Merit/Demerit Goods
Merit Demerit
Definition A merit good is a good that the government deems
socially desirable but consumers underconsume
them, resulting in allocative inefficiency.
Consumers consume too little of these goods from
societys point of view because of three main
reasons: (i) imperfect information affecting
personal well-being argument and (ii) positive
consumption externalities argument (iii) excessive
income inequality argument.
Sources of
Market i. Imperfect Information
Failure o If left to the free market, it is likely that
healthcare/education will be under-consumed
because individuals undervalue their private
benefits from the consumption of services
such as health-screening and education.
o Individuals may not act in their best interests
due to the lack of information about the full
benefits of consuming merit goods and the
costs of consumption.
o Imperfect Information: Individuals not fully
aware of full benefits to themselves
Underestimate/undervalue their private
benefits from consuming education/basic
healthcare
Perceived demand with imperfect
information < Actual demand with perfect
information for healthcare services
Consumers may be unaware of the
benefits of health-screening (routine
medical check-up), i.e, that the early
detection of illnesses like cancer leads to
high chances of cure and recovery
ii. Income inequality
o With excessive income inequality, some
people will have insufficient dollar votes
their preference for the good is not
considered by the free market
o Due to the excessive income inequality
there will be a lack of effective demand
since lower-income groups unable to afford
healthcare services in the free market in
absence of dollar votes
Information Failure
A demerit good is a good that the government Imperfect information occurs when people have
deems socially undesirable but consumers inaccurate, incomplete, uncertain or misunderstood
overconsume them, resulting in allocative data.
inefficiency. Consumers consume too much of them
from societys point of view because of two main
reasons: (i) imperfect information affecting personal
well-being argument and (ii) negative consumption
externalities argument.
i. Imperfect Information
o If left to the free market, consumers will
overconsume demerit goods because they will
overvalue the private benefit of consuming the
good such as cigarettes and alcohol
o Hence the government takes on a
paternalistic role and judges that
individuals may not act in their own best
interests because of imperfect and
incomplete information about the benefits
that arise from the consumption of demerit
goods.
o Imperfect information: Individuals not fully
aware of the full costs to themselves and tend
to overvalue the their private benefits if left to
the free market
Individuals may not be fully aware of the ill
health effects on themselves of consuming
cigarettes
Individuals generally believe that the risk of o Imperfect information could stem from ignorance,
them getting sick from smoking/drinking is complexity of information, uncertainty about
low. costs/benefits, cost of acquiring information is too
high, persuasive advertising etc.
i. Inaccurate/incomplete information in the case
of asymmetric information: situation whereby
one party has better information than the
other
Over/Underestimate benefits of consumption
In the case of persuasive or misleading
advertising which are inaccurate, incomplete
and tend to misinform consumers about the
potential benefits about consumption of
 o If left to the free market , equilibrium quantity
consumed and produced = Qe
o Thus, with income inequality, there will be
underconsumption of merit goods leading to
allocative inefficiency
Diagrammati
c Analysis
Step 1: Explain the free market equilibrium
where private individuals make their decisions
Due to imperfect information private
individual underestimates the full benefits of
consuming healthcare services such as
health screening (eg. disease prevention),
the perceived demand for healthcare
services is lower than that of the actual
demand for healthcare services with perfect
information.
Private individual consumes up to only Qe
Step 2: Explain how imperfect information
leads to underconsumption of merit good such
as healthcare in the free market
However, the socially optimal level of
consumption is at QS
Underconsumption of QeQs units of
healthcare
Explain DWL area: Represented by area ABC
which arises from imperfect information as the
certain goods contributes to peoples
ignorance
Misleading advertising/information leads to
a higher demand for a good hence leads to
overconsumption if left to the free market.
Step 1: Explain the free market equilibrium
where private individuals make their decisions
The free market equilibrium (with imperfect
information, DD0) occurs at output Qe with price
P e.
Step 2: Explain how imperfect information leads
to overconsumption of merit good such as
healthcare in the free market
However, the socially optimal level of
consumption is at output Qs with price Ps (with
perfect information).
Hence, with imperfect information, demerit
good will be over-consumed.
Explain DWL area: Represented by area ABC as
the additional benefits gained in consuming QsQe
units of demerit goods is less than the additional
costs incurred from the resources allocated in
consuming them. Hence, the overconsumption of
demerit goods results in allocative inefficiency.
benefit forgone in not consuming QeQs units
exceeds the resources saved under consuming
QeQs units of health screening. Hence, the net
benefit forgone from the underconsumption
leads to allocative efficiency.

Step 1: Explain the free market equilibrium

where private individuals make their decisions
The free market will allocate resources based
on the dollar votes, where DD = SS and
produce at Qe units of output
It could also skew the market to provide for
expensive medical facilities serving only the
rich who have stronger dollar votes

Step 2: Explain how excessive income

inequality leads to underconsumption of merit
good such as healthcare in the free market
However, consumers who lack the
willingness and ability to afford healthcare will
be priced out of the market due to lack of
effective demand at the prevailing market
equilibrium price due to the lack of dollar
votes
Societys welfare will improve if income is
less unequal as that will cause the effective
demand to increase from DD0 to DD1 and
output to increase to Qs.
 Explain DWL area ABC benefit from
consumption of additional units of healthcare is
greater than the cost savings from the under
consumption net benefit forgone results in
allocative inefficiency
Externalities: An externality occurs when some of the costs or benefits associated with the production or consumption of a good 'spills over' onto third parties, that
is, to non-participating parties (not the immediate seller or buyer).
Positive Externality in Consumption
Definition The spillover benefits on third parties who are not directly involved in the
consumption of a good and who do not pay for the benefits enjoyed by them.
1. If you are analyzing positive externalities in consumption, you must
assume that there are no externalities on the production side and there
are no external costs. As such, MPC = MSC.
Source o In the free market, due to pursuit of self-interests, consumers will only
take into account of private costs and benefits in their consumption
decision to undertake consumption of education/healthcare
o As such, consumers will ignore the existence of external benefits/positive
externalities of consumption of education/healthcare
o Therefore, they will consume up to QE, where MPB=MPC.
o The existence of the external benefits of consumption of
education/healthcare that generates the higher economic growth leads to
the divergence between the private and social benefits of
consumption of education/healthcare
where MPB of consuming education according to screening
hypothesis, there is a strong positive correlation between
educational attainment and productivity higher abilities/skills
enable individuals to attain a higher paying job and hence higher
salary
where MPB of consuming healthcare/vaccination healthier
individual, lower medical expenses together with lower absenteeism.
Higher productivity level, higher bonuses and wage increments
where MSB = MPB + MEB
o This means that the marginal social benefit arising from the individuals
consumption of the good (MSB) is higher than the marginal private
benefit (MPB) as the benefits accrued to the third parties increases the
overall benefit to the society by the amount of the MEB
Negative Externality in Consumption
The spillover costs on third parties who are not directly involved in the consumption
of a good and who are not compensated for the costs inflicted upon them.
1. If you are analyzing negative externalities in consumption, you must
assume that there are no externalities on the production side. As such,
assume MPC=MSC and no external benefits.
o In the free market, due to pursuit of self-interest, consumers will only take into
account of private costs and benefits in their consumption decision to
undertake consumption of alcohol/cigarettes
o As such, consumers will ignore the existence of external costs/negative
externalities of consumption of demerit goods.
o For example, when consumers consume cigarettes/alcohol, non-smokers/non-
drinkers will be negatively affected through second-hand smoking, drink
driving, sexual/physical assaults arising from alcohol abuse, road accidents
and etc
o Therefore, private individuals will consume up to QE, where MPB=MPC.
o The existence of the external costs of consumption of alcohol/cigarette leads
to the divergence between the private and social benefits of consumption
where MPB of consuming demerit goods satisfaction/pleasure one
derives from smoking/drinking
where MSB = MPB + (-MEB) ; alternatively known as MEC
o Hence, the MSB from consuming cigarettes/alcohol is lower than the MPB
from consuming demerit goods private valuation of the benefit of smoking
or drinking is greater than societal valuation of the benefit hence, the costs
incurred by the third parties reduces the overall benefit to the society by the
amount of external costs
Diagrammati
c Analysis
Step 1: Explain the free market equilibrium where private individuals
make their decisions
In the pursuit of self-interest, individuals only consider their own private
benefits (reduction in frequency of falling ill or prevention of catching on
certain illnesses) and costs and ignore the external benefits (Herd
immunity effects)
Free market equilibrium point is at point A with output at Qe units,
where MPB=MPC.
Step 2: Explain how presence of external benefits leads to
underconsumption of merit good such as healthcare/education in the
free market
However, if private individuals internalize the external benefits of
consuming healthcare/education, the socially desired output level will be
Qs units at point C (MSB=MSC)
Therefore, societal valuation of the benefits of healthcare is greater than
private valuation of benefits (MSB>MPB)
Explain DWL area ABC benefit from consumption of additional units of
healthcare is greater than the cost savings from the underconsumption net
benefit forgone by the society results in allocative inefficiency market
fails
Step 1: Explain the free market equilibrium where private individuals make
their decisions
In the pursuit of their self-interests, consumers of demerit goods will only take
into consideration their MPB and MPC, ignoring the negative consumption
externalities generated
Free market equilibrium is at point A with output Qe units, where
MPB=MPC.
Step 2: Explain how presence of external costs leads to overconsumption of
demerit good such as alcohol/cigarettes in the free market
On the other hand, if the private individuals internalise the external costs of
consuming alcohol/cigarettes, the socially optimal (allocatively efficient)
output level of consumption will be at Qs units at point C (MSB=MSC)
Thus, private valuation of cigarettes/alcohol is greater than the societal
valuation of the benefits (MPB>MSB)
Explain DWL area ABC there excess of social costs over social benefits from
overconsuming demerit goods net loss incurred by the society results in
allocative inefficient market fails