Explain merit and demerit goods and why the market under-provides the first and over-provides the second

What this dot point is asking

The syllabus wants you to explain merit and demerit goods and why the market under-provides the first and over-provides the second. The big idea is that for some goods, people do not value them correctly, often because they ignore benefits or harms to others or to their own future selves, so the market produces the wrong amount.

The answer

What a merit good is

Examples are education, healthcare and vaccination. The market under-provides merit goods for two reasons:

• External benefits. A merit good benefits not just the user but third parties too. An educated worker makes the whole economy more productive; a vaccinated person protects others. Because individuals ignore these benefits to others, they consume too little.
• Information failure. People often underestimate the long-term benefit of merit goods, such as the future gains from studying or from regular health checks, so they consume less than is good for them.

What a demerit good is

Examples are cigarettes, alcohol and gambling. The market over-provides demerit goods for two reasons:

• External costs. A demerit good harms not just the user but third parties too, through second-hand smoke, alcohol-related accidents, or the public cost of treating illness. Because individuals ignore these costs to others, they consume too much.
• Information failure. People often underestimate the harm to their own health, or are addicted, so they consume more than is good for them.

How governments respond

Because the market gets the amount wrong, governments often step in:

• For merit goods, they subsidise or provide them (free schooling, subsidised healthcare) and run campaigns to inform people of the benefits, to raise consumption.
• For demerit goods, they tax them, restrict or ban advertising, set minimum ages, and run health campaigns, to lower consumption.

Examples in context

Example 1. Subsidised healthcare in Singapore. Singapore subsidises healthcare through schemes that lower the cost of treatment and check-ups. Because healthcare is a merit good that the market would under-provide, this subsidy raises consumption toward the level that is best for a healthy, productive society.

Example 2. Heavy taxes on tobacco. Cigarettes are a demerit good, so Singapore taxes them heavily, bans their advertising and restricts where people may smoke. These measures raise the effective price and inform the public, reducing consumption below the level a free market would reach.

Try this

• Cue. Define a merit good. A good that is better for people and for society than they realise, which brings external benefits and so is under-provided by the market.

• Cue. Explain one reason the market over-consumes a demerit good such as alcohol. Either: it imposes external costs on third parties (accidents, public health costs) that the drinker ignores, or the drinker underestimates the harm to their own health (information failure), so they consume too much.

• Cue. State one policy a government could use to raise consumption of a merit good. Either subsidise or provide the good cheaply, or run an information campaign to make people aware of its benefits.