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Market failure is
the term used when the market fails to allocate resources efficiently, where
goods are over or under-allocated from the view of what is socially desirable. In
the case of negative externalities, the market over-allocates the resources or
goods that produce negative externalities. Theoretically, ‘allocative
efficiency is achieved when marginal benefit equals marginal cost’ (Sloman, et
al., 2015, p. 315).
When the market fails to equate marginal social benefit and marginal social
cost, Pareto optimality is not achieved. Negative externalities are the undesirable
effects on a third party not involved in the transaction of a good between
producer and consumer, and can be the result of both consumption or production.


Demerit goods are
goods that are considered to be socially undesirable as they produce a negative
externality when consumed, for example the consumption of cigarettes, sweets
and soft drinks. The UK government considers both tobacco and sugar to be demerit
goods that produce negative externalities, shown by the implementation of the
sugar tax on soft drinks, and the rise of the tobacco tax where ‘smokers will be hit with a tobacco tax that will continue to
rise at inflation plus 2 per cent’ (Batchelor, 2017), in order to reduce
and correct these externalities.

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A negative externality of consumption occurs when
marginal social benefit is less than marginal private benefit (MSB < MPB) as the private consumption of a demerit good is what produces the external cost, with the value of the external cost being the difference between the MSB curve and the MPB curve. The market supply, without government intervention is Qm and Pm, where the market over allocates resources to the point where Qm is greater than Qopt. However, the social optimum level of consumption of a demerit good is when MSB is equal to MSC, thus because of this overconsumption, there is a deadweight welfare loss to society, shown by the highlighted red triangle. If the market was assumed to be perfect in all other aspects and there was presence of a price taker, the frim would face a horizontal demand curve and social optimum output would be P = MC.   The regular consumption of sugar in food and drink can lead to health problems such as 'obesity, type 2 diabetes, cardiovascular disease, tooth decay and bone density problems'. (Davey, 2018) In the UK, data shows that the high level consumption of sugary foods and drinks in the UK is leading to '170 children and teenagers a day are having operations in NHS hospitals to remove multiple teeth that have been rotted by sugar' (Matthews-King, 2018), which is the costing the UK government £36.2 million pounds annually. This high cost of treating just one of the consequences of sugar consumption negatively affects society because of the opportunity cost of using government revenue to treat the consequences of sugar consumption, especially when it is preventable. This revenue could have been spent on publics goods and merit goods such as education, job training, advertisement or improving infrastructure, all of which are beneficial to society. Moreover, poor health adversely affects job productivity which is another instance of market failure.   Additionally, negative externalities can adversely affect the environment. For example, the smoking of cigarettes by the consumer not only can also lead to health problems such as lung cancer and respiratory complications, and affect other members of society with the phenomenon of passive smoking, but can harm the environment by contributing to pollution.   On the other hand, negative externalities, including those on the environment, can be the result of production which occurs when the marginal social cost is larger than marginal private cost (MSC > MC). These external costs arise when goods are produced
by firms using fossil fuels which result in carbon emissions polluting the air and
bodies of water, as well as having adverse affects on human health. CO2 emissions
acidify fresh bodies of water as well as the ocean, contributing to the harm of
aquatic wildlife, which affects the supply of seafood in the economy.  Another example is intensive agricultural
farming that destroys hedgerows and wildlife.  Common access resources, where there is no
legal ownership, such as the ocean and air in the free market economy means they
attract external costs because ‘no one can prevent or charge for their use as a
dump for waste’. (Sloman, et al., 2015, p. 324)

The marginal social cost of chemical or fossil fueled
production exceeds the marginal private cost. Qm is greater than Qopt,
indicating that the market over allocates resources from what is socially desirable,
Qopt, while the market supply is Qm. The deadweight
welfare loss that arises from resource misallocation is highlighted by the red triangular
are in the diagram above. Many countries, specifically 195, are aiming to meet
obligations specified by the Paris climate agreement in 2015 which aims to reduce
carbon emissions and therefore contain the harmful affects of climate change. ‘These include devastating natural disasters such as droughts and
flooding, which are increasingly being directly linked with rising temperatures’ (Gabbatiss, 2018), all of which negatively
affect society and strain the economy. The opportunity cost of the high cost of
rebuilding infrastructure and buildings damaged by the natural disasters, and
the high prices of goods – particularly agricultural goods – due to supply shock
affect producers and consumers alike.

government can intervene to address the market failure and improve social
efficiency by reducing or completely eradicating the external costs and equating
MSB to MSC, while adopting the second-best solution in an attempt to ‘minimise the
overall distortionary effects of the policy measure’. (Sloman, et al., 2015, p.
The government has two choices in terms of intervention: market-based polices
or command approaches which include legislation and regulation. ‘Market-based
policies change price incentives of firms and consumers’ (Tragakes, 2015, p. 21), including indirect
taxes and subsidies. In the case of negative externalities where resources are
over allocated and over consumed, taxes are used to reduce production and
consumption of goods.

indirect tax on a demerit good causing negative externalities of consumption
such as tobacco or sugary soft drinks, shifts the supply curve decreasingly to
the left, to MPC plus tax which results in a rise in price. Therefore,
consumers pay a higher price while producers receive a lower price because
producers will increase the price in order to counteract the rise in production
costs due to the indirect tax. The government levies the tax so the burden
falls on both the producer and the consumer. If the value of the tax is equal
to the value of external costs, the externality and resulting welfare loss to
society will be removed as MPC + tax will intersect MPB at Qopt output
level with a higher price. This higher market price should act as an incentive
for consumers to reduce consumption of cigarettes and sugary foods and drinks.

In order to reduce
the external costs of production, particularly carbon emissions and greenhouse gases,
the government can levy indirect taxes on output or emissions such as the carbon
tax, as well as cap and trade schemes and tradable permits. Both taxes on
emissions and output decreasingly shift the supply curve (MPC) towards MSC as
the tax offers incentives to switch to clean technology in production so as not
to increase production costs, as the fewer pollutants emitted, the lesser the


Market based
polices are effective as they can internalise the externality by making the
producers pay for the cost of the externality, and are more efficient as they
produce an incentive to switch to clean technology at a lower cost. The
policies also affect price mechanism to deter consumers from buying demerit
goods, while simultaneously raising government tax revenue. However, there is
great difficulty in identifying the value of the external cost and the value of
the tax that would counteract the welfare loss. Additionally, indirect taxes
are regressive which means they affect the poor more than the rich, further
increasing income inequality.


governments can use regulation, legislation, education and advertisement to directly
reduce environmental damage and to change consumer behaviour to decrease demand
of demerit goods. Often these policies are simpler to implement than
market-based policies and are attractive to those who disagree with government
intervention in the market. These polices can be effective in reducing the
costs of negative externalities yet only partially effective as they are unlikely
to fully shift the MPB curve towards MSB curve. Additionally, these government policies
involve the cost of enforcing and monitoring as well as opportunity cost of
spending government revenue on advertisements and enforcement of regulation. Also
they do not provide the same incentive for firms to switch to cleaner
technology as market-based policies.


Ultimately, negative
externalities must be removed to allow for social and Pareto optimality, particularly
externalities of production. Carbon and greenhouse emission are a global problem
which are effecting everyday lives, and the government can use both
market-based policies and command policies to reduce negative externalities. 

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