Demerit Goods

A demerit good is a good that is overprovided by the market and is deemed to be harmful for society.

These goods or services are considered to be harmful because they have great negative consumption externalities meaning that the consumption of these goods results in spillover effects on a third party and no compensation is paid.

An externality occurs when the actions of consumers or producers give rise to positive or negative side-effects on third parties, and these effects are not paid for or compensated for.

In a demerit good, the benefit to the personal consumer is greater than the benefit received by society, or MPB > MSB. This is a negative externality of consumption. The market is producing at Q_m, but from society’s point of view Q_opt is the preferable level of production. At Q_m, MSB≠MSC, this shows there is market failure, as allocative efficiency has not been achieved.

When allocative efficiency is achieved, the quantity of goods produced and consumed at Q_m, the market equilibrium quantity is not equal to  Q_opt, the quantity deemed most socially desirable. When allocative efficiency is achieved, resources are allocated so well, that if anyone was made better off another party would have to be made worse off.

In the diagram above, the pink triangle has been calculated as the welfare loss, and has been calculated by comparing community surplus at both Q_m and Q_opt and then subtracting the size of the externality up to the quantity of production Q_m. The use of community surplus as a measure of welfare will be discussed in future posts.

A good example of a demerit good is smoking, because the benefit gained by the  consumer is high, but the adverse effects on third parties are great. The externality includes passive smoking and the long term effects which may result from passive smoking, such as development of cancers. Obviously it is difficult to quantify the size of the externality, because when assessing the negative impact, there are elements such as pain or irritation which are difficult to assign a monetary value to.

After government intervention, in this case negative advertising, a decrease in demand occurs and demand shifts left from D to D₁, meaning that the externality has decreased in size. Continuing the smoking example, on most cigarette packets the government enforces mandatory  negative advertising, such as pictures of cancers. After the decrease in demand, D₁ intersects S at a lower quantity, so Q₁ is now closer to Q_opt, meaning that the quantity supplied is now more favourable from society’s point of view. Thus the pink externality has decreased in size, meaning that society is less worse off.

An example of negative advertising, on an Australian cigarette packet.