1 Merit Good, Market Failure and Externalities Merit Good the Concept of a Merit Good Introduced in Economics by Richard Musgrav

Merit good, Market failure and Externalities Merit Good The concept of a merit good introduced in economics by Richard Musgrave (1957, 1959) is a commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay. The term is, perhaps, less often used today than it was in the 1960s to 1980s but the concept still lies behind many economic actions by governments which are not performed specifically for financial reasons or by supporting incomes (e.g. via tax rebates). Examples include the provision of food stamps to support nutrition, the delivery of health services to improve quality of life and reduce morbidity, subsidized housing and arguably education. In many cases, merit goods provide services which it is argued should apply universally to everyone in a particular situation, a view that is close to the concept of primary goods found in work by philosopher John Rawls or discussions about social inclusion. On the 'supply' side, it is sometimes suggested that there will be more support in society for implicit redistribution via the provision of certain kinds of goods and services, rather than explicit redistribution through income. Alternatively, it is sometimes suggested that society in general may be in a better position to determine what individuals need (such arguments are often criticised for being paternalistic, often by those who would like to reduce to a minimum economic activity by government). Sometimes, merit and demerit goods are simply seen as an extension of the idea of externalities. A merit good may be described as a good that has positive externalities associated with it. Thus, an inoculation against a contagious disease may be seen as a merit good. This is because others who may not now catch the disease from the inoculated person also benefit. However, merit and demerit goods can be defined in a different way which makes it different from externalities. The essence of merit and demerit goods is to do with an information failure to the consumer. This arises because consumers do not perceive quite how good or bad the good is for them: either they do not have the right information or lack relevant information. With this 1 definition, a merit good is defined as good that is better for a person than the person who may consume the good realises. Other possible rationales for treating some commodities as merit (or demerit) goods include public-goods aspects of a commodity, imposing community standards (prostitution, drugs, etc.), immaturity or incapacity, and addiction. A common element of all of these is recommending for or against some goods on a basis other than consumer choice.[3]However, there is no reason why governments should not consult their populations on such issues as they increasingly do in a number of economic contexts (e.g., development planning by the World Bank or resource allocation in health systems using information on health-benefits). In the case of education, it can be argued that those lacking education are incapable of making an informed choice about the benefits of education, which would warrant compulsion In this case, the implementation of consumer sovereignty is the motivation, rather than rejection of consumer sovereignty. Public Choice Theory suggests that good government policies are an under-supplied merit good in a democracy. A merit good can be defined as a good which would be under-consumed (and under-produced) in the free market economy. This is due to two main reasons: 1. When consumed, a merit good creates positive externalities (an externality being a third party/spill-over effect which arises from the consumption or production of the good/service). This means that there is a divergence between private benefit and public benefit when a merit good is consumed (i.e. the public benefit is greater than the private benefit). However, as consumers only take into account private benefits when consuming merit goods, it means that they are under-consumed (and so under-produced). 2. Individuals are myopic, they are short-term utility maximisers and so do not take into account the long term benefits of consuming a merit good and so they are underconsumed. Market failures: Imperfections, Decreasing costs and Externalities: Market Failure 2 In economics, market failure is when the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off. (The outcome is not Pareto optimal.) Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient that can be improved upon from the societal point of view The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, externalities, or public goods. The existence of a market failure is often the reason that self-regulatory organizations, governments or supra-national institutions intervene in a particular market. Economists, especially micro-economists, are often concerned with the causes of market failure and possible means of correction. Such analysis plays an important role in many types of public policy decisions and studies. However, government policy interventions, such as taxes, subsidies, bailouts, wage and price controls, and regulations (including poorly implemented attempts to correct market failure), may also lead to an inefficient allocation of resources, sometimes called government failure. Given the tension between, on the one hand, the undeniable costs to society caused by market failure, and on the other hand, the potential that attempts to mitigate these costs could lead to even greater costs from "government failure," there is sometimes a choice between imperfect outcomes, i.e. imperfect market outcomes with or without government interventions. But either way, if a market failure exists the outcome is not Pareto efficient. Most mainstream economists believe that there are circumstances (like building codes or endangered species) in which it is possible for government or other organizations to improve the inefficient market outcome. Several heterodox schools of thought disagree with this as a matter of principle. Different economists have different views about what events are the sources of market failure. Mainstream economic analysis widely accepts a market failure (relative to Pareto efficiency) can 3 occur for three main reasons: if the market is "monopolised" or a small group of businesses hold significant market power, if production of the good or service results in an externality, or if the good or service is a "public good". Externalities: A good or service could also have significant externalities, where gains or losses associated with the product, production or consumption of a product because it differs from the private cost. These externalities can be innate to the methods of production or other conditions important to the market. For example, when a firm is producing steel, it absorbs labor, capital and other inputs, it must pay for these in the appropriate markets, and these costs will be reflected in the market price for steel. If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for the use of this resource, then this cost will be borne not by the firm but by society. Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing. In this case, the market equilibrium in the steel industry will not be optimal. More steel will be produced than would occur were the firm to have to pay for all of its costs of production Consequently, the marginal social cost of the last unit produced will exceed its marginal social benefit. Traffic congestion is an example of market failure that incorporates both non-excludability and externality. Public roads are common resources that are available for the entire population's use (non-excludable), and act as a complement to cars (the more roads there are, the more useful cars become). Because there is very low cost but high benefit to individual drivers in using the roads, the roads become congested, decreasing their usefulness to society. Furthermore, driving can impose hidden costs on society through pollution (externality). Solutions for this include public transportation, congestion pricing, tolls, and other ways of making the driver include the social cost in the decision to drive. Perhaps the best example of the inefficiency associated with common/public goods and externalities is the environmental harm caused by pollution and overexploitation of natural resources. 4 Climate change is the greatest market failure the world has ever seen, and it interacts with other market imperfections. Three elements of policy are required for an effective global response. The first is the pricing of carbon, implemented through tax, trading or regulation. The second is policy to support innovation and the deployment of low-carbon technologies. And the third is action to remove barriers to energy efficiency, and to inform, educate and persuade individuals about what they can do to respond to climate change. Examples of Externality: River pollution: - To given by Louis Gevers. Traffic James. Pecuniary externality. The rat-race problem. The tragedy of the commons. Bandwagon effect. 5 .

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