8.5 - Merit and demerit goods

What is a merit good?

A good, such as healthcare, for which the social benefits of consumption exceed the private benefits. Value judgements are involved in deciding that a good is a merit good.

What are the two important characteristics of merit goods?

-Positive externalities in consumption

- Information failures

How are merit goods linked to positive externalities of consumptions?

When a person consumes a merit good such as healthcare, the resulting positive externalities benefit other people. An obvious example is that healthy people seldom spread diseases. The social benefit by the wider community is greater than the private benefit enjoyed by the healthy person.

How are merit goods and information failures linked?

For a merit good such as healthcare, the long term private benefit of consumption exceeds the short term private benefit of consumption. But when deciding how much to consume, individuals take account of short term costs and benefits, ignoring or undervaluing the long term private costs and benefits.

Underconsumption of a merit good in a free market shown on a diagram?

(page 251)

If educational services were to be provided solely through the market, and at market prices, too few people would benefit from education. In the diagram, the privately optimal level of consumption is Q1, determined at point A, where MPC=MPB. This is below the socially optimal level of consumption, Q2. The socially optimal level of education lies below point B on the diagram, located where MSC=MSB. According to this analysis, free markets provision of merit goods leads to under consumption. The MSB of units of education between Q1 and Q2 is greater than the MSC of these units. Producing and consuming these units will add to the welfare of society.

Suppose that the government reacts by providing a subsidy, which reduces the price of education to P2. At the subsidised price, consumption of education rises to the socially optimal level of Q2. The market failure has now been corrected.

What are demerit goods?

Goods, such as tobacco, for which the social costs of consumption exceed the private costs. Value judgements are involved in deciding that a good is a demerit good.

What are two important characteristics of demerit goods?

- Negative externalities of consumption

- Information failures

How are demerit goods and negative externalities linked?

When a person consumes a demerit good such as tobacco, negative externalities are generated which are unpleasant or harmful to other people. People unwillingly create in fumes the smoker discharges, with eventual harmful health on their health. Hence, the marginal social benefit is less than the marginal private benefit.

How are demerit goods and information failures linked?

When teenagers first get into the habit of smoking, drinking or drug taking, they may either ignore the long term private costs they may suffer later in life or downplay the significance of these costs. Either way, young people tend to be shortsighted with respect to the costs of consuming demerit goods. A person who started drinking as a teenager may regret the decision later in life when suffering an alcohol related illness. Hence, the long net benefit of consuming a demerit good is less than the short term benefit.

How does negative consumption externalities cause over consumption of demerit goods, shown on a diagram?

(pg 254)

The diagram shows that too much tobacco is consumed when bought at market prices unadjusted by taxes or by a minimum price law. At least in the short term, the privately optimal level of consumption is Q1, where MPC=MPB. This is greater than the socially optimal level of consumption, Q2, located where MSC=MSB. Free market provision of demerit goods therefore leads to over consumption, and hence overproduction of tobacco.