--EXAMPLE # 1--

Using a diagram, explain why demerit goods are considered to be an example of market failure. (10)

--UNDERSTANDING--

Before writing I must be clear that this question requires me to show how a demerit good results in an OVERCONSUMPTION/PRODUCTION situation.

--DEFINITIONS--

In order to answer this question, we will first define some key terms. Market failure occurs when the quantity of scarce productive resources allocated to the production of a particular good or service does not result in the socially optimal or allocatively efficient level of output where MSC=MSB. A demerit good refers to a product that when produced or consumed, creates external costs for 3rd parties who are not compensated, these are referred to as negative externalities and can occur from both production and consumption activities.

--RESTATE QUESTION--

...as to why demerit goods are considered a market failure...

--EXPLANATION --

...as mentioned, demerit goods create external costs for third parties. In the case of negative externalities of production such as pollution from the burning of fossil fuel during the production process, these 3rd party costs are not factored into the firm's private costs of production, meaning that it has a lower marginal cost per unit and if we assume that the firm produces at its profit maximimising level of output where MC=MR, they will produce at a level that is greater than the socially optimal, hence creating a market failure.

We can illustrate both these concepts in the diagram below.

• #1 MARKET FAILURE: Must show MSC=MSB and Qso/Pso ...In figure 1 we can see that the socially optimal level of output occurs at Qso, where the MSC and MSB curve intersect

• #2 DEMERIT GOOD: neg. ext of prod. MPC<MSC or neg. ext of con. MPB+EB MSB ...In figure 1. we can see that a demerit good creates external costs per unit equal to the vertical difference between the MPB and MSB curves, labeled EC. We can also see that the equilbrium output produced when these EC are not 'internalised' at MSC=MPB results in over consumption of....units, creating a deadweight loss of area....