Embedded Files
"Imagine there is one smoker in your friendship group who gets a massive 'buzz' from inhaling all that poisonous, life-shortening death gas into their lungs, then expelling it in close proximity to the non-smoking group members."
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"Do you think the smoker is 'fully-aware' of the impacts of their activity on their own health and that of others?"
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"Not likely, right?", "They probably 'think' they know more than the medical experts ('bounded rationality')', boasting about how their 80-year-old father has smoked since he was a teen and has run over 100 marathons as evidence that its harmless..."
"...as well as being completely oblivious to or in denial (cognitive dissonance) about the harm they are doing to others, likely believing all official statistics are exaggerated and based on some nonsense pseudoscience."
[PICTURE OF SMOKER SAYING TO FRIENDS THAT THEY ARE COUGHING
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"Also, do you think they will be forced to 'compensate' the non-smokers for the treatment costs of any second-hand smoking-related illnesses that their actions have created?"
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"...again not likely, right?", "Despite creating costs for others, they can happily ignore the need to reimburse them, leaving them even more income to spend on cigarettes."
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PICTURE OF THE SMOKER HAPPILY IGNORING the moans of his friends about bills for sore throats and medicine
"So, we effectively have consumers that firstly are not fully informed of the net benefit that they will receive from consuming cigarettes ('imperfect information') and secondly who take this risk with others' health as they know they will not have to bear the full consequences or costs of that risk ('moral hazard').
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"So what, you might ask?" "Well, think about the demand curve used to determine the market equilibrium output for cigarettes; is it the socially optimal one?"
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"No, it isn't, because even though the demand curve is supposed to reflect the total 'net benefit to society' (aka social benefit curve,) which includes both the smokers' benefit and the 'compensation cost' for the negative benefits, in reality...."
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"...the market has no mechanism to 'internalise' these external costs to capture the 'net-benefit' and therefore the market equilibrium output is based solely on the private benefit curve, leading to...."
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"That's right, a market equilibrium output that exceeds the socially optimum equilibrium output, leading to 'overconsumption.'
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"Let's get some defining...!"
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--THINK AHEAD--
"Imagine there is one smoker in your friendship group who gets a massive 'buzz' from inhaling all that poisonous, life-shortening death gas into their lungs, then expelling it in close proximity to the other non-smoking group members who are quietly repulsed."
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"Do you think the smoker is 'fully-aware' of the side effects of their activity on themselves and on others?" "If they could see a countdown clock showing how smoking reduces their exact lifespan and that of others, do you think they would smoke as much?"
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"Not likely, right?", "They probably 'think' they know about the harmful effects but in truth have no idea of the exact long-term impact it's having on their own individual health and that of others ('bounded rationality').", "Would they continue to smoke in front of others if they knew with 100% certainty that it was killing them?"
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"Also, do you think they will be forced to 'compensate' the non-smokers for the treatment costs of any second-hand smoking-related illnesses that their actions have created?"
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"...again not likely, right?", "Despite creating costs for others, they can happily ignore the need to reimburse them, leaving them even more income to spend on cigarettes."
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"So, we effectively have consumers that firstly are not fully informed of the net benefit that they will receive from consuming cigarettes ('imperfect information') and secondly who take this risk with others' health as they know they will not have to bear the full consequences or costs of that risk ('moral hazard').
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"So what, you might ask?" "Well, think about the demand curve used to determine the market equilibrium output for cigarettes; is it the socially optimal one?"
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"No, it isn't, because even though the demand curve is supposed to reflect the total 'net benefit to society' (aka social benefit curve,) which includes both the smokers' benefit and the 'compensation cost' for the negative benefits, in reality...."
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"...the market has no mechanism to 'internalise' these external costs to capture the 'net-benefit' and therefore the market equilibrium output is based solely on the private benefit curve, leading to...."
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"That's right, a market equilibrium output that exceeds the socially optimum equilibrium output, leading to 'overconsumption.'
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"Let's get some defining...!"
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--DEFINITION--
--DEFINITION--
A NEGATIVE EXTERNALITY OF CONSUMPTION occurs when an INDIVIDUAL'S CONSUMPTION of a good or service decreases the well-being (CREATES EXTERNAL COSTS) of others (THIRD PARTIES) to whom they fail to COMPENSATE These goods are referred to as DEMERIT GOODS and this results in the OVERCONSUMPTION of this good beyond the socially optimal level of output.
In other words, the market's equilibrium output is greater than the socially optimal output level, implying that the demand curve is too far to the right, but why?
-WHY OVERCONSUMED?-
-WHY OVERCONSUMED?-
"In the smokers' example above, we identified the following two main reasons why demerit goods tend to be overconsumed."
FIRSTLY, if the CONSUMERS DO NOT NEED TO COMPENSATE (REIMBURSE) the third parties for the EXTERNAL COSTS they create then the MARKET PRICE THEY PAY is based solely on this 'private benefits' of teh cinsumer rather than the net benefits demand curve be LOWER than it should be and therefore the QUANTITY DEMANDED will be HIGHER than the
SECONDLY, because some of the CONSUMERS are IGNORANT (UNAWARE) about the FULL COST of the product to themselves such as FUTURE HEALTH ISSUES, THE MORAL IMPACT ON OTHERS, etc they will DEMAND MORE T ECH PRICE LEVEL.
--DIAGRAM--
--MPB > MSB--
--MPB > MSB--
"Ok, so you should have realised that there are in fact two demand curves, a 'private one,' based on the benefits the consumption of the good gives the consumers of it, and a 'societal one' (based on the benefits the consumption gives the consumers less the negative costs that it gives to third parties) and therefore, assuming a single supply curve, there will be two levels of output determined."
--EXAMPLES--
--EXAMPLE #1: SMOKING--
--EXAMPLE #1: SMOKING--
An individual smoker's demand curve for cigarettes represents their own MARGINAL PRIVATE BENEFIT (MPB) that they expect to receive from CONSUMING each additional unit of cigarette.
However, the impact of PASSIVE SMOKING creates EXTERNAL COSTS (NEGATIVE BENEFITS) to 3rd parties (SOCIETY) such as health treatments, increased sick days, loss of work hours etc.... and yet the smoker DOES NOT COMPENSATE them.
If this negative benefit was deducted from the private benefits of smokers we would arrive at SOCIETY'S BENEFIT CURVE (MSB).
--EXAMPLE #2: ALCOHOL--
--EXAMPLE #2: ALCOHOL--
An individual DRINKER's demand curve for alcohol represents their own MARGINAL PRIVATE BENEFIT that they expect to receive from CONSUMING each additional unit of alcohol.
However, the impact of ALCOHOL CONSUMPTION creates EXTERNAL COSTS (NEGATIVE BENEFITS) to 3rd parties such as health treatments, increased sick days, loss of work hours, cost of policing alcohol-related crimes, etc, and yet the drinker DOES NOT COMPENSATE them.
If this NEGATIVE BENEFIT WAS DEDUCTED from the private benefits of drinkers we would arrive at SOCIETY'S BENEFIT CURVE.
Alternatively, It may be easier to think of the impact on quantity demanded if the value of this negative benefit was charged directly to the consumer.
--EXAMPLE #3: SUGAR--
--EXAMPLE #3: SUGAR--
An individual SUGAR-CONSUMER's demand curve for SUGARY GOODS represents their own MARGINAL PRIVATE BENEFIT that they expect to receive from CONSUMING each additional unit of SUGAR.
However, the impact of EXCESSIVE SUGAR CONSUMPTION creates EXTERNAL COSTS (NEGATIVE BENEFITS) to 3rd parties such as health treatments, increased sick days, loss of work hours, cost to taxpayers etc.... and yet the consumer DOES NOT COMPENSATE them.
If this negative benefit was deducted from the private benefits of drinkers we would arrive at SOCIETY'S BENEFIT CURVE.
--EXAMPLE #4: PLASTIC BAGS--
--EXAMPLE #4: PLASTIC BAGS--
--EXAMPLE #5: DIESEL CAR USAGE--
--EXAMPLE #5: DIESEL CAR USAGE--
--TASK: 'ANTIBIOTICS'--
--TASK: 'ANTIBIOTICS'--
Watch the video below and REWRITE the following paragraphs using ANTIBIOTICS USAGE instead of CIGARETTES:
An individual smoker's demand curve for cigarettes represents their own MARGINAL PRIVATE BENEFIT (MPB) that they expect to receive from CONSUMING each additional unit of cigarette.
However, the impact of PASSIVE SMOKING creates EXTERNAL COSTS (NEGATIVE BENEFITS) to 3rd parties (SOCIETY) such as health treatments, increased sick days, loss of work hours etc.... and yet the smoker DOES NOT COMPENSATE them.
If this negative benefit was deducted from the private benefits of smokers we would arrive at SOCIETY'S BENEFIT CURVE (MSB).
--TASK 1--
--TASK 1--
IMAGINE THAT YOU ARE AN 'ANTI-SMOKING' ADVOCATE AND YOU WISH TO INCREASE THE BANNING OF SMOKING IN PUBLIC, IN PARTICULAR WITHIN 200M OF ALL SCHOOL PROPERTY. WRITE A LETTER TO THE LOCAL CONGRESSPERSON, EXPLAINING WHY SMOKING IS CREATING EXTERNAL COSTS AND RESULTING IN A MARKET FAILURE AND HOW A FURTHER BAN IS NECESSARY.
DEFINITIONS: MARKET FAILURE, EXTERNAL COST, NEG. EXT OF CONSUMPTION
DIAGRAM SHOWING MARKET FAILURE
DIAGRAM SHOWING HOW BAN WILL IMPACT MARKET
--TASK 2--
--TASK 2--
IMAGINE THAT YOU ARE NOW THE CONGRESSPERSON WHO RECEIVED THE 'ANTI-SMOKING' ADVOCATE'S LETTER YOU AGREE THAT SMOKING IS A PROBLEM BUT YOU ARE NOT CONVINCED THAT A 'BAN' WILL BE VERY EFFECTIVE, AND YOU WISH TO SUGGEST OTHER SOLUTIONS THAT ARE ALREADY BEING IMPLEMENTED.
DISCUSS WHY BANS MAY NOT BE SO EFFECTIVE
EXPLAIN THE OTHER METHODS THAT ARE BEING USED
SHOW IMPACT OF THESE METHODS ON ORIGINAL DIAGRAM
MAKE SURE THAT YOU ARE BALANCED AND CRITIQUE EACH METHOD
--CORRECTIVE POLICIES--
--MARKET-BASED--
--#1: INDIRECT ('PIGOUVIAN') TAX ON OUTPUT--
--#1: INDIRECT ('PIGOUVIAN') TAX ON OUTPUT--
In order to reduce the quantity of the good consumed, governments can intervene by raising the final price paid by consumers via the imposition of an 'INDIRECT TAX' on EACH UNIT OF OUTPUT PRODUCED. This tax is paid by the producer to the government after the consumer has bought the product; thus, it is considered an increase in the costs of production, SHIFTING THE MSC CURVE to the LEFT, creating a new curve called the MSC + TAX CURVE., in most cases, its 'burden' is (partly) passed on to the consumer in the form of a HIGHER FINAL SELLING PRICE; therefore, this shift to the left will result in a MOVEMENT UP THE DEMAND CURVE, leading to a HIGHER PRICE and a FALL IN QUANTITY DEMANDED, hopefully closer to the socially optimal level of consumption.
--PROS--
--PROS--
An INDIRECT TAX clearly increases the costs of production for a firm which in most cases will be passed on (In part) to the consumer and therefore LEAD TO A RISE in the PRICE and a FALL IN THE QUANTITY DEMANDED (and CONSUMED).
The GOVERNMENT CAN EARN REVENUE from the tax which they can SPEND ON MERIT GOODS.
--CONS--
--CONS--
LESS EFFECTIVE when dealing with INELASTIC GOODS. For example, DEMERIT GOODS such as cigarettes have ADDICTIVE QUALITIES, meaning any % rise in price will result in only a small % fall in Qd, as such only a VERY LARGE TAX will be useful.
REGRESSIVE in NATURE, as it will impact low-income earners more than high-income earners.
UNEMPLOYMENT may occur in the industry due to the fall in production, which may create external costs.
SUGARY DRINK PRODUCERS HAVE NO INCENTIVE TO REFORMULATE TO LOWER SUGAR CONTENT AND AVOID THE TAX as the tax is Imposed on UNITS PRODUCED rather than on SUGAR CONTENT.
IMPOSSIBLE TO DETERMINE THE CORRECT SIZE OF THE TAX, given that working out the exact size of the EXTERNAL COST is impossible, so too is the size of the tax to correct it, thus if it is too HIGH then it could cause UNDERCONSUMPTION to occur.
--PROS--
--PROS--
The tax RAISES THE PRICE which will REDUCE THE QUANTITY DEMANDED.
The tax is REGRESSIVE which means it will be MORE EFFECTIVE AT DISCOURGAING LOW INCOME CONSUMERS, which includes youngsters who in the case of smoking will be be less likely to TAKE UP THE BAD HABIT IN THE FUTURE.
As it is ADDICTIVE, its DEMAND is INELASTIC meaning the TAX REVENUE COLLECTED CAN BE SUBSTANTIAL which it can use to FUND EDUCATION to RAISE AWARENESS and LOWER MPB.
SPECIAL CASES
SPECIAL CASES
"In the first example, the producer paid the tax to the gov't, however, there are occasions when the consumer pays the 'indirect' tax 'directly', 😕 such as a 'congestion charge', or a 'plastic-bag tax', can you explain how these differ in terms of the 'timing of the impact on third parties' as well as who are the 'third parties"?
he external cost of these of activities differ in terms of is how you might explain/illustrate this?", TIP: "Ask yourself, who's cost are being added to
you supply the trips
you supply
"That's right, its the 'private costs' of the driver and the shopper that are increasing, therefore their MPC should shift to the left, like with the tax paid by the producer.
Tip: Even though the congestion tax is an indirect tax (paid by the consumer at the point of use), its impact on the externality diagram is identical to a direct Pigouvian tax. The economic incidence (who bears the burden) and the shift in the curves are the same.
price order to reduce the quantity of the good consumed, governments can intervene by raising the final price paid by consumers via the imposition of an 'INDIRECT TAX' on EACH UNIT OF OUTPUT PRODUCED. This tax is paid by the producer to the government after the consumer has bought the product; thus, it is considered an increase in the costs of production, SHIFTING THE MSC CURVE to the LEFT, creating a new curve called the MSC + TAX CURVE., in most cases, its 'burden' is (partly) passed on to the consumer in the form of a HIGHER FINAL SELLING PRICE; therefore, this shift to the left will result in a MOVEMENT UP THE DEMAND CURVE, leading to a HIGHER PRICE and a FALL IN QUANTITY DEMANDED, hopefully closer to the socially optimal level of consumption.
--THINK AHEAD--
--THINK AHEAD--
"Can you think of a soda brand that HASN'T introduced a 'sugar-free' version?", "Do you think it's due to health concerns and falling demand?", "What do you think they are trying to avoid?"
--#2: INDIRECT TAX ON CONTENT (SUGAR)--
--#2: INDIRECT TAX ON CONTENT (SUGAR)--
If an INDIRECT TAX is applied to EACH UNIT OF SUGAR CONTENT CONTAINED WITHIN THE DRINK (usually measured in grams), it will HAVE TWO EFFECTS:
Firstly, firms that can't remove sugar from their drinks will see their COSTS OF PRODUCTION RISE, shifting their PRIVATE COST CURVE TO THE LEFT (Which equals the MSC, so we get a new MSC = MPC = MSC+TAX)
Secondly, firms will have the INCENTIVE TO AVOID THE TAX by REDUCING THE SUGAR CONTENT by REFORMULATING THEIR DRINKS. As a result, the average sugar content per unit should fall, lowering the negative benefit and shifting the SOCIAL BENEFIT (MSB) CURVETO THE RIGHT, closer the to MPB (as the size of the negative benefit per unit has now decreased)
Both these effects in theory result in the market output getting closer to the socially optimal level.
--#3: INDIRECT TAX ON TRIPS TO THE CITY--
--#3: INDIRECT TAX ON TRIPS TO THE CITY--
--PROS--
--PROS--
INCENTIVISES REFORMULATONS rather than a reduction in the units sold, as producers can avoid the tax by reducing the sugar content.
GREATER CONSUMER SURPLUS as more units are consumed at lower prices (Assuming the flavour stays the same)
--CONS--
--CONS--
Reduced sugar content may make the products flavour change which could result in FEWER SALES and revenue
Loyal customers may object to the change in sugar content which could lead to BAD PUBLICITY.
CONGESTION CHARGES & TOLLS
Is this a tax on cars? discuss
How can you show this on an externality diagram??
Do you use the market for cars???
Is it a rise in the price of using cars? Or is it a rise in the price of a trip to the city?
--#4: INDIRECT TAX ON PLASTIC BAGS--
--#4: INDIRECT TAX ON PLASTIC BAGS--
--COMMAND-BASED--
--LEGISLATION & REGULATION--
--LEGISLATION & REGULATION--
LEGISLATION & REGULATION refers to LAWS implemented that for the most part aim to REDUCE THE DEMAND for DEMERIT GOODS.
This results in a LEFTWARD SHIFT in the MPB CURVE.
--SODA BAN--
--AGE RESTRICTIONS ON BUYING TOBACCO--
--SMOKING FREE ZONES--
--ALCOHOL FREE ZONES--
--GENERATIONAL BAN--
--PROS--
--PROS--
Can be effective if ENFORCED REGULARLY and CONSEQUENCES ARE PROHIBITIVE.
--CONS--
--CONS--
The HIGH COST of ENFORCEMENT
Often BLACK MARKETS develop.
The FINE is set TOO LOW?
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Can you draw a diagram for a complete ban?
Can you draw a diagram for a BAN ON an illegal product?
Can the Qso be zero, if so is there a diagram?
How to draw for an illegal market?
--OTHER APPROACHES--
--EDUCATION & AWARENESS CREATION--
--EDUCATION & AWARENESS CREATION--
This is also INTENDED TO REDUCE THE DEMAND FOR DEMERIT GOODS by making consumers or potential consumers more aware of the external costs of consumption.
--PROS--
--PROS--
CAN BE VERY EFFECTIVE IF ENFORCED REGULARLY AND CONSEQUENCES ARE PROHIBITIVE
--CONS--
--CONS--
NOT APPLICABLE TO MANY TYPE OF GOODS, SUCH AS SUGAR AND PETROL CONSUMPTION
--NUDGES--
--NUDGES--
A 'NUDGE' refers to a way of INFLUENCING CONSUMER'S CHOICES WITHOUT using the following:
1) FINANCIAL REWARDS for compliance.
2) SANCTIONS for non-compliance.
3) LIMITING CHOICES.
Nudges are designed to alter people’s behaviour without coercively forbidding options. As Richard Thaler and Cass Sunstein wrote in their 2008 book Nudge: “putting fruit at eye level counts as a nudge. Banning junk food does not”.
--PROS--
--PROS--
--CONS--
--CONS--
RFF-Resources-143-antibiotic.pdf
If in THE PROCESS OF CONSUMING a good, there are EXTERNAL COSTS (or to put it another way 'NEGATIVE BENEFITS') to third parties that are NOT ACCOUNTED FOR IN THE CONSUMER'S PERCEIVED BENEFITS FROM CONSUMPTION, then the CONSUMER'S DEMAND CURVE only represents their PRIVATE BENEFITS (MPB) and therefore will not represent society's demand curve (MSB) which is equal to the PRIVATE BENEFIT LESS THE NEGATIVE BENEFITS or 'NET-BENEFIT' of this activity on society.
In other words, if we based the demand curve on the marginal price society is willing to pay per unit (as represented by the marginal net-benefit they expect to receive per unit) rather than the marginal price private individual consumers are willing to pay per unit (as represented by the marginal private benefit they expect to receive) we will derive TWO DEMAND CURVES, one representing society (MSB CURVE) and one representing the private consumers (MPB CURVE) with the MSB curve more to the LEFT.
IF WE ASSUME THE MSC CURVE IS FIXED then the equilibrium quantity transacted using the MSB curve is LESS THAN the equilibrium quantity transacted using the MPB curve.
Hence the free market output is GREATER THAN the socially optimal amount (MSB = MSC).
We can see in the diagram below, that the exclusion of negative benefits results in the consumer's demand curve (MPB) being to the RIGHT, of the MSB curve, (MPB>MSB) leading to OVERCONSUMPTION and a DWL.
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