MERIT GOODS and DEMERIT GOODS


There is no God of economics. Economists and authors of textbooks treat topics differently and the concept of merit and demerit goods is no exception.

Approach 1 – externalities
Merit goods are goods which are under-consumed and under-produced in a free market, and there are external benefits to society when they are consumed. The marginal social benefits are greater than the marginal private benefits. An example would be inoculations against measles. If one person gets immunised this not only protects them from the disease it reduces the likelihood of anyone else getting measles too.

The free market level of output occurs where the marginal private costs and benefits are equal (MPC=MPB). At this free market level of output, Qfm, there are gains from exchange equal to area 1, and there are positive externalities equal to area 2. But if the level of output was the social optimum where MSC=MSB (Qso), then society would receive an additional welfare gain of area 3.

If production and consumption occurs at Qso, we can say area 3 is a welfare gain, but if production is at Qfm we could describe it as a welfare loss, or a potential welfare gain to society depending how the sentence is phrased.

Positive externalities for merit good

A demerit good is one that is over-consumed and overproduced in a free market, and there are negative externalities from consumption. Marginal private benefits are greater than the marginal social benefits. An example would be alcohol. The drinker may cause an accident to a third party when they drive home, which is the negative externality. The marginal social benefits are less than the marginal private benefits. At the social optimum there are negative externalties equal to area 1 and 2. At the free market level of output Qfm there is an additional negative externality of area 3 which we can label a welfare loss to society.

Negative externalities for a demerit good

Approach 2 – information failure
Merit goods are goods whose benefits consumers are not fully aware of, and which are therefore under-consumed and under-provided by the free market. Someone with terrible body odour maybe unaware of their smell and not realise that wearing it will bring private benefits such as having more friends.

Demerit goods are goods whose harmful problems consumers are not fully aware of which are therefore over-consumed and over-provided by the free market. Ecstasy tablets are consumed because they induce a state of euphoria but may be over-consumed because the user is unaware of the risk of death associated with them. Horse riding may fall under the same category!

Approach 3 – long-term effects not understood
This is a variant of the information failure argument but which argues the short term benefits of a demerit good, such as cigarettes (looking cool and the nicotine rush) are in fact just a rocky road to lung cancer and early death at some point in the future. For a merit good such as education, the benefits of a satisfying and well paid career in the future are not fully grasped when compared to the perceived short term benefits of staying in and finishing homework.

For approaches 2 and 3 the diagrams are the same as above but the labels are changed subtly.

Demerit good (information failure)


Merit Good (information failure)

An all-inclusive definition?
Given there are different approaches to defining merit and demerit goods, it is possible to write all-inclusive statements, although they are cumbersome.

Merit goods are under-consumed and under-produced because the long term benefits are not fully understood, and/or there is a lack of information about their benefits and/or the long term benefits are not appreciated and/or there may be positive spill-over (positive externalities) effects for third parties.

Demerit goods are over-consumed and overproduced because the long-term benefits are not fully understood, and/or there is a lack of information about their benefits and/or the long term benefits are not appreciated and/or there may be negative spill-over (positive externalities) effects for third parties.

Evaluation point - The Austrian/FMS view
‘I had a great evening getting blind drunk with my friends, but broke my arm, on the way home and woke up with a really ugly person, but it turns out they have a fantastic personality and now I am married with three gorgeous children, one of whom is now a heart surgeon who has saved a hundred lives – I’m really happy and have come to terms with the fact I have liver cancer and won't live much longer!

How can you possibly know all the future costs and benefits of an economic decision? The concepts of social costs and social benefits are poor theory. The free market allows for millions of pieces of information to be accumulated, which are then reflected in the price, so leave decisions to the free market system! Besides, the theory involves value judgements and is normative economics anyway.