JC Economics Essay Series #53 – Market Failure & Demerit Goods

JC Economics Essay Market Failure & Demerit Goods Model Answers 

In Microeconomics, market failure is one of the core topics, of which we examine the ways in which a market may not be working efficiently. Demerit goods are goods or services with consumption levels believed to impose costs on society as a whole greater than those reflected in consumers’ own costs incurred and is known as a Negative Externality in Consumption. Besides being an externality issue, other demerit goods are more of an issue of information failure (aka imperfect information). Without government intervention deeming such goods as socially undesirable, products like cigarettes, alcohol, junk food, sugary and fatty foods, etc are easily over-consumed, 

There are 3 types of imperfect information, namely, incomplete info, inaccurate info and asymmetric information. Here we also discuss why and how come consumer places a low value on costs incurred.


The removal of soft drink machines in primary schools and a proposal to tax sugary drinks aim to tackle the obesity problem and high government spending on healthcare in S’pore. Discuss the economic rationales and effectiveness of the above government measures. [25]


JC Economics Essay – Positive Externality in Consumption for Demerit Good

Suggested Answer:

In a free market without any government intervention, both imperfect information and the disregard for negative externalities could lead to allocative inefficiency, a situation where resources are allocated in such a way that the combination of goods and services produced does not maximise society’s welfare. When this happens, market failure occurs. To then correct the market failure arising from the consumption of soft drinks, the introduction of a 6% tax on soft drinks and the removal of soft drink machines were implemented.


Consumers may have imperfect information because of ignorance. For example, individuals are unaware of the full extent of the harmful effects of consuming soft drinks. As a result, consumers may over-estimate the private benefits of consuming the good. In other words, consumers’ perceived marginal private benefit (MPB) would be higher than their actual MPB, leading to an overconsumption of soft drinks and therefore, market failure.


In the market for soft drinks, there exists negative externalities in consumption, which is the harmful side effects of production or consumption on third parties who are not involved in the production and consumption of the goods. In this case, the consumption of soft drinks might cause obesity related illnesses and as a result, increases the medical cost placed on third parties who aren’t involved in the consumption of soft drinks since government healthcare plans are funded by taxpayers. Companies who hire obese workers might suffer because of their lower productivity level as well.


The existence of negative externalities (or external costs) causes the social cost of consuming soft drinks to deviate from the private cost. The social cost of consuming soft drinks is the total cost incurred by the entire society when the consumer consumes soft drinks. Thus, the marginal social cost (MSC) of consuming soft drinks is the sum of marginal private cost (MPC) and marginal external cost (MEC). Since MEC> 0 (due to increase healthcare cost as a result of increasing obesity), MSC will exceed MPC in this case.


Assuming there is no external benefit, we could draw a diagram to illustrate:
(Sketch the diagram on your own, as an exercise.)

Referring to the sketched diagram, the actual consumption of soft drinks is at Q where MPC-MPB, because consumers only consider the private benefits of consuming (so as to maximize their own welfare) and ignore the external costs of obesity. However, the socially optimal level of consuming soft drinks is at Q, where MSC-MSB (i.e., the additional cost incurred by the society in consuming the last unit of soft drinks is equal to the additional benefit for the society in consuming the last unit of soft drinks). At this point, society’s welfare is maximized. Since Qm exceeds Qs, there is an over consumption of soft drinks, which leads to welfare loss to society (as given by the shaded area).

(Qn: is the 3rd part cost society significant?)


JC Economics Essay – Incomplete Information of Demerit Good

Highlight the gap between marginal private benefit (MPB) “perceived” vs MPB “real” or “actual”. Give examples of the lack of information of the full costs of consuming excessive sugary drinks.

This means that the free market has failed to allocate resources in a way that maximizes society’s welfare (.e. allocative inefficiency). Thus, market failure results and the economic rationale of the measures is the need for the government to intervene to overcome this market failure.



JC Economics Essay – Microeconomic Policy Options

To tackle the obesity problems, a soft drink tax was introduced. As explained previously in (a). assuming the amount of tax is equal to MEC, this will cause the supply of soft drinks to shift left to MSC as seen in the ‘sketched diagram’. The actual market outcome (Qm) then approaches Qs, which is the socially optimal outcome. Thus, the external cost is internalized and the market failure is corrected. Similarly, the removal of soft drink machines will cause the market outcome (Qm) to approach Qs, correcting market failure in the process.

(Qn: How about policies to address imperfect information?)


However, there are limitations to these measures. Firstly, considering the advertising undertaken by drink makers to encourage the consumption of soft drinks, which increases the demand for soft drinks, the market outcome may not be reduced to Qs even after the tax. The more effective the advertisements are the lower will be the success of the measures. IN the online world, firms can use internet and social media channels like YouTube and also employ influencers to market their sugary drinks.


In addition, the true MEC is difficult to estimate. An under or overestimation of MEC would still result the over or under consumption of soft drinks respectively. Both of which still results in allocative inefficiency. Furthermore, the aforementioned measures do not tackle the problem of imperfect information unless the government takes steps (e.g. distribution of pamphlets) to explain the rationale of the tax in process. Only then will the perceived MPB be aligned to the actual MPB, allowing the market to attain a greater degree of allocative efficiency.


Very often, the lower income groups consume soft drinks, as it is a cheaper alternative to healthier drinks. If these soft drinks are still cheaper than healthier drinks after the tax, they face little incentive to change their consumption habits. As such, the effectiveness of this measure might only be limited to the middle and upper income group of consumers, who can afford to be health-conscious rather than cost-conscious.


To tackle the problem of obesity through the market for soft drinks may not guarantee success as soft drink is not the only cause of obesity and may not even be the major cause of obesity. The other causes could include the consumption of fattening food and the lack of exercise. By intervening in this soft drink market alone may not be sufficiently effective and there might be a need for the government to intervene in the other markets (e.g. fast food) as well in order to reduce its high spending on healthcare,


Hence, the disregard for negative externalities and presence of imperfect information leads to the overconsumption of soft drinks and this calls for the need for the government to intervene. However, just these measures alone in the soft drink market will not be sufficient to tackle the obesity problem. Given that there is near zero benefits in consuming such drinks, tougher measures ought to be in place.


Remarks by JC Econs Tutor
1. A few market failure types in this market. Choose any 2 or 3. Information failure cannot be omitted. Also choose -VE EXT and/or equity. (Is it possible to even choose market dominance in Market Structures?)

2. Another possible rationale of introducing a tax on soft drinks is for the government to raise more tax revenue in order to finance their spending. As the tax results in the shift of the supply curve and increases price, it will raise its tax revenue collected. Depending on the price elasticity of the demand (PED) curve, the revenue collected will be affected. For example, the more price inelastic the demand curve is, the higher the revenue is. However it must be noted that it is unlikely that the main intention of the tax imposed by the SG Gov was to raise tax revenue. Rather, it is more likely that correcting the market failure due to demerit goods was the original intention behind the measures and the increase in tax revenue is merely an added incentive for the government to undertake this measure.


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Essay # 52 | #54