Demerit & Merit Goods (Cambridge (CIE) A Level Economics): Revision Note

Under-consumption of merit goods

• Merit goods are products that are beneficial for society but the free market does not provide enough of them

• Demerit goods are products which have harmful impacts on consumers or society

• Value judgements play a role in determining whether goods are classified as merit or demerit goods

• Some goods are clearly defined as being a merit or demerit good, such as education (merit good) and illegal drugs (demerit good)

• The classification of some goods can be unclear, as it is based on a value judgement

Classification of goods based on value judgements

Merit goods

• Consumers under-consume merit goods, as they do not fully recognise the private or external benefits

• Merit goods are often under-consumed in a free-market and are a cause of partial market failure

  • Common examples include vaccinations, education and electric cars

  • Governments often have to subsidise these goods in order to lower the price and/or increase the quantity demanded

Diagram analysis

• The marginal social costs (MSC) are assumed to be equal to the marginal private cost (MPC) as the focus is on the consumer (demand side) of the market

• The optimal allocation of resources for society would generate an equilibrium where marginal social benefit (MSB) = MSC

  •  At P_eQ_e where there is no market failure

• The free-market equilibrium for merit goods is underconsumed as consumers fail to consider the external benefits from consumption

  • This is shown at P_eQ_e where the MPB=MSC

• The quantity consumed at Q_e is below the socially optimal level resulting in an under-consumption and a partial market failure

  • There is a deadweight loss to society (pink triangle)

• To be socially efficient, more factors of production should be allocated to producing this good/service

Over-consumption of demerit goods

• Consumers over-consume demerit goods to a greater extent than is considered desirable by society

• Consumers are unlikely to consider all of the consequences when making consumption decisions

  • The social costs of consumption outweigh the private costs 

• Demerit goods are often over-consumed in a free-market and are a cause of partial market failure

  • These goods are usually addictive and harmful for consumers, e.g. gambling, alcohol, drugs, sugary foods/drinks

  • Governments often have to regulate these goods in such a way that they raise the prices and/or limit the quantity demanded

• The activities of producers can generate significant external costs, e.g. pollution caused by coal-burning power stations during the production of electricity

  • However, electricity is considered to be a merit good

  • The smoke is a by-product and not a good or service

• For this reason, economists usually consider demerit goods to be goods used in consumption

Diagram analysis

• The MSC is assumed to be equal to the MPC as the focus is on the consumer (demand) side of the market

• The optimal allocation of resources for society would generate an equilibrium where MSB = MSC

  • At P_eQ_e where there is no market failure

• The free-market equilibrium for demerit goods is overconsumed as consumers fail to consider the external costs from consumption

  • This is shown at P_eQ_e where the MPB=MSC

• The quantity consumed at Q_e is above the socially optimal level, resulting in overconsumption and a partial market failure. There is a deadweight loss to society (pink triangle)

• To be socially efficient, fewer factors of production should be allocated to producing this good/service