In contrast to a merit good, consuming a demerit good creates negative spillover effects.
For example, if a driver consumes excessive alcohol and then crashes into an innocent driver causing damage to their vehicle, a negative consumption externality has arisen. Society has suffered because the actual benefit of drinking by some has reduced the benefits possible (from driving) to others. This reduces the Marginal Social Benefit (MSB) by the extent of the negative effect on others, so that the socially efficient consumption of alcohol is less than the free market level of consumption.
Similarly, cigarette smoking by some individuals in public places
will reduce the benefits to others in the form of passive smoking. This
may also lead to higher taxes for all taxpayers which the government pay
need to pay for increased healthcare in the future.
Similarly, cigarette smoking by some individuals in public places will reduce the benefits to others in the form of passive smoking. This may also lead to higher taxes for all taxpayers which the government pay need to pay for increased healthcare in the future.
Diagram for demerit good
The negative consumption externality created by some consumers reduces the private benefit of others. Hence, the Social Marginal Benefit (SMB) which represents all marginal benefits is reduced when demerit goods are consumed, and the socially efficient quantity will be less than the market quantity, which only takes into account the Marginal Private Costs and Benefits.
The welfare loss associated with 'over-consumption' of a demerit good is the excess of Social Marginal Cost above Social Marginal Benefit, which is the quantity Q1 to Q in the above diagram, and the welfare area ABC.
There are several remedies for negative consumption externalities, including imposing indirect taxes, and setting minimum prices, imposing fines for over-consumption, controlling supply through a licensing system.