(a) Explain ‘public goods’ and ‘merit goods’,
making clear how these cause markets to fail. [10]
Adapted from an actual Economics Examination:
November 2008, H1, A-Level
A public good is a good that is not produced
by the free market despite it being beneficial or desirable to society. This is
because a public good is non-rivalrous or non-diminishable, meaning that its
supply is not depleted by an additional user and consumption by one does not
reduce the amount available to others. Also, it is non-excludable, meaning that
it is impossible or costly to exclude non-payers from consuming the good.
By being non-rivalrous, it means that the
marginal cost of allowing an additional consumer to share in the usage of such
a good is zero, and so is the marginal cost of serving an additional user.
Hence, since at the socially optimum level, P=MC, if MC=0, then the price of
the public good is also equal to 0. Hence, none of the good will be supplied by
profit-motivated private suppliers as they have no incentive to do so.
By being non-excludable, consumers do not have
much incentive to pay for the good and suppliers will find it difficult or
impossible to collect fees for the benefits they provide; this is the problem
of free riders. When large numbers of people become free riders, there is
virtually no incentive for consumers to offer to pay for the good. This
non-expression of demand makes it impossible for profit-motivated private suppliers
to charge a market price for the public good, leading to either none or not
much of the public good being produced. This situation leads to a missing
market for public goods. Hence, there is no provision of the public good in the
free market, resulting in market failure as there is allocative inefficiency
when resources are not allocated to producing public goods, which are essential
or beneficial to society.
Figure 1 –Imperfect Information when Consuming
Merit Goods
A merit good is a good or service that a
paternalistic government perceives as beneficial for individuals consuming them
because of the information failure causing them to under-estimate their private
benefits in consuming them. An alternative view is that merit goods generate
positive externalities in consumption. As consumers underestimate their private
benefits when consuming merit goods, if left wholly to the private sector, it
is likely they will be under-consumed because individuals do not understand or
appreciate the good effects that can result from consumption. Examples of merit
goods include healthcare and education. Because knowledge of these benefits is
an ongoing process, individuals themselves will tend to underestimate the long
term private gains from a proper education or proper healthcare. If the
consumers were fully informed of the additional private benefits, the demand
curve would be D (perfect info) and the equilibrium output Y as shown in figure
1, where the true and full information value of an extra unit of good equals to
its Marginal Social Benefit. However, the free market equilibrium occurs at
output Z since consumers cannot individually discover the benefits associated
with the particular good, such as the fact that proper education allows
consumers to have higher potential earnings over one’s working life and be
employed. Hence, imperfect information incurs a welfare cost ABC when the
uninformed consumers use the wrong marginal valuation of benefits of the good.
Figure 2 –Positive Externality in Consuming
Merit Goods
At the same time, merit goods also create a
positive externality in consumption, assuming perfect competition and that the
Marginal Private Cost curve is the same as the Marginal Social Cost Curve, as
shown in figure 2. Since the consumption of the good generates positive
externalities, otherwise known as Marginal External Benefit (MEB), the Marginal
Social Benefits arising from individual’s consumption of the good (MSB) is
higher than Marginal Private Benefit (MPB) by the amount of the MEB, creating a
divergence between MSB and MPB. The free market equilibrium is at Em with
output Qe units; however, the socially desired output level is Qs units.
From society’s point of view, there is under-consumption of the good by QeQs
units, and too little resources are channelled to its production. This is a
situation of allocative inefficiency. The money value of benefits from output
QeQs =Area QeREsQs, and the money value of resources from output QeQs =Area
QeEmEsQs. Hence there is a deadweight loss in not producing output QeQs = equal
to Area EmREs. This shows that there is market failure in consuming merit goods
as they incur a positive externality.
JC Economics Essays: Tutor's Comments - This is an Economics answer based
on an actual A level Economics examination, but it has been amended and changed
to fit this blogpost as well as show the answering technique and approach. This
is a very well written answer that is to the point and analyses the diagrams
(they were drawn in the actual answer); yet, the usual tutor's question
applies: how would you improve upon this Economics answer? Let me give you a
hint from an Economics tutor's point of view - whilst this is an excellent
theoretical answer, perhaps it lacks consistent application of real world examples...?
Yes, you should include more real world examples such as national defence. By
the way, this is the basic questioning approach that I take in this site:
imagine you are an Economics tutor or examiner, and as a tutor or examiner -
what would you like to see in the answer? Think about this question and think
of the implications for how you would approach Economics essays. Also do note
that there are many other public goods and merit goods essays in this site
here, so do explore and compare and contrast various questions and the
concomitant answers. Thanks for reading and cheers.
