Negative Consumption Externality and Market Failure
Explain, with the use of an appropriate graph, the externality that a ‘fat-tax’ would aim to address. Using economics, explain why the ‘fat tax’ in Denmark was unsuccessful, and outline the possible advantages and disadvantages of this type of tax.
Several countries today have implemented a tax on unhealthy food to combat obesity and other health related problem. In today’ world, the consumption habit of people has shifted from traditional food to unhealthy fast food containing huge amount fat. The consumption of these food entail a negative externality in form of different diseases and associated health cost. In the presence of negative externality, the functioning of demand and supply fails to ensure efficient outcome. The negative consumption externality ends up with an overconsumption of unhealthy food. To correct the externality a market based policy tool is Pigouvian taxation. With implementation of taxes government aims to reduce consumption of healthy foods and ensure efficient outcome. A pioneering nation that implement a fat tax is Denmark (Alston and Okrent 2017). Denmark however has failed to achieve the intended objective of tax. The benefit of reduced consumption was more than offset by other unintended costs. Hence, the tax was abolished within 15 months from its introduction.
In response to the worldwide problem of obesity and overweight and resulted increase in the health expenditure become a major cause of concern for government. This makes government and public authorities to intervene in the market to incentivize heathy food habit or discourage unhealthy food habits in order to control body weight. In particular, government aims to prevent people from too much intake of fatty food by imposing a tax on unhealthy food. A fat tax signifies a tax that is levied on fattening food or beverages with the objective of reducing consumption of food items that are related to obesity or other health risk. In 2011, Denmark imposed a fat tax on butter, milk, pizzas, cheese, oil, meet and processed food products with the benchmark that the product contains more than 2.3% of the saturated fat (Vallgarda, Holm and Jensen 2015). The rationale for levying food tax was simple. The basic economic rationale is to make unhealthy fatty food more expensive relative to healthy foods. Following simple law of demand, the high price induces people to shift their consumption habit from unhealthy to healthy food habit. The imposition of tax becomes crucial as it is evident that the unhealthy of fatty food comes at a lower cost as compared to fresh products and meat. Government in different nations thus call for a tax on fatty products. Government hopes that in response to tax people tend to change their dietary habits which in turn help to improve health condition of the society (Poppitt 2017). Researchers have found that current epidemic of obesity is expanding fast due to expansion of food industry. The Junk outlets are spreading at a fast rate contributing to a change in dietary habits that lead to a detrimental effect on health. Taxes in addition to reducing consumption on unhealthy food provides an additional source of government revenue.
Market Correction through Tax: Pigouvian Taxation
Under free market condition the demand and supply side forces lead to a stable market equilibrium. The demand here reflects the marginal social benefits while supply reflect the marginal social cost. At equilibrium, as marginal social benefit coincides with marginal social cost the socially efficient outcome is achieved. However, in presence of any external effect the demand and supply curve do fails to represents the true social benefit or cost (McKenzie and Lee 2016). Hence, free market equilibrium deviates from socially efficient outcome. This is described as the situation of market failure. Presence of externality is one primary reasons for market failure. Externality is defined as a spill-over effect generated from either production and consumption activity and affect a third party not involved in production or consumption. The positive external effect is termed as positive externality while the negative effect is termed as negative externality.
A negative consumption externality is present when consumption of something imposes an additional cost on society. Consumption of unsaturated fat has the consequence of raising calorie intake and results in various diseases (Jensen et al. 2016). With too much intake of such fatty product people suffer wit problem of obesity, diabetes and other associated diseases. The health cost or additional medical expenses are not reflected in free market pricing of these items. The negative consumption externality associated with unhealthy fatty products thus leads to overproduction of such items (Rader 2014).
Figure 1: Negative consumption externality and market failure
(Source: as created by Author)
The market demand curve is DD and the market supply curve is SS. Because of added health and medical cost, demand curve only represents marginal private benefit not marginal social benefit. In the presence of negative consumption externality marginal social benefit curve lies below the marginal private benefit. Without government intervention, the market produce Q1 amount of output sold at a price P1. Socially efficient outcome is at point E1 where marginal social benefits intersects marginal social cost (Cowen and Tabarrok 2015). Corresponding to E1, the socially efficient outcome is QE. The presence of negative externality thus results in overconsumption of unhealthy foods. The social inefficiency or welfare loss is represented as the area of the dead weight loss.
In order to correct negative externality of consumption and ensure socially efficient outcome government need to intervene in the market. Government can use the instrument of pigouvian taxation to address the problem of externality. Under this rule a tax is levied on consumption of specific good or service. Tax raises the price paid by the buyers of the tax. The Pigouvian tax is a market based policy to address the problem of externality (Nicholson and Snyder 2014). The tax is imposed by an equivalent amount of the difference between marginal social benefit and marginal private benefit. The figure below describes how a Pigouvian tax works to correct negative consumption externality.
Denmark’s Failed Experiment with ‘Fat Tax’
Figure 2: Effect of tax on consumption externality
(Source: as created by Author)
The demand and supply curve in the market is represented as DD and SS respectively. Without tax the equilibrium is at point E yielding a market price of P* and corresponding quantity of Q*. Now, suppose a tax on t is imposed on consumption of food that has saturated food by more than 2.3%. As the tax is imposed on consumption, the immediate impact is one the demand curve. There is a proportionate shift in the demand curve by the amount of tax (Bodker et al. 2015). Market equilibrium now shifts to E1. Buyers now pay a price of P1 while sellers receive only P2. The difference in the two prices go the hand of government (Mochrie 2015). From the proposed tax, the earned government revenue is shown by the rectangle P1P2E1F. As seen from the figure above the tax reduces equilibrium quantity to Q1.
The first problem associated with the fat tax in Denmark was in form of regulatory framework. The collection and institution of fat tax seems very costly. This weakened the medium and small enterprises of Denmark. The administrative formalities associated with a very high institutional cost (Smed et al. 2016). The direct effect of the fat tax was artificial increase in the prices if food items covered under the range of the levied tax. The price in Denmark soared far higher as compared to those in other Euro region. Before the tax, prices of these items were close to the average price prices prevailed in the continent. However, after tax price rose by 14% in case of oil and fats, 4% for meat and around 3% for milk. The imposed tax instead of reducing domestic consumption gave a rise in trans-border trade as price outside Denmark seems relatively cheaper. The expansion of trade hurts domestic production and distribution of food industry in Denmark. The tax failed to achieve any notable reduction in consumption of the intended items. The consumption has declined only by 0.4% from October 2011 to July 2012 (Smith et al. 2018). Instead of reducing consumption of fatty items the shoppers switch to consumption cheaper brands which has a higher adverse impact on health. The victims of the tax are mostly the poorer section of the society.
The fat tax in Denmark has thus proved a failure. Once the ministry realized the tax is creating no benefits rather imposing additional burden on society on the society and government, it was decided to abolish the tax in January 2013 (Vallgqarda, Holm and Jensen 2015).
The obesity and related health diseases has now become a widespread problem. The problem of obesity is generally associated with too much intake of food having high percentage of fat. Unhealthy food habit of people leads to the problem of overweight. This raises the burden of health or medical expenses. Consumption of these items is thus associated with a negative external effect. The presence of negative externality results in a market failure. In order to correct the market failure, government intervene in the market by introducing a tax on products that are harmful to health. Denmark in 2011 introduced such a fat tax to reduce the consumption of items containing excessive fats. The policy however was far from success. Consumption reduced only by a smaller proportion. The added costs of taxation were high level of inflation, cross border trade, huge administration cost and job losses in domestic market
Reference list
Alston, Julian M., and Abigail M. Okrent. “Introduction.” In The Effects of Farm and Food Policy on Obesity in the United States, pp. 1-12. Palgrave Macmillan, New York, 2017.
Bodker, Malene, Charlotta Pisinger, Ulla Toft, and Torben Jorgensen. “The rise and fall of the world’s first fat tax.” Health policy 119, no. 6 (2015): 737-742.
Cowen, Tyler, and Alex Tabarrok. Modern Principles of Microeconomics. Palgrave Macmillan, 2015.
Jensen, Jorgen Dejgaard, Sinne Smed, Lars Aarup, and Erhard Nielsen. “Effects of the Danish saturated fat tax on the demand for meat and dairy products.” Public health nutrition19, no. 17 (2016): 3085-3094.
McKenzie, Richard B., and Dwight R. Lee. Microeconomics for MBAs. Cambridge University Press, 2016.
Mochrie, Robert. Intermediate microeconomics. Palgrave Macmillan, 2015.
Nicholson, Walter, and Christopher M. Snyder. Intermediate microeconomics and its application. Cengage Learning, 2014.
Poppitt, S. D. “Obesity and Weight Control: Is There Light at the End of the Tunnel?.” Current Nutrition Reports 6, no. 2 (2017): 51-62.
Rader, Trout. Theory of microeconomics. Academic Press, 2014.
Smed, Sinne, P. Scarborough, M. Rayner, and Jørgen Dejgård Jensen. “The effects of the Danish saturated fat tax on food and nutrient intake and modelled health outcomes: an econometric and comparative risk assessment evaluation.” European journal of clinical nutrition 70, no. 6 (2016): 681.
Smith, Emma, Peter Scarborough, Mike Rayner, and Adam DM Briggs. “Should we tax unhealthy food and drink?.” Proceedings of the Nutrition Society (2018): 1-7.
Vallgårda, Signild, Lotte Holm, and Jørgen Dejgård Jensen. “The Danish tax on saturated fat: why it did not survive.” European journal of clinical nutrition 69, no. 2 (2015): 223.
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