Regulation and Legislation

Government regulation and legislation aim to reduce the negative production externalities through introducing and enforcing environmental standards, quotas for pollutants, licenses or permits to limit who can produce or outright bans/restrictions on production. The aim of all these policies is to reduce production and therefore shift the MPC leftwards, closer to the social optimum level of output

Examples of Government regulation can include

restrictions on emissions of pollutants from factories and industrial production by setting a maximum level of pollutants permitted. Firms will be unable to pollute more than a certain level limiting how much firms can produce whilst polluting, reducing the MPC curve and shifting it to the left.
requirements for steel mills and power plants to install smokestack scrubbers to reduce emissions. This can increase the cost of production for firms and reduce the pollutants, shifting MPC to the left and possibly in the long run, reducing the MSC as less dangerous emissions are released.
banning the use of harmful substances. For example Chlorofluorocarbon (CFC) was commonly used in refridgerators. It was found that this gas was damaging to the Ozone. Under the Montreal Protocol in 2006, the use of this gas was banned and member countries signing the protocol agreed to ban the use of this gas in their countries. This links in to the role of International Agreements which we will look at below.
using permits or licenses. For example, in some countries to be able to fish in public ponds, people must posses a license or require a permit to do so. The idea behind these is to reduce, limit the number of people or control the number of people doing that activity. The idea is that the number of permits or licences can be changed to promote more sustainable use.
restricting the construction on, industrialisation of or agricultural use of on protected lands. Governments can also enforce protection of land for its biodiversity. For example, 27.8% of land in Costa Rica is National Park and therefore can't be built on or used for agriculture.

Pro's of Regulation and Legislation

Easy to impose and put into effect
Effective for certain problems such as banning harmful substances
Firms are forced to comply with the regulation and therefore may achieve the desired outcome more as compared to market based.

Con's of Regulation

Limited incentive for firms to reduce emissions and switch to using greener technologies.
Not all firms costs to reduce pollutants are the same and may not reduce supply by the desired amount
Difficult to monitor actual levels and track firms as well as additional costs for governments to monitor and enforce.
Regulation focusing on CO2 emissions ignores other pollutants released and therefore may not reduce all negative effects.

Understanding Common Access Resources

Common access resources (or common pool resources) are resources that firms and individuals can access without restriction. They differ from other types of goods because of specific characteristics:

They are rivalrous. This means the consumption by one person, will directly affect another persons ability to consume that good.
They are non excludable. This means that no one can be excluded from the consumption of that particular good. This is because common access resources have no price mechanism, therefore meaning people can access the good and not be excluded.

Examples of common access resource include; Forests, Lakes, Rivers, Air, Land. The examples of the overuse of these common access resources is extensive.

Deforestation and illegal logging to clear land for agriculture

Pollution to the air from production

Overfishing

In all of the above situations, there is the overuse of these common access resources and negative consequences of the overuse of these common access resources. Deforestation can have damaging effects on climate change as can the release of carbon emissions into the atmosphere. Overfishing can cause changes in marine biodiversity. All of these actions have negative consequences to individuals that are not involved in the production or consumption of a good. This presents us with a situation where the free markets have failed and affected those not involved in the economic transaction. We are all aware nowadays of the environmental damages from our current over production and consumption levels. Therefore, why do we continue to do so?

Tragedy of the Commons

As we have mentioned, Common Access Resources are Non Excludable but Rivalrous. This leads to the problem we call Tragedy of the commons.

What the video below to find more information.

As we can see, due to the non excludable but rivalrous elements of a common access resources, these tend to get over used due to self interests. Therefore, common access resources and negative production externalities that we will look at next, both pose a threat to sustainability (one of our key concepts)

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