Implications of misallocation of resources in relation to the over-consumption of demerit goods and goods with external costs

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Allocation of Resources: Market Failure

The Allocation of Resources – Market Failure

Objective

To understand the implications of misallocation of resources when there is over‑consumption of demerit goods and goods that generate external costs.

Key Concepts

  • Demerit Goods: Goods that are over‑consumed because consumers underestimate the personal costs (e.g., cigarettes, alcohol).

  • External Costs (Negative Externalities): Costs imposed on third parties not reflected in the market price (e.g., pollution from factories).

  • Social Cost: The total cost to society, equal to private cost plus external cost.

    \$\text{Social Cost}= \text{Private Cost}+ \text{External Cost}\$

  • Market Failure: When the free market does not allocate resources efficiently, leading to a deadweight loss.

Why Over‑Consumption Occurs

  1. Consumers ignore or undervalue personal health risks (information failure).

  2. Addictive properties reduce price elasticity of demand.

  3. External costs are not borne by the consumer, so the market price is lower than the true social cost.

Implications of Misallocation

When demerit goods are over‑consumed, the following economic and social effects arise:

  • Deadweight Loss: Resources are diverted from more valuable uses, reducing total welfare.

  • Increased Healthcare Expenditure: Governments may face higher public spending to treat diseases linked to demerit goods.

  • Reduced Labour Productivity: Health problems lower worker output and increase absenteeism.

  • Environmental Degradation: For goods with external costs, pollution can damage ecosystems, reducing future productive capacity.

  • Inter‑generational Inequity: Current over‑consumption can impose costs on future generations (e.g., climate change).

Comparison: Demerit Goods vs. Goods with External Costs

AspectDemerit GoodsGoods with External Costs
Primary IssueConsumer undervalues personal harmThird‑party (societal) harm not reflected in price
Typical ExamplesCigarettes, alcohol, fast foodCoal‑fired electricity, motor vehicles, industrial chemicals
Market PriceBelow true social cost (private cost only)Below true social cost (private cost only)
Resulting QuantityQmarket > QoptimalQmarket > Qoptimal
Common Government InterventionsExcise taxes, age restrictions, public health campaignsPigouvian taxes, regulation, tradable permits

Government Intervention – Economic Rationale

To correct the market failure, governments aim to internalise the external cost so that the price faced by consumers reflects the social cost.

  • Pigouvian Tax: A tax equal to the marginal external cost.

    \$\text{Pigouvian Tax}= \text{Marginal External Cost}\$

  • Subsidies for Alternatives: Encourage consumption of less harmful substitutes (e.g., nicotine patches).

  • Regulation & Standards: Set limits on emissions or ban certain harmful products.

  • Public Information Campaigns: Reduce information asymmetry about health risks.

Suggested Diagram

Suggested diagram: Supply and demand curves showing the private marginal cost (PMC), social marginal cost (SMC), and the resulting deadweight loss from over‑consumption of a demerit good.

Key Take‑aways

  1. Over‑consumption of demerit goods and goods with external costs leads to a misallocation of resources and a loss of total welfare.

  2. The market price fails to reflect the true social cost, creating a gap between private and social equilibrium.

  3. Government policies such as taxes, regulation, and information campaigns aim to internalise externalities and move the market towards the socially optimal outcome.

  4. Understanding these mechanisms is essential for evaluating the effectiveness of economic policies in correcting market failures.