Merit goods

The essential feature of a merit good is that the benefits of consumption are shared between the individual consumer (or user) and society.  Merit goods fit between pure private goods and pure public goods.

Like private goods, merit goods provide an individual with utility, the benefit of which can be denied to others. However, like public goods, some of the benefit of consumption spills over to others in the form of external benefits1. The external beneficiaries (or 'third parties') cannot be excluded from gaining these spill-over benefits, and cannot be charged - they are, in effect free riders.

Hence, merit goods provide both private and external benefits when they are consumed. However, if left purely to market forces, the allocation of resources to merit goods would be distorted by the impact of information failure given that large numbers of individual consumers (or users) are likely to be unaware of the future spill-over benefits to others, and indeed unaware of all the private benefits to themselves.

Education as a merit good

For example, being educated not only provides the individual with private benefits, including job prospects and pay, but it also provides benefits to others. The allocation and sharing of these benefits will vary considerably depending on the type of education being considered.

At one extreme we have the private tuition of individual students. The benefit of this tuition will almost exclusively be gained by the individual student, and in this sense the education provided can be considered a private good. At the other extreme are the basic skills of numeracy, literacy and working with others which are taught in the early years of education (primary or elementary schooling) and which clearly benefit others and, as such could be considered a public good.

Of course, well educated and skillful workers are likely to pay more tax, which can be used for the benefit of others through government spending. Being educated also means that individuals may become teachers or doctors, or may eventually become employers, all benefitting others and helping the economy prosper.

In addition, the benefits of education are cumulative, and increase the more it is 'consumed'. Economic theory predicts that, for most goods and services, there is a diminishing marginal benefit from consumption, but the consumption of education provides an increasing marginal benefit - hence the external benefits of consuming merit goods increases.

Healthcare is also regarded as a merit good given that, like education, the benefits of better health are shared between the individual and society.

The merit good diagram

In terms of how resources are allocated to merit goods through markets, the demand curve reflects the perception of the benefit gained by individuals from consumption, and can be referred to as the marginal private benefit (MPB) curve. The curve slopes downwards, reflecting the principle of diminishing marginal utility [and ignores the possibility that the marginal utility of education and knowledge actually increases].

However, some of the benefit also goes to third-parties as a positive spillover, and if we add this to the private benefit we get the marginal social benefit (MSB).

Merit goods

Social efficiency will occur at the output where marginal social benefit equals marginal social cost (graphically shown at QS).

However, if left to free markets, equilibrium output would be at Q, where MSC equals MPB. At this output, Q, there is a welfare loss of area a,b,c.

This clearly suggests that the market alone would fail to meet society's need for merit goods.


Video on merit and demerit goods

Under-supply and market failure

What is clear from economic theory is that the free market allocation of resources to the production of merit goods will be sub-optimal, with merit goods being under-consumed and under-supplied. This does not mean that private firms will not enter the market for merit goods. Indeed, the price mechanism will operate to encourage private suppliers to enter the market.

Given that individuals can be excluded from some of the specific and targeted benefit of merit goods (such as dental treatments) there is no free rider problem and individuals can be charged - hence the private supply of merit goods provided by profit-seeking suppliers is likely to satisfy the needs of a section of the population. However, economic theory predicts that there will also be an appreciable section of the population who are either unaware of the full range of benefits of merit goods, or who cannot afford the price (or fee) charged by private suppliers, or simply choose not to consume the merit good in question.

So, what can be done?

Given that merit goods are under-consumed and under-produced, two basic types of remedy are possible. Firstly, measures to increase supply, and secondly, measures to increase consumption.

Measures to increase supply

Supply by central or local government

Government can use tax revenues to fund the public (state) supply of merit goods. Given that there are both private and external beneficiaries the publicly funded supply of merit goods (including publicly funded schools and healthcare) out of general taxation is justifiable under the principle that 'beneficiaries should pay'. 

In the UK, some state schools were given grant maintained (GM) status, which meant they could opt out of local authority control and operate independently, but financially supported by the state. GM status was ended in 1998, and replaced in 2000 with Academy schools which are funded directly by the state.

There are clear issues with increased state involvement. Increasing taxation can create a disincentive effect on an economy's supply-side, and there is an opportunity cost as resources might be diverted from other uses. 

There is also the possibility of resource crowding out. As the state sector increases, resources are diverted from the private sector, which reduces the availability of these resources, and drives up prices (and wages). For example, an expansion of state provision of education will increase demand for teachers, and possibly drives up their pay. This means that private, fee-charging schools and colleges have fewer teachers available to them, and an increased wage bill to pay.

Finally, as with any intervention by government there is the possibility of government failure. This may include information failure, with governments not having full access to the information required to allocate resources efficiently, moral hazard, where state provision provides an insurance policy against the inefficient use of resources, and excessive bureaucracy, which may arise as a result of trying to solve the principal-agent problem by excessive reporting and monitoring.

Subsidies

Governments can also subsidise privately supplied merit goods. For example, in the UK, while private schools are funded by a combination of tuition fees, gifts and endowments, central government can provide private schools with special grants to implement state schemes, or allow tax exemptions such as awarding charitable status.

Graphically, a subsidy would shift the supply curve outwards and increase equilibrium output to QS. In the diagram, the subsidy per unit would be ‘b’ to ‘d’. This would also encourage consumption to expand through a positive income and substitution effect.

However, there are clear issues with subsidies, including the opportunity cost, and other possible inefficiencies, such as information failure - for example, not knowing the level of subsidy that will be required to achieve the socially desirable output.

Measures to increase demand

The effect of a subsidy will not only be on supply. Any reduction in price is likely to encourage demand. However, consumers may be unresponsive to lower prices (or zero price) so other measures are likely, including:

Compulsion

Individuals may be compelled to consume/use merit goods. For example, compulsory schooling is a universal requirement, with penalties for those not attending. Individuals requiring treatment for serious mental health issues may be compelled to attend hospital.

Insurance

Various state run and private insurance schemes operate across the globe to reduce or eliminate the price or fee charged for merit goods at the point of consumption. Health insurance is available privately, and while individuals pay for this service, payments are spread out over time, with the purchaser paying a reduced fee or no fee for specific treatments. Health insurance can also be state funded, such as the Medicare system in the US.

Information

Given that the benefit of merit goods may not be appreciated, governments (or organisations sponsored by governments) may employ TV, press and website campaigns to raise awareness of the benefits of merit goods. For example, governments have spend vast sums on campaigns to encourage individuals to become vaccinated to reduce the spread of COVID-19. Similar campaigns have been run to increase awareness of mental health issues, and improve physical fitness.

Nudge theory

Legislation and information campaigns may be supported by small 'nudges' to encourage people to increase consumption of merit goods. During the COVID-19 crisis many governments provided information regarding the number of people who do abide by the rules, and who have 'taken-up' the vaccine. 'Nudge theory' has become an increasingly significant contributor to understanding behaviour and to developing policies to change behaviour. Individuals can be 'nudged' towards making choices that generate increases in welfare for themselves and others.

Criticisms

Measures to increase demand are also subject to criticism. As with measures to increase supply, the response of consumers may be limited, and resources spent on government schemes could be spent elsewhere. Critics also point to the potential waste of resources, and unnecessary bureaucracy associated with government schemes. Finally, some object to the excessive use of compulsion as it reduces individual freedom and the right to exercise choice.

1. External benefits are the benefits gained by 'third parties' as a result of a transaction or economic activity. The first and second parties in a transaction are those directly involved, and typically involve the seller and buyer.


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