Merit goods and demerit goods

1. AS Microeconomics Merit goods and demerit goods chris@chrisrodda.com

2. Merit goods • There is no God of economics – different textbooks/teachers have different explanations

3. Merit goods ? innoculations

4. Approach 1 – externalities • Merit goods have positive externalities in consumption. e.g. Alcohol is a social lubricant and other people like you better at a party when you have had a drink. You may disagree if you are a Muslim! Remember this is a value judgement

5. Merit goods have positive externalities in consumption Costs & Benefits £ welfare loss MSC=MPC 1 2 3 MSB MPB Q free market social optimum Output (Q)

6. Approach 2 – Information failure • Merit goods are underconsumed because the private benefits are not fully understood. • e.g. You are unaware that you smell and need deodorant • (Demerit goods are overconsumed because the bad effects are not fully understood. E.g. Alcohol leading to an injury – (or waking up with someone you rather you didn’t)

7. Approach 3 – short v. long term • Merit goods are underconsumed because the long term benefits are not fully understood. • E.g. You are not going to vols because you are unaware of how important a decent A level grade is. • (demerit good – long term effect of smoking not appreciated)

8. Information failure • Consumers value cigarettes at MPB1 because of informational failure, but if they knew all the facts they would know cigarettes are bad for them and the actual benefit to them is less than they thought so would change their MPB curve to MPB2 and consume less Costs & Benefits £ MSC=MPC welfare loss MPB1 - imperfect info Q of cigarettes MPB2 - full information Q Q* Difference between MPB1 and MPB2 is due to INFORMATION FAILURES – consumers are not aware of true benefits which differs from their perceived benefits The same idea can be expressed using MPC – the consumer believes the private cost to them at the margin is simply the cost of the cigarettes, when in reality it is the road to cancer…

9. Information failure – demerit good Costs & Benefits £ MSC=MPC welfare loss MPB1 - imperfect info Q of cigarettes Q* Q MPB2 - full information Over-consumption

10. Information failure – merit good Costs & Benefits £ Potential welfare gain MSC=MPC MPB2 - full information Q of cigarettes Q* Q MPB1 - imperfect info under-consumption

11. Approach 4 – best of all worlds? • 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.

12. But … an Austrian/FMS approach • I got blind drunk and broke my arm, woke up with a really ugly person, but it turns out later they have a fantastic personality and I got married and now we have three gorgeous children one of whom is now a heart surgeon and has saved a hundred lives – I’m really happy – but have liver cancer! How can you possibly know all the future costs and benefits – this is poor theory and the free market allows for millions of pieces of information to be assembled and accumulated which is reflected in the price – leave it to the FMS! Besides merit and demerit are value judgments anyway.

13. Merit goods – AQA exam question • With the help of an appropriate diagram, explain why merit goods are often underprovided. (12 marks) 10 marks maximum for written explanation You MUST draw a diagram in order to get all 12 marks

14. Merit Goods – definition(s) • Merit goods have positive externalities in consumption and are underprovided by the free market. (1 mark) or • Merit goods exist where the marginal private benefits are greater than the marginal private costs (1) or • Merit goods exist where the perceived maginal private benefits are not as great as the actual marginal private benefits. (1)

15. Merit Goods – definition(s) Social costs = Private costs + external costs Marginal external cost is the spillover effect suffered by third parties when a product is produced. Marginal external benefit is the spillover effect enjoyed by third parties when a product is consumed. Definitions = 1 mark each up to a maximum of 2

16. Merit Goods – chain of reason • Merit goods are often underprovided because consumers only consider the private benefits (2 marks) • so the positive (consumption) externalities are not taken into account (2) • so the MPB is less than the MSB (2) • the level of consumption ends up below the social optimum (2) • and there is a deadweight loss of social welfare (2)

17. Private benefits and some external benefits ? Even demerit goods must have some private benefits or else nobody would smoke and some external benefits - Marlene Dietrich does look cool!

18. Demerit goods - Really?

19. Imperfect Information • Informative advertising Advertising that provides customers with information about the price, product and where to buy it but does not appeal to emotions. ✓

20. Imperfective Information • Persuasive advertising Advertising that seeks to differentiate the product or service from other products and make the demand for it more price inelastic, often by appealing to emotions. Evaluation point or is it ✓? The world would be dull without different products X poor use of scare resources

21. Imperfect Information • Asymmetric information Where one party in a transaction has more or better information than the other. George Ackerlof Nobel Prize in Economics 2001

22. Plum or Lemon • imagine a world where there is no information available to buyers. • If buyers believe that half the cars are lemons and half plums they would pay £1,000 for a lemon and £5000 for a plum • (0.5 x £1,000) + (0.5 x£ 5,000) = £3,000.

23. Plum or Lemon?

24. Plum or Lemon? X don’t sell

25. Adverse selection Only the lemons are left! The good products drive out the bad

26. Imperfect information • Adverse selection A situation of market failure caused where buyers and sellers have asymmetric information, and the poor quality products (or customers) drive out the good.

27. Plum or Lemon?

28. Imperfect information • Moral hazard Any situation in which the agent makes the decision about how much risk to take, while the principal bears the cost if things go badly. You tube/Channel Four video clip

29. Moral hazard • Principal agent problem concerns the difficulties in motiving the agent to act in the best interests of the principal. Agent (Sir) Fred Goodwin - Agent principal

30. Imperfect information in employment markets A degree from a good university provides information about ability and attitude to work Offering a higher than market wage means the lazy will work hard to keep their jobs, as the opportunity cost of losing their job is high….BUT…….

31. Classical Unemployment Unemployment that results from real wages being above their market clearing level and causing an excess supply of labour Classical unemployment Real wages AS labour w1 w AD labour Employment Qd1 E Qs1