Market Failure: Merit & Demerit Goods (AQA A Level Economics)
Revision Note
Written by: Claire France
Reviewed by: Steve Vorster
Classification of Merit and Demerit Goods
Merit goods are products that are beneficial for society but the free market does not provide enough of them
Demerit goods are products which have harmful impacts on consumers or society
Value judgements play a role in determining whether goods are classified as merit or demerit goods
Some goods are clearly defined as being a merit or demerit good, such as education (merit good) and illegal drugs (demerit good)
The classification of some goods can be unclear as it is based on a value judgement
Classification of Goods Based on Value Judgements
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Cannabis |
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Contraception |
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Merit Goods
Consumers under-consume merit goods as they do not fully recognise the private or external benefits
Merit goods are often under-provided in a free-market and are a cause of partial market failure
Common examples include vaccinations, education and electric cars
Governments often have to subsidise these goods in order to lower the price and/or increase the quantity demanded
Diagram: Merit Goods in a Free Market
Positive externalities from the consumption of merit goods
Diagram analysis
The marginal social costs (MSC) are assumed to be equal to the marginal private cost (MPC) as the focus is on the consumer (demand side) of the market
The optimal allocation of resources for society would generate an equilibrium where marginal social benefit (MSB) = MSC
At PeQe where there is no market failure
The free-market equilibrium for merit goods is under consumed as consumers fail to consider the external benefits from consumption
This is shown at PeQe where the MPB=MSC
The quantity consumed at Qe is below the socially optimal level resulting in an under-consumption and a partial market failure. There is a deadweight loss to society (pink triangle)
To be socially efficient, more factors of production should be allocated to producing this good/service
Worked Example
Which one of the following applies to merit goods?
They are always over consumed by individuals
They are likely to be provided by the market
They can only be supplied by the government
They are always free
Answer
B. They are likely to be provided by the market.
Merit goods (education and hospitals) can often be provided by the market. They are beneficial to society and usually not enough are provided.
Demerit Goods
Consumers over-consume demerit goods to a greater extent than is considered desirable by society
Consumers are unlikely to consider all of the consequences when making consumption decisions
The social costs of consumption outweigh the private costs
Demerit goods are often over-provided in a free-market and are a cause of partial market failure
These goods are usually addictive and harmful for consumers, e.g. gambling, alcohol, drugs, sugary foods/drinks
Governments often have to regulate these goods in such a way that they raise the prices and/or limit the quantity demanded
The activities of producers can generate significant external costs, e.g. pollution caused by coal-burning power stations during the production of electricity
However, electricity is considered to be a merit good
The smoke is a by-product and not a good/service
For this reason, economists usually consider demerit goods to be goods used in consumption
Diagram: Demerit Goods in a Free Market
Negative externalities from the consumption of demerit goods
Diagram analysis
The MSC is assumed to be equal to the MPC as the focus is on the consumer (demand) side of the market
The optimal allocation of resources for society would generate an equilibrium where MSB = MSC
At PeQe where there is no market failure
The free-market equilibrium for demerit goods is over consumed as consumers fail to consider the external costs from consumption
This is shown at PeQe where the MPB=MSC
The quantity consumed at Qe is above the socially optimal level, resulting in overconsumption and a partial market failure. There is a deadweight loss to society (pink triangle)
To be socially efficient, fewer factors of production should be allocated to producing this good/service
Examiner Tips and Tricks
Not all products that result in positive or negative externalities in consumption are merit or demerit goods. This is a common misconception.
You should be able to illustrate the misallocation of resources resulting from the consumption of merit and demerit goods using diagrams showing marginal private and social cost and benefit curves.
Worked Example
Which of the following applies to demerit goods
Their marginal private benefit is greater than their marginal social benefit
They are always under provided by the market
Their marginal social benefit is greater than their marginal private benefit
They have the characteristics of non-excludability and non-rivalry
Answer
A. Their marginal private benefit is greater than their marginal social benefit
Individuals may derive some private benefit from consuming demerit goods, but the overall social benefit is less due to the negative consequences on society. The MPB (the benefit to the individual consumer) tends to exceed the MSB (the benefit to society as a whole)
The other options are incorrect:
Demerit goods may tend to be over-provided and over-consumed by the free market
Demerit goods are associated with negative externalities, implying that the social benefit is less than the private benefit
Demerit goods can often be characterised by excludability and rivalry, meaning they can be restricted to to those willing and able to pay and their consumption by one person reduces its availability to others
Merit & Demerit Goods & Imperfect Information
A lack of information can make it difficult for consumers to make decisions about a good or service
Due to imperfect information, consumers may have incomplete or inaccurate information about the external consequences associated with merit or demerit goods
Merit goods are often under-provided, due to a lack of demand. Consumers are often unaware of the positive effects of consuming such goods
Demerit goods are often over-provided, due to high demand as consumers are ill-informed regarding the consequences of consuming such goods
Efforts to educate the public by the government, such as public awareness campaigns can help consumers make more informed choices
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