When the facts change, I change my mind.
- John Maynard Keynes
Although some people, like John Maynard Keynes, search for facts and information, consumers generally do not have access or choose to ignore important information. This is known as the information problem. The information problem is a key reason behind why merit and demerit goods exist. Let’s study their characteristics.
The idea of merit good was coined by economist Richard Musgrave in the 1950s. He defined merit goods as commodities that individuals and society should be able to benefit from, regardless of their willingness and ability to pay.
What are merit goods?
Merit goods are goods or services that are considered to be beneficial to individuals and society as a whole, but are often under-consumed in a free market economy. These goods have positive effects on health, education, or the environment, but individuals may not consume them in optimal quantities.
Merit goods are goods for which the social benefits of consumption outweigh private benefits, as they are beneficial to both individuals and society as a whole.
Imagine that there is a town where most people drive cars to work every day, but there is also a good public transportation system available. The public transportation system is a merit good, as it has positive externalities such as reducing traffic congestion and air pollution, but many individuals may not use it due to lack of information. To encourage greater use of public transportation, the government could offer subsidies or other incentives to make it more attractive to consumers.
The classification of merit and demerit goods is based on value judgments.
Merit goods examples
Examples of merit goods include education, healthcare services, public transportation and renewable energy.
- Education is often considered a merit good because it provides benefits not just to the individual student, but also to society as a whole. Education can lead to higher levels of economic growth, increased civic engagement, and improved health outcomes.
- Access to healthcare services can improve the overall health of a population, which can lead to increased productivity and reduced healthcare costs over time. In addition, healthy individuals are better able to participate in the workforce and contribute to the economy.
- The use of renewable energy sources like solar, wind, and hydropower can help reduce greenhouse gas emissions and mitigate the negative effects of climate change. Investing in renewable energy can also create jobs and stimulate economic growth.
- Access to public transportation can reduce traffic congestion, air pollution, and travel costs, while also increasing mobility and access to job opportunities. This can lead to increased economic activity and a more connected and cohesive society.
The characteristics of merit goods
Let’s study the main characteristics of merit goods.
Merit goods and positive externalities
Consumption of merit goods benefits society as a whole. These benefits outweigh the private benefits enjoyed by the individual due to positive externalities.
Exploring the healthcare example in more detail, a consumer that consumes healthcare (merit good) also benefits the community, as they are less likely to spread diseases (positive externality). Therefore, the benefits to society outweigh the individual benefits. If healthcare was only provided privately, fewer people would benefit from it.
Let’s look at this example in a diagram. In Figure 1 below, S1 represents the market supply of healthcare. It represents the quantity of healthcare private healthcare providers are willing to supply at various price levels. D1 shows how much healthcare consumers are willing to buy. Q1 represents the quantity of private healthcare consumed at price P1.
On the other hand, D2 represents both the external benefits (positive externalities) and the individual benefits of consuming healthcare. Q2 shows the socially optimal level of healthcare, whereas Q1 shows the privately optimal level of healthcare. In the free market economy, the positive externalities of merit goods often go unnoticed, so consumption and production are under the socially optimal level.
The price of healthcare has to decrease to P2 in order to reach equilibrium at Q2. However, private suppliers are unwilling to supply at this price as it would decrease their profits significantly. To increase the supply of healthcare to S2, governments subsidise it. The vertical distance between S1 and S2 represents the unit size of the subsidy.
Fig. 1 - Effect of a subsidy on merit goods
Why are merit goods underprovided?
A merit good is under-provided and under-consumed because of the following factors:
- Imperfect Information: Consumers may not have access to all the information they need to make an informed decision about the benefits of the merit good, leading them to under-consume it.
- Presence of positive consumption externalities: The benefits of a merit good, such as education or healthcare, may extend beyond the individual who consumes it to society as a whole. However, these positive externalities are not factored into the individual's decision-making, resulting in an under-provision of the good.
- Poor decision-making: Individuals may prioritize short-term costs over long-term benefits, leading them to under-consume a merit good that would be beneficial in the long run. This can be exacerbated by factors such as income inequality, where individuals with lower incomes may prioritize immediate needs over long-term investments in merit goods such as education or healthcare.
Merit goods can also be rejected in some instances. For example, free vaccinations.
What are demerit goods?
Demerit goods are the opposite of merit goods, as the social costs for the community are higher than the private costs for individual consumption. Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual. Social costs include the negative externalities that occur during the consumption of the good.
A demerit good is a good for which the social costs of consumption outweigh the private costs.
Social cost = external cost + private cost
Imagine that there is a town where there are many fast food restaurants, which offer unhealthy food options that can lead to health problems such as obesity and heart disease. Fast food is a demerit good, as it has negative externalities that impose costs on others beyond the individual consumer, such as increased healthcare costs. To discourage the over-consumption of fast food, the government could implement policies such as a tax on fast food or regulations requiring restaurants to offer healthier options.
Demerit goods examples
Examples of demerit goods that can have destructive impacts on individuals and society as a whole include alcohol, tobacco, fast-food, single-use plastics, and gambling.
- Tobacco products are widely recognized as a demerit good due to their negative effects on health, including an increased risk of lung cancer, heart disease, and other illnesses.
- Excessive consumption of alcohol can lead to a range of health problems, including liver disease, mental health issues, and an increased risk of accidents and injuries. Alcohol can also contribute to social problems such as violence and crime.
- Fast food and other high-calorie, low-nutrient foods are often considered demerit goods due to their contribution to obesity and related health problems. Overconsumption of these types of foods can also lead to increased healthcare costs and decreased productivity.
- Single-use plastics such as straws, bags, and packaging contribute to environmental pollution and harm wildlife. These plastics take hundreds of years to degrade and can end up in our oceans and waterways, causing serious harm to marine life.
- Gambling can be addictive and can lead to financial problems for individuals and their families. In addition, the promotion of gambling can lead to social issues such as crime and addiction.
The characteristics of demerit goods
Let’s study the main characteristics of merit goods.
Demerit goods and negative externalities
As we know, demerit goods create negative externalities. Looking at Figure 2 below, we can see that the sale of tobacco at market prices results in over-consumption. A privately optimal level of tobacco consumption happens at Q1, where prices are at P1. This is higher than the socially optimal level of tobacco consumption (Q2). Providing tobacco at free-market prices, therefore, results in overconsumption and overproduction.
As a result, governments can introduce taxes on the consumption of tobacco in an attempt to decrease the demand. This results in the supply curve shifting from S1 to S2, raising prices from P1 to P2 and allowing consumption to fall back to the socially optimal level. The vertical distance between S1 and S2 represents the unit size of the tax.
Fig. 2 - Taxation and demerit goods
Tax on demerit goods
Taxation on demerit goods is a policy tool used by governments to discourage the consumption of goods that have negative externalities. The idea is that by increasing the price of demerit goods, individuals will be less likely to consume them and the negative externalities will be reduced. Here are some examples of taxes on demerit goods from different countries:
- Tobacco taxes in the United States: The United States has one of the highest tobacco taxes in the world, with federal and state taxes accounting for over half the retail price of a pack of cigarettes. The aim of these taxes is to discourage smoking, which has been linked to a range of health problems. According to the Centers for Disease Control and Prevention, higher tobacco taxes have been shown to reduce smoking rates, particularly among youth.
- Alcohol taxes in Canada: In Canada, each province and territory sets its own alcohol taxes, with rates varying widely across the country. The aim of these taxes is to reduce excessive alcohol consumption, which can lead to a range of health and social problems. According to a report by the Canadian Institute for Health Information, higher alcohol prices have been linked to lower alcohol consumption and fewer alcohol-related problems.
- Plastic bag taxes in the United Kingdom: In 2015, the United Kingdom introduced a 5p (about 7 cents) tax on single-use plastic bags (increased to 10p in 2021) in an effort to reduce plastic waste.
Why are demerit goods overconsumed?
In the same way that merit goods are under-consumed, demerit goods are over-consumed. This is, again, due to imperfect information. Consumers often do not realise the extent of the harm caused by demerit goods which therefore leads to their over-consumption. Consumers also tend to ignore the negative externalities caused to society by consuming demerit goods.
In the early twentieth century, cigarettes were advertised as healthy and beneficial for certain health problems. This likely led to the overconsumption of cigarettes.
Merit goods, demerit goods, and value judgements
Value judgements are personal opinions that characterise what a particular person finds desirable or not.
Value judgments play a large role in determining which goods can be classified as merit and demerit goods. There are certain products that can clearly be defined as merit goods (like education and healthcare) and products that can clearly be defined as demerit goods (like tobacco and illegal drugs). However, due people’s different values and religions, there are certain goods for which the classification is not as easy. For example, some view contraception as a merit good and others as a demerit good. Therefore, the classification depends on the value judgment of the person making the classification.
Merit and Demerit Goods - Key takeaways
- Merit goods are goods for which the social benefits of consumption outweigh private benefits, whereas demerit goods are goods for which the social costs of consumption outweigh private costs.
- Merit goods are under-provided by markets.
- Healthcare and education are examples of merit goods.
- Demerit goods are over-consumed due to imperfect information.
- Examples of demerit goods include tobacco, alcohol and sugar.
- Demerit goods lead to negative externalities and are often taxed by the government.
- The information problem occurs when people make incorrect decisions as they do not have or choose to ignore important information.
- Value judgements are personal opinions that characterise what a particular person finds desirable or not. They play a large role in determining which goods are classified as merit and demerit goods.
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