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

1. The Basic Economic Problem (Syllabus 1.1‑1.4)

1.1 Scarcity and Choice

  • Resources are limited but human wants are unlimited → societies must decide what, how and for whom to produce.

1.2 Factors of Production

FactorTypical Examples
LandNatural resources, space, minerals
LabourHuman effort, skills, time
CapitalMachinery, factories, infrastructure
Enterprise (entrepreneurship)Risk‑taking, innovation, organisation

1.3 Opportunity Cost

When a choice is made, the next best alternative that is foregone is the opportunity cost.

Example: If a country uses a factory to produce cars instead of textiles, the opportunity cost is the value of the textiles that could have been produced.

1.4 Production Possibility Curve (PPC)

Typical PPC showing efficient (on curve), inefficient (inside) and unattainable (outside) points. The slope at any point is the marginal rate of transformation (MRT) – the opportunity cost of one good in terms of the other.

2. Allocation of Resources – The Market Mechanism (Syllabus 2.1‑2.8)

2.1 Demand and Supply

  • Demand: Quantity of a good that consumers are willing & able to buy at each price (downward‑sloping).

  • Supply: Quantity that producers are willing & able to sell at each price (upward‑sloping).

2.2 Market‑price Determination

Equilibrium occurs where Quantity demanded = Quantity supplied. The corresponding price is the market price.

2.3 Shifts in Curves

FactorEffect on DemandEffect on Supply
Income (normal good)Right‑shift–
Price of substituteRight‑shift–
Technology–Right‑shift (increase)
Input price–Left‑shift (decrease)

2.4 Elasticity

  • Price Elasticity of Demand (PED) = %ΔQd / %ΔP

    Interpretation: How responsive quantity demanded is to a price change.

  • Price Elasticity of Supply (PES) = %ΔQs / %ΔP

Determinants include availability of substitutes, proportion of income spent, time horizon, and spare capacity.

Numeric Example (PED)

Price of a soft drink rises from £1.00 to £1.20 (↑20%). Quantity demanded falls from 100 000 to 80 000 (↓20%).

PED = (‑20%)/(+20%) = –1.0 → demand is unit‑elastic.

2.5 Market Failure (Syllabus 2.9)

A market fails when the free‑market equilibrium does not achieve the socially optimal outcome – i.e. the quantity produced/consumed is not the level that maximises total welfare, creating a dead‑weight loss (DWL).

2.5.1 Causes of Market Failure

CauseBrief ExplanationTypical Example
Demerit goods (negative consumption externalities)Consumers underestimate personal harms; price reflects only private cost.Cigarettes, alcohol, sugary drinks
Negative production externalitiesThird‑party costs are not borne by producer/consumer.Factory pollution, motor‑vehicle emissions
Positive externalitiesThird‑party benefits are not reflected in the market price.Vaccinations, education
Public goodsNon‑rival & non‑excludable → markets under‑provide.National defence, street lighting
Merit goodsPrivate benefits are less than the total social benefit.Primary schooling, preventive healthcare
Monopoly / imperfect competitionSingle seller restricts output, price > marginal cost.Utility companies in some regions
Information failureConsumers or producers lack full/accurate information.Misleading food labels, hidden fees

3. Key Terminology (Syllabus 2.9)

TermDefinition (one sentence)
Private Cost (PC)Cost incurred directly by the producer or consumer.
External Cost (EC)Cost imposed on third parties that is not reflected in the market price.
Social Cost (SC)PC + EC – the total cost to society of producing a good.
Private Benefit (PB)Benefit received directly by the consumer.
External Benefit (EB)Benefit enjoyed by third parties without payment.
Social Benefit (SB)PB + EB – the total benefit to society of consuming a good.

4. Why Over‑Consumption of Demerit Goods & Goods with External Costs Occurs

  1. Information failure: Consumers underestimate personal health risks or the magnitude of external harms.

  2. Addictive or habit‑forming properties: Reduce price elasticity of demand, making consumption less responsive to price changes.

  3. External costs are not internalised: Market price reflects only private cost, so it is lower than the social cost.

5. Economic & Social Implications of Misallocation

  • Dead‑weight loss (DWL): Resources are diverted from more valuable uses, lowering total welfare.

  • Higher healthcare expenditure: Public funds must treat diseases linked to demerit goods.

  • Reduced labour productivity: Ill‑health and addiction lower output and increase absenteeism.

  • Environmental degradation: Pollution damages ecosystems, reducing future productive capacity.

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

6. Comparison: Demerit Goods (Consumption Externality) vs. Goods with Production External Costs

AspectDemerit Goods (Consumption)Goods with Production Externalities
Primary issueConsumer undervalues personal harmThird‑party (societal) harm not reflected in price
Typical examplesCigarettes, alcohol, sugary drinksCoal‑fired electricity, motor vehicles, industrial chemicals
Market priceBelow true social cost (reflects only private cost)Below true social cost (reflects only private cost)
Resulting quantityQmarket > QoptimalQmarket > Qoptimal
Common government interventionsExcise taxes, age restrictions, health campaignsPigouvian tax, regulation, tradable permits, subsidies for cleaner alternatives

7. Government Intervention – Economic Rationale (Syllabus 2.9)

Goal: internalise external costs so that the price faced by consumers/producers reflects the social cost, moving the market toward the socially optimal equilibrium.

7.1 Direct Tools for Negative Externalities

  • Pigouvian tax – a tax equal to the marginal external cost (MEC).

    Pigouvian Tax = MEC

  • Regulation & standards – legal limits on emissions, bans on harmful products.

  • Tradable permits (cap‑and‑trade) – a total allowable amount of pollution is allocated; firms trade rights.

  • Subsidies for cleaner alternatives – e.g., subsidies for electric vehicles or nicotine‑replacement therapy.

  • Public information campaigns – reduce information asymmetry about health and environmental risks.

7.2 Additional Intervention Options Required by the Syllabus

ToolWhen It Is UsedRationale (one sentence)
Maximum (price ceiling)When a good is essential but unaffordable.Prevents price from rising above an affordable level, protecting consumers.
Minimum (price floor)When producers receive too low a price (e.g., agriculture).Ensures producers can cover costs and stay in business.
Indirect tax (general excise)Broad‑based taxes on harmful goods.Raises price, reducing quantity demanded while generating revenue.
Indirect subsidyEncouraging consumption of merit goods.Lowers price, increasing socially beneficial consumption.
Direct provision of goods/servicesWhen the market fails to supply a public or merit good.Government produces the good to ensure adequate provision.
PrivatisationWhen a state‑owned monopoly is inefficient.Transfers ownership to the private sector to improve efficiency.
NationalisationWhen a private monopoly exploits consumers.Government takes control to protect the public interest.
Quotas (import or production)To limit the quantity of a harmful good.Directly caps output or imports, reducing over‑consumption.

7.3 Diagram – Over‑Consumption of a Demerit Good

Supply‑demand diagram showing Private Marginal Cost (PMC), Social Marginal Cost (SMC), market equilibrium (Qm, Pm) and socially optimal equilibrium (Qopt, Popt). The shaded area between SMC and PMC from Qopt to Qm represents the dead‑weight loss.

8. Mixed Economic System – Arguments For & Against (Syllabus 2.10)

ArgumentFor a Mixed EconomyAgainst a Mixed Economy
EfficiencyMarkets allocate most resources efficiently; government intervenes only where failure occurs.Intervention can distort price signals and create inefficiencies.
EquityState involvement can redistribute income and provide merit/public goods that markets under‑provide.Excessive redistribution may reduce incentives to work and invest.
Flexibility & InnovationPrivate sector drives innovation; public sector ensures basic standards.Public sector may be slower to adopt new technologies and prone to bureaucracy.
Control of ExternalitiesGovernment can impose taxes, regulations, or tradable permits to correct market failures.Regulatory capture or poorly designed policies can worsen outcomes.

9. Micro‑Economic Decision‑Makers (Syllabus 3.1‑3.5)

Decision‑makerMain VariablesTypical Diagram
HouseholdsIncome, preferences, prices of goods, saving/borrowing choices.Indifference curve & budget line
FirmsCosts of production, technology, output price, profit maximisation.Average & marginal cost curves; MR = MC
GovernmentTax rates, public spending, regulation, provision of merit/public goods.Fiscal‑policy diagram (budget balance)
Foreign sectorExchange rate, world prices, import/export quantities.Supply‑demand for foreign exchange
Money & bankingInterest rate, money supply, reserve requirements.Simple money‑market diagram (LM curve style)

9.1 Labour‑Market Example

Supply of labour (upward) and demand for labour (downward). Equilibrium wage (W*) and employment (E*) illustrate how a minimum wage (price floor) creates unemployment (DW).

9.2 Firm‑Cost Example

Average Total Cost (ATC) curve with marginal cost (MC) intersecting ATC at its minimum. Shows profit‑maximising output where MR = MC.

10. Government & the Macro‑Economy (Syllabus 4.1‑4.6)

10.1 Fiscal Policy

  • Tools: Government spending (G) and taxation (T).

  • Goal: Influence aggregate demand (AD).

    • Expansionary fiscal policy: ↑G or ↓T → AD shifts right → higher output & employment.

    • Contractionary fiscal policy: ↓G or ↑T → AD shifts left.

AD‑AS diagram showing the effect of an expansionary fiscal policy (AD shifts right from AD₁ to AD₂, raising real GDP and price level).

10.2 Monetary Policy

  • Tools: Interest rate (i), reserve ratio, open‑market operations.

  • Goal: Control money supply (M) and influence aggregate demand.

  • Lower interest rates → cheaper borrowing → AD shifts right; higher rates → AD shifts left.

Simple money‑market diagram: a decrease in the policy interest rate moves the LM curve right, raising output.

10.3 Supply‑Side Policies

  • Improve productive capacity: investment in education, training, infrastructure, research & development.

  • Reduce regulatory burdens, promote competition.

10.4 Macro‑economic Objectives

ObjectiveKey IndicatorTypical Target
Economic growthReal GDP growth ratePositive, sustainable growth (e.g., 2‑3% p.a.)
Low unemploymentUnemployment rate = (Number unemployed ÷ Labour force) × 100Usually < 5‑6 %
Price stabilityInflation rate (CPI growth)Typically 2‑3 % (target range)
External balanceCurrent‑account balanceClose to zero, avoiding large deficits/surpluses
Equitable distribution of incomeGini coefficient, poverty rateLower inequality, reduced poverty

10.5 Simple Calculations

  • Unemployment rate: If 2 million people are unemployed and the labour force is 20 million, unemployment = (2/20) × 100 = 10 %.

  • Inflation (CPI): CPI last year = 110, this year = 115 → Inflation = ((115‑110)/110) × 100 = 4.5 %.

11. Economic Development (Syllabus 5.1‑5.5)

11.1 Living Standards

  • Measured by real GDP per capita, Human Development Index (HDI), life expectancy, literacy rates.

  • Higher living standards → better health, education, and consumption possibilities.

11.2 Poverty

  • Absolute poverty: living on less than a set minimum (e.g., $1.90 a day).

  • Relative poverty: income below a certain proportion of the median income (e.g., < 60 % of median).

11.3 Population Issues

IssueEconomic Effect
Population growthCan increase labour supply but may strain resources if growth outpaces productivity.
Age structure (young vs. ageing)Young populations need education & jobs; ageing societies increase health‑care costs.
UrbanisationBoosts economies of scale but can create housing shortages and congestion.

11.4 Cross‑Country Differences

  • Factors influencing development: natural resources, institutions, technology, education, health, political stability.

  • Trade‑off between economic growth and environmental sustainability is a key contemporary issue.

12. Key Take‑aways

  1. Scarcity forces societies to make choices; opportunity cost is the value of the next best alternative.

  2. The market mechanism (demand, supply, price) normally allocates resources efficiently, but elasticity determines how responsive quantities are to price changes.

  3. Market failure occurs when private costs/benefits diverge from social costs/benefits, leading to dead‑weight loss.

  4. Over‑consumption of demerit goods and goods with external costs misallocates resources, harms health, reduces productivity, and damages the environment.

  5. Governments can internalise externalities through taxes, regulation, tradable permits, subsidies, information campaigns, and price controls.

  6. A mixed economy seeks to combine market efficiency with state intervention to correct failures and promote equity.

  7. Understanding the roles of households, firms, government, the foreign sector, and the banking system is essential for analysing micro‑ and macro‑economic outcomes.

  8. Fiscal and monetary policies, together with supply‑side measures, are the main tools for achieving macro‑economic objectives (growth, low unemployment, price stability).

  9. Economic development is judged by living standards, poverty levels, population dynamics and the ability to sustain growth without degrading the environment.