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Merit and Demerit Goods

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Economics

When the facts change, I change my mind.

- John Maynard Keynes

Although some people, like John Maynard Keynes, search for facts and information, consumers generally do not have access or choose to ignore important information. This is known as the information problem. The information problem is a key reason behind why merit and demerit goods exist. Let’s study their characteristics.

The idea of merit good was coined by economist Richard Musgrave in the 1950s. He defined merit goods as commodities that individuals and society should be able to benefit from, regardless of their willingness and ability to pay.

What are merit goods?

Merit goods are goods that markets under-provide and therefore lead to partial market failure.

To understand the concept of merit goods, it is important to distinguish them from public goods. Public goods are non-excludable and non-rival, meaning consumers can’t be excluded from consuming them based on their ability to pay. As a result, markets often fail to provide them, causing market failure.

On the other hand, markets do provide merit goods, although they under-provide them. This leads to partial market failure.

Merit goods are goods for which the social benefits of consumption outweigh private benefits, as they are beneficial to both individuals and society as a whole.

Social benefit = private benefit + external benefit

Healthcare and education are examples of merit goods. The market provides both private education and healthcare but in quantities that are not optimal.

The classification of merit and demerit goods is based on value judgments.

The characteristics of merit goods

Let’s study the main characteristics of merit goods.

Merit goods and positive externalities

Consumption of merit goods benefits society as a whole. These benefits outweigh the private benefits enjoyed by the individual due to positive externalities.

Exploring the healthcare example in more detail, a consumer that consumes healthcare (merit good) also benefits the community, as they are less likely to spread diseases (positive externality). Therefore, the benefits to society outweigh the individual benefits. If healthcare was only provided privately, fewer people would benefit from it.

Let’s look at this example in a diagram. In Figure 1 below, S1 represents the market supply of healthcare. It represents the quantity of healthcare private healthcare providers are willing to supply at various price levels. D1 shows how much healthcare consumers are willing to buy. Q1 represents the quantity of private healthcare consumed at price P1.

On the other hand, D2 represents both the external benefits (positive externalities) and the individual benefits of consuming healthcare. Q2 shows the socially optimal level of healthcare, whereas Q1 shows the privately optimal level of healthcare. In the free market economy, the positive externalities of merit goods often go unnoticed, so consumption and production are under the socially optimal level.

The price of healthcare has to decrease to P2 in order to reach equilibrium at Q2. However, private suppliers are unwilling to supply at this price as it would decrease their profits significantly. To increase the supply of healthcare to S2, governments subsidise it. The vertical distance between S1 and S2 represents the unit size of the subsidy.

Merit and Demerit Good Merit Goods and Positive Externalities StudySmarterFigure 1. Effect of a subsidy on merit goods - StudySmarter Originals.

Merit goods and the information problem

The information problem occurs when people make incorrect decisions as they don’t have or choose to ignore important information. People often only think about the short term.

Continuing with the healthcare example, the long-term private benefits of consuming healthcare outweigh the short-term private benefits. However, consumers often only take into consideration short-term costs, rather than long-term benefits.

Therefore, due to imperfect information, consumers often ignore the full benefits of merit goods. For example, people might be unaware of a health condition that they have due to a lack of information, making their demand for healthcare lower than it should be. This results in healthcare being under-consumed.

Merit goods can also be rejected in some instances. For example, free vaccinations.

What are demerit goods?

Demerit goods are the opposite of merit goods, as the social costs for the community are higher than the private costs for individual consumption. Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual. Social costs include the negative externalities that occur during the consumption of the good.

A demerit good is a good for which the social costs of consumption outweigh the private costs.

Social cost = external cost + private cost

Tobacco is a demerit good. It is harmful to the individual smoker and it also creates negative externalities that impact society as a whole, like secondhand smoke or litter from people throwing their cigarette butts on the street.

The characteristics of demerit goods

Let’s study the main characteristics of merit goods.

Demerit goods and negative externalities

As we know, demerit goods create negative externalities. Looking at Figure 2 below, we can see that the sale of tobacco at market prices results in over-consumption. A privately optimal level of tobacco consumption happens at Q1, where prices are at P1. This is higher than the socially optimal level of tobacco consumption (Q2). Providing tobacco at free-market prices, therefore, results in overconsumption and overproduction.

As a result, governments can introduce taxes on the consumption of tobacco in an attempt to decrease the demand. This results in the supply curve shifting from S1 to S2, raising prices from P1 to P2 and allowing consumption to fall back to the socially optimal level. The vertical distance between S1 and S2 represents the unit size of the tax.

Merit and Demerit GoodsDemerit goods and negative externalities StudySmarterFigure 2. Taxation and demerit goods - StudySmarter Originals.

Demerit goods and the information problem

In the same way that merit goods are under-consumed, demerit goods are over-consumed. This is, again, due to imperfect information. Consumers often do not realise the extent of the harm caused by demerit goods which therefore leads to their over-consumption. Consumers also tend to ignore the negative externalities caused to society from consuming demerit goods.

In the early twentieth century, cigarettes were advertised as healthy and beneficial for certain health problems. This likely led to the overconsumption of cigarettes.

Merit goods, demerit goods, and value judgements

Value judgements are personal opinions that characterise what a particular person finds desirable or not.

Value judgments play a large role in determining which goods can be classified as merit and demerit goods. There are certain products that can clearly be defined as merit goods (like education and healthcare) and products that can clearly be defined as demerit goods (like tobacco and illegal drugs). However, due people’s different values and religions, there are certain goods for which the classification is not as easy. For example, some view contraception as a merit good and others as a demerit good. Therefore, the classification depends on the value judgment of the person making the classification.

Merit and Demerit Goods - Key takeaways

  • Merit goods are under-provided by markets. As a result, they lead to partial market failure. They are goods for which the advantages of consumption outweigh private benefits, as they are beneficial to both individuals and society and create positive externalities. Healthcare and education are examples of merit goods.
  • Consumers often ignore the full benefits of merit goods and therefore under-consume them due to imperfect information.
  • The information problem occurs when people make incorrect decisions as they do not have or choose to ignore important information.
  • A demerit good is a good for which societal costs outweigh private costs. They are the opposite of merit goods. Demerit goods lead to negative externalities and are often taxed by the government.
  • Demerit goods are over-consumed due to imperfect information.
  • Value judgements are personal opinions that characterise what a particular person finds desirable or not. They play a large role in determining which goods are classified as merit and demerit goods.

Merit and Demerit Goods

Merit goods create social benefits, whereas demerit goods bring about social costs.

The question of which goods should be merit and demerit goods are based on value judgements, meaning it is up for interpretation. However, there are certain goods like healthcare and education that should be defined as merit goods.

Demerit goods create negative externalities. They are taxed since providing demerit goods at free-market prices would lead to their overconsumption and overproduction.

Merit goods are goods for which the social benefits of consumption outweigh private benefits, whereas a demerit good is a good for which the social costs of consumption outweigh private costs.

Final Merit and Demerit Goods Quiz

Question

What is a merit good?

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Answer

Merit goods are goods for which the social benefits of consumption outweigh private benefits.

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Question

Name an example of a merit good.

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Answer

Healthcare.

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Question

Why do merit goods cause partial market failure?

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Answer

Because merit goods are under-provided in the market.

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Question

Describe why education is a merit good.

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Answer

Education is provided by the market, but in quantities that are not optimal.

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Question

Merit goods lead to _________ .

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Answer

positive externalities

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Question

What is the privately optimal level of consumption of a merit good?

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Answer

Where demand and supply for a merit good which is not subsidised are in equilibrium.

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What is the socially optimal level of consumption of a merit good?

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Answer

The level of consumption that is possible when merit goods are subsidised.

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Question

Why would the government want to subsidise education?

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Answer

To reach the socially optimal level of education.

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Question

Why do customers often ignore the full benefit of merit goods?

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Answer

Due to imperfect information.

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Question

What is a demerit good?

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Answer

A demerit good is a good for which the societal costs of consumption outweigh private costs.

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Question

Name an example of a demerit good.

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Answer

Tobacco.

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Question

What are the private costs of a demerit good?

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Answer

Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual.

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Question

What are the social costs of a demerit good?

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Answer

Social costs include the negative externalities that occur during the consumption of the good.

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Question

How do governments try to discourage the consumption of demerit goods?

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Answer

By introducing/increasing taxes on demerit goods.

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Question

What are value judgements?

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Answer

Value judgements are personal opinions, which characterise what a particular person finds desirable or not.

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