Merit and Demerit Goods (AQA A-Level Economics): Revision Notes

Merit and Demerit Goods

Merit and demerit goods represent an important type of market failure. Unlike public goods, which cannot be provided efficiently by markets due to their non-excludable and non-rival characteristics, merit and demerit goods can be supplied by markets. However, the free market tends to provide the wrong quantity of these goods, leading to a partial market failure. Understanding these goods requires examining both externalities and information failures.

What are merit goods?

A merit good is a good or service for which the benefits to society as a whole are greater than the benefits received by the individual consumer. Value judgements play a crucial role in deciding whether a good should be classified as a merit good.

Merit goods have two key characteristics that distinguish them from other types of goods:

Positive externalities in consumption

When individuals consume merit goods, they create positive externalities that benefit the wider community. These external benefits mean the social benefit exceeds the private benefit enjoyed by the consumer.

$\text{Social benefit} = \text{Private benefit} + \text{External benefit}$

Information failure and merit goods

Information failure occurs when people make decisions that are not in their best interests because they lack relevant information or ignore it. Often, individuals focus on immediate consequences rather than considering the future implications of their choices.

With merit goods, the long-term private benefit of consumption typically exceeds the short-term private benefit. However, when making consumption decisions, individuals often consider only short-term costs and benefits. They may ignore or undervalue the long-term private costs and benefits.

Examples of merit goods

The most widely recognised examples of merit goods are:

• Education at all levels
• Healthcare services including vaccination, preventative dental care, and HIV testing
• Safety equipment such as crash helmets and car seatbelts
• Cultural facilities including museums and public parks

Under-consumption of merit goods and market failure

If educational services were provided only through the market at market prices, too few people would benefit from education. The diagram above illustrates this market failure.

According to marginal analysis, free-market provision of merit goods leads to under-consumption.

The marginal social benefit of units of education between $Q_1$ and $Q_2$ exceeds the marginal social cost of these units. Producing and consuming these additional units would add to society's welfare. The shaded triangle ABC represents the welfare loss or deadweight loss that results from under-consumption in a free market.

Government intervention through subsidies

To correct this market failure, the government can provide a subsidy. A subsidy is a payment made by government or other authority, usually to producers, for each unit of the subsidised good that they produce. Consumers can also receive subsidies, such as free or reduced-price bus passes for children.

Suppose the government reacts by providing a subsidy that reduces the price of education to $P_2$. At this subsidised price, consumption of education rises to the socially optimal level of $Q_2$. The market failure has now been addressed.

What are demerit goods?

As the name suggests, demerit goods are the opposite of merit goods. A demerit good is one for which the costs to society from consumption exceed the private costs incurred by the consumer. This occurs because consumption by an individual produces negative externalities that harm the wider community.

Just as with merit goods, value judgements are involved in determining whether something should be classified as a demerit good.

Negative externalities in consumption

When people consume demerit goods such as tobacco or alcohol, negative externalities are generated which are unpleasant or harmful for other people. The private cost can be measured by the money spent on purchasing the good, along with any health damage the consumer suffers. However, the social costs of consumption also include the cost of the negative externalities.

$\text{Social cost} = \text{Private cost} + \text{External cost}$

These negative externalities include costs imposed on others from:

• Passive smoking
• Road accidents caused by drunk drivers
• The cost of taxes raised to fund the care of victims of tobacco- and alcohol-related diseases

For demerit goods, the benefit the smoker or drinker derives from consumption exceeds the benefit to society. The second key characteristic relates to information failures that affect the consumption decision.

Demerit goods and information failures

When teenagers first develop the habit of smoking, drinking or taking drugs, they may either ignore the long-term private costs they may face later in life, or downplay the significance of these costs. Young people tend to be short-sighted regarding the costs of consuming demerit goods.

Examples of demerit goods

The two most widely recognised examples of demerit goods are:

• Tobacco products including cigarettes
• Alcoholic drinks

Other commonly cited examples include:

• Narcotic drugs such as heroin and crack cocaine
• Pornography
• Prostitution

Cigarettes and alcoholic drinks are the best-known examples of demerit goods. In many countries, including the UK, governments either ban tobacco and alcohol advertising or severely regulate what advertisers can show. This represents a significant change from past practices.

Over-consumption of demerit goods and market failure

Just as the consumption of merit goods generates positive externalities that benefit the wider community, the consumption of demerit goods leads to negative externalities imposed on others.

In the short term at least, the privately optimal level of consumption is $Q_1$, where $\text{MPC} = \text{MPB}$. This is greater than the socially optimal level of consumption, $Q_2$, located where $\text{MSC} = \text{MSB}$. Free-market provision of demerit goods therefore leads to over-consumption, and hence over-production, of tobacco and similar products.

The shaded area in the diagram represents the welfare loss that occurs at the free-market equilibrium quantity $Q_1$.

Government intervention through taxation

To bring about the socially optimal level of consumption at $Q_2$, an indirect tax equal to the distance between points B and C could be imposed. This would increase the price of tobacco to $P_2$. The tax needs to be set equal to the marginal external cost (MEC) of consumption at the socially optimal level of consumption ($Q_2$).

Merit and demerit goods and value judgements

The classification of goods as merit goods or demerit goods depends upon value judgements made by those doing the classifying. The table below shows how different goods might be categorised:

Merit goods	Merit or demerit goods?	Demerit goods
Education	Contraception	Tobacco
Healthcare (e.g. vaccination, preventative dental care, HIV testing)	Abortion	Alcohol
Crash helmets	Sterilisation	Narcotic drugs (e.g. heroin, crack cocaine)
Car seatbelts		Pornography
Museums and public parks		Prostitution

It is worth noting that under-provision of merit goods and over-provision of demerit goods may result not only from externalities but also from the imperfect information that consumers possess. This can lead to failure to give adequate weight to the long-term consequences of consuming goods such as tobacco.

Do merit and demerit goods actually exist?

Some economists, usually of a pro-free-market persuasion, question whether any goods are truly demerit goods or merit goods. These economists are libertarians who believe that government intervention should be minimal. They argue that individuals are the best judges of what is bad or good for them.

Merit and demerit goods and information failure

Some economists argue that under-consumption of merit goods and over-consumption of demerit goods stem not primarily from the externalities that consumption generates, but from information failure. Many people become addicted to demerit goods during their teenage years. Because of peer-group pressure and related factors, teenagers are heavily influenced by lifestyle and personal circumstances. At the same time, they may be ignoring, downplaying or being short-sighted about how their addictions may affect them many years ahead.

Individuals consider short-term costs and benefits but ignore or undervalue the long-term private costs and benefits. For most merit goods, the long-term private benefit of consumption exceeds the short-term private benefit. Conversely, for demerit goods, when deciding how much to consume, individuals often take account of only short-term costs and benefits.

Case study: museums as merit goods

Museums perform important cultural functions including conserving, interpreting, researching and displaying heritage. Museums in the UK have a mix of ownership patterns. Over 40% of UK museums are governed by public authorities, with the rest privately owned, mostly on a non-profit basis. Museums cover a wide range of institutions of varying size and reputation, ranging from internationally renowned institutions such as the British Museum to relatively small, locally focused museums.

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