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(a) Explain ‘public goods’ and ‘merit goods’, making clear how these cause markets to fail. [10] (Adapted from the A levels)

(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. 

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