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Merit goods

What are merit goods?

Merit goods are the opposite of demerit goods - they are goods which are deemed to be socially desirable, and which are likely to be under-produced and under-consumed through the market mechanism. Examples of merit goods include education, health care, welfare services, housing, fire protection, refuse collection and public parks.

In contrast to pure public goods, merit goods could be, and indeed are, provided through the market, but not necessarily in sufficient quantities to maximise social welfare. Thus goods such as education and health care are provided by the state, but there is also a parallel, thriving private sector provision. Indeed, there is considerable disagreement between economists on the right and left of the political spectrum over the extent to which such goods should be provided by the state or the private sector. We consider these arguments later in this section.

Before we proceed with our discussion of merit goods, and in particular the question of why merit goods tend to be underprovided by the market, it would be useful at this stage to summarise the main differences between public goods, private goods and merit goods. Have a go at filling in the blank table below (we have put in a few entries to help you along). Once you have had a go, follow the link under the table to compare your answers with ours.

Main features Public goods Merit goods Private goods
Diminishability (non-rivalry) Non-diminishable (non-rivalry)
Excludability Excludable
Benefits Individual and communal (strong positive externalities)
Provider Usually private enterprise
Financed by Usually taxation

Main features of public, merit and private goods - full table

Why might merit goods be underprovided by the market?

Merit goods will tend to be underprovided by the market because:

  • they generate positive externalities;
  • there is an unequal distribution of income;
  • consumers may lack perfect information;
  • consumers may be uncertain as to their future needs;
  • and monopoly power may arise.

We shall examine each of these factors in more detail in turn below:

Merit goods generate substantial positive externalities

Merit goods confer benefits on society in excess of the benefits conferred on individual consumers; in other words, there is a divergence between private and social costs and benefits, as the social benefits accruing to society as a whole from the consumption of such goods tend to be greater than the private benefits to the individual. This divergence means that the private market cannot be relied upon to ensure an efficient allocation of society's scarce resources. The problem is that individual consumers and producers make their decisions on the basis of their own, internal costs and benefits, but, from the standpoint of the welfare of society at large, externalities must be considered. This point can be illustrated in relation to health care and education:

Health care generates a number of positive externalities; for example, if all people receive adequate levels of healthcare, the nation's workforce is likely to be fitter and healthier, less working days would be lost through sickness, and this would have beneficial effects on the level of output and economic growth; vaccinations and preventative health care which prevent the spread of contagious diseases such as small-pox and whooping cough, clearly not only benefit the individuals receiving the treatment, but also the rest of society at large. Indeed, a major reason for the relatively weak economic performance of many of the poorer countries of the world is the widespread incidence of ill-health and disease amongst their populations.

Similarly, in the case of education, there are a number of positive externalities from which society at large may benefit, which may not directly accrue to the individual pupil/student. Individuals clearly derive private benefits from higher levels of education as, for example, earning capacity is to a considerable extent a function of educational attainment. However, society at large receives the benefits of a more highly skilled, adaptable and thus more efficient workforce, which is one of the key ingredients of economic success - the West German post-war 'economic miracle' has, in part, been attributed to its highly educated and trained workforce. Society also benefits in less tangible ways as it could be argued that educated people are less prone to crime and racial intolerance, although this argument is obviously not foolproof!

The important point then is that if people had to pay privately through the market for such merit goods as health and education they would consider only their private benefits and their private costs and would thus consume too little from the point of view of the best interests of society as a whole. This problem of under-consumption is illustrated in Figure 1 below.

Figure 1 Under-consumption of a merit good.

In the diagram, OQ is the free market level of consumption, as, at this point, individuals equate their private marginal benefit with their private marginal cost. The existence of positive externalities means that the social marginal benefit curve lies above the private marginal benefit curve as the social benefits of consumption exceed the private benefits. Allocative efficiency would require a level of consumption of OQ1 at which SMB = SMC.

There is an unequal distribution of income

Perhaps a more basic reason for the market tending to under-provide merit goods is that, given the highly unequal distribution of income, and the widespread poverty such as exists in most economies today, many people would be unable to afford adequate education, health care and housing in the absence of state provision or subsidy. A market system only takes effective demand into account; that is, demand backed by the ability to pay the asking price. It does not respond to human demand as indicated by peoples' needs, so quite simply the poor may have to go without. Thus, on the grounds of equity, it may be decided that such merit goods as health and education should be provided free on the basis of need rather than according to ability to pay. Underpinning this approach would be the view that all have a fundamental human right to the various merit goods, which should not be determined by the market criteria of prices and profits.

Consumers may lack perfect information

At one level, market provision of health care and education may not provide a socially optimum outcome because consumers may not be aware of all the benefits of such goods, and may behave in a foolish manner - they may choose to spend their money on demerit goods such as cigarettes, alcohol and pornography, rather than making adequate provision for their own and their children's medical and educational needs. In this case, government provision may be justified on the paternalistic grounds of protecting us against our own folly.

At another level, consumers of such goods as health care and education may have every intention of behaving wisely, but because of the particular characteristics of these goods, may not be able to do so. A basic assumption of economic theory is that consumers are aware of their own best interests better than anybody else, and providing they possess full information, will act in such a way as to maximise their satisfaction. Thus, consumers of fresh fruit will not usually experience too much difficulty in establishing the best prices available in the market, and most would be able to make fairly accurate assessments of quality merely by sight and feel; and, if an incorrect decision is made, for instance by purchasing sour satsumas which were perceived to be sweet, the consequences of such a mistaken decision are unlikely to be too catastrophic, as the amounts spent are likely to be relatively small, and the sour satsumas could simply be thrown away.

However, health care and education are considered to be different from other goods, and the sovereignty of the consumer is likely to be considerably less than in the case of fresh fruit, for instance.

A major problem of providing health care through the market is that there is likely, in the overwhelming majority of cases, to be an imbalance between the information possessed by the suppliers i.e. the doctors, and the consumers i.e. the patients: medical treatment is usually technically complex, and consumers will rarely possess sufficient information to make rational choices between the alternatives available - most would have to rely on the suppliers of medical care for their information; and it is somewhat doubtful as to whether a profit maximising supplier could always be relied upon to provide completely impartial information. Also, as many medical problems only occur once, any information acquired may be of no future use; and finally, in contrast to buying a sour instead of a sweet satsuma, any mistaken choices in the case of health care are likely to involve a far greater cost and to be considerably more difficult to reverse; for example, the consumption of poor quality facial plastic surgery.

Similarly, in the case of education , consumers, usually parents, intending to act wisely, may not be able to do so and the consequences of mistaken decisions may be extremely great; education is a multi-faceted, complex process about which there is considerable disagreement, even amongst the 'experts', and obtaining the necessary information on such variables as teachers' qualifications, examination performance, intake according to social class, the incidence of bullying and racial harassment, may be extremely time-consuming and difficult to acquire ; moreover, in the case of higher education, it is usually far more difficult for those who have not experienced it to appreciate its benefits and make wise decisions, as compared with those who have. As it is generally accepted that education is a prime determinant of life chances, future earning potential and quality of life, mistaken decisions because of imperfect information can have particularly severe consequences.

Consumers may be uncertain as to their future needs

Not only is a lack of information likely to cause market failure, but so too can uncertainty of information - particularly in the case of health care. A situation in which consumers are uncertain about future market information can lead to allocative inefficiency, with too little health care being consumed if state provision is not available. Few people are able to predict with any degree of certainty the level and type of health treatment that they will require at some point in the future, as the incidence of serious accidents or ill-health are essentially unknown variables, even for the smartest of medical practitioners. As paying through the market for an operation, hospitalisation or long-term disability would almost certainly involve exceedingly large sums of money, it would be very difficult for individuals to plan their savings and consumption so as to ensure that all future medical requirements could be met; the market in this situation is unlikely to provide the optimal quantity of health care because at the particular point in time when consumers actually need it, they may lack the wherewithal to pay the market price. Direct government provision of health care, free at the point of contact, overcomes this problem.

A possible market-based solution to this problem would be that of private medical insurance; in the same way that it is obligatory for all motorists to take out some form of car insurance, everybody could be required to purchase a minimum level of health insurance to guard against unforeseen contingencies. However, such a scheme is likely to present a number of problems:

  • As all motorists are aware, the quality of insurance cover depends on the premiums paid, and the type of policy purchased; a driver who has the benefit of the more expensive 'fully comprehensive' cover will be guarded against most eventualities; however, a person with the cheaper 'third-party, fire and theft' type of policy will find that they are entitled to no compensation whatsoever for a whole variety of occurrences, for example, damaging a car by driving it into a lamp-post; similarly, and more seriously in the case of health care, those who have paid the smallest premiums would be entitled to the least insurance cover, which may be insufficient to cover serious ill-health, should it arise; and clearly those who are likely to have the lowest cover would be the poorest, most vulnerable groups in society, who are probably the ones who need health care the most, but who would be least able to afford it;
  • Not only are the most needy likely to have the least insurance cover, but, as is the case with motor insurance, there are likely to be those who have no medical insurance at all;
  • Like other private sector business organisations insurance companies are motivated by the goal of long term profit maximisation, and would thus be reluctant to insure such 'unprofitable' categories of people as the long term sick, the permanently disabled and the very old; for all these people the market solution is likely to be no solution;
  • In contrast to the problems of under-provision for the most needy, a system of health provision, based solely on private medical insurance, is likely to lead to overprovision for those, almost certainly the better off, with the most comprehensive and expensive cover: in such cases, neither doctors nor patients may have any incentive to economise on treatment - fully covered patients may wish to visit their doctor as often as possible to obtain value for money, and doctors may be induced to diagnose the most expensive of treatments to maximise their earnings.

Monopoly power may arise

Previously we demonstrated how under monopoly, price will tend to be higher and output lower compared to the case of perfect competition; and as price will be set at a level above marginal cost, and the firm is unlikely to operate on the lowest point of its average cost curve, neither allocative nor productive efficiency will occur. Thus, where monopoly occurs, the market could not be relied upon to produce an efficient allocation of resources.

If education were provided solely through the market, it is likely that spatial monopolies would arise, as various geographical areas would not be adequately populated to support more than one school, college or university i.e. monopolistic educational providers would be protected from competition by virtue of distance and such provision may lead to sub-optimality in the market.

Spatial monopoly

Spatial monopoly is monopoly power obtained by a business organisation through locating at a distance from its competitors.

Similarly, in the case of health care, market provision would be likely to generate substantial monopoly power, and therefore market failure: as the consumers of medical services lack perfect or even adequate information about the products they consume, scouring the market place for the best deals is not possible, and in this situation the suppliers i.e. the doctors and hospitals, would be able to act like monopolists and raise their prices with relative impunity; and, not only might consumers face monopoly pricing, but may also, on account of their relative ignorance, end up purchasing more health care than they might actually need: the 'sound of cash-tills' might induce the less scrupulous practitioners to be over-zealous as the regards the amount and type of treatment they recommend; for example, in the USA where a direct charge for childbirth delivery is usually made, many more caesarean deliveries on average are carried out as compared to the UK, where most childbirth is provided free through the NHS.