Unit 2.8: Merit goods


This lesson looks at another reason for market failure in economics - the under supply of merit goods in an economy.  I find that students will sometimes confuse the concepts of merit goods and positive externalities.  It is important to make the distinction that merit goods are goods or services which consumers will often undervalue, but which provide positive externalities to third parties when consumed.  Positive externalities can be described as benefits enjoyed by a third-party when a consumer makes a purchasing decision.  Examples include health or education services.

The lesson also focuses on how governments can correct market failure, by the implementation of subsidies on those goods and services.  Your students need to be given the opportunity to practice drawing each of the diagrams on market failure - so they become proficient in illustrating the benefits of government action to correct market failure.  Market failure is a common question on the paper one examination and any response must include a suitable diagram.  It is my experience that students find it difficult to draw market failure diagrams.

Enquiry question

Why might the provision of some goods e.g. health and education services be under provided by the market.  What measures can a government take to ensure an adequate production of merit goods are provided within any society.

Teacher notes

Lesson time: 90 minutes

Lesson objectives:

Explain, using diagrams and examples, the concepts of positive externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.

Explain that merit goods are goods whose consumption creates external benefits.

Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behaviour, and direct provision of goods and services.

Teacher notes:

1. Opening question - Either ask students to complete this activity in their notebooks or have a volunteer complete the exercise on the whiteboard. (5 minutes)

2. Processes - technical Vocabulary - your classes can learn the required vocabulary watching the first two videos and completing the first two activities.  Activity 2 specifically applies the theory of market failure to the provision of flu vaccinations.  (20 minutes)

3. Reinforcement activities - attached to the class handout are a number of activities which relate the theory included in this section to specific merit goods.  Activities 3 and 4 relate to the merit good education, while 5 focuses on the market for clean energy.  (25 minutes).

4. Link to the IA - many students choose to complete a microeconomics commentary on a merit good and the benefits associated with correcting the market failure using a government subsidy.  Activities 2 - 5 include examples of such a scenario, complete with diagrams, the problem identified as well as the solution illustrated. 

5. Group discussion activities - both activities 5 and 6 are suitable as areas for discussion.  Allow 15 minutes for the two activities.

6. Activities 8 and 9 - also provide examples of how this topic could be incorporated into an internal assessment, comparing the UK's social health care system with the USA's private one. (10 minutes)

7. TOK links - activity 10 is suitable for use as a TOK exercise. (5 minutes)

8. Link to the assessment - the last activity, number 11 includes a relevant paper one style question for your students to consider or attempt as a classwork / homework exercise.  (10 minutes)

Beginning activity

1. Governments will collect tax revenue to fund essential public services.  Which public service(s) do you think offer the best return for governments in terms of their impact in the growth of GDP?

2. Should governments provide merit goods such as public transport, health and education free of charge at the point of sale?  Consider the opportunity costs of such a decision.

According to the United Nations spending on health and education services provides the best return on investment with a strong correlation between increased investment in human capital and economic growth.  Another good use of government spending is improvements to infrastructure, which also result in more than proportional rises in economic growth.

The opportunity cost of providing any public service free of charge is represented by the cost to the tax payer of providing those services.  This may be unpopular with citizens who do not necessarily want to pay higher taxes for goods and services that they may not even use.  This also further increases the free rider problem − individuals using services that they have not paid for.  On the other hand providing merit goods free of charge encourages their use, making them available to all members of a society.

Key terms:

Merit goods - goods or services with strong positive externalities.  Merit goods would be under-provided by the market and so under-consumed.

Positive externalities - benefits enjoyed by a third-party when a consumer makes a purchasing decision.

Marginal private benefit - the private benefit (utility) enjoyed by a household (or business) in actually consuming (or producing) a good.

Marginal social benefit − this is equal to marginal private benefit (MPB) + the externalities of consumption or production.

Social efficiency - this occurs when the resources in an economy are used in the most efficient way possible and are represented by the output level where the social marginal costs = the social marginal benefits of production. 

The activities on this page are available as a PDF file at:  Merit goods

Activity 1

Watch the following short video and then answer the following questions:

(a) What is a merit good? 

A good or service with strong positive externalities of consumption and / or production.

(b) Identify some examples from the video of goods that provide obvious positive benefits to any society.

The video identifies the following goods as merit goods - provision of housing stamps to improve nutrition, subsidised housing, education and health services

(c) Why are many merit goods under demanded (relative to the social optimum level of production), in free market systems?

By definition all merit goods are likely to be undervalued, relevant to the socially optimum level of consumption level.  This is because consumers do not consider the external benefits of any consumption decision when making a purchase, considering only their own private benefit (utility) and not the benefits enjoyed by other third parties.  In many cases this is also caused by a lack of information, while in some cases, the irrational consumer is under demanding a merit good because of a lack of maturity or the influence of peer pressure.

(d) What other reasons does the video give to explain why many merit goods are provided by governments?

Providing merit goods is often a more popular way of redistributing income than doing so via taxation and welfare benefits?  Other reasons identified include the dangers of addiction or other socially undesirable consumption such as prostitution or pollution.

(e)  Outline a criticism of merit good provision by governments.

Some economists believe that this policy is overly paternalistic and of course comes at an opportunity cost.

Activity 2: Applying the theory to Flu vaccinations

Watch the following short video and then answer the two questions that follow:

(a) What are the spillover costs associated with flu shots?

(b) why does this represent a market failure in free market systems?

The spillover costs associated with the under consumption of flu shots is that when an individual receives the jab they are protected from catching the disease.  This is an obvious marginal private benefit to them and the reason why many people are prepared to pay the market price for the shot.  However, in receiving the jab they not only protect themselves against the flu but also anybody else who might otherwise come into contact with them - a marginal social benefit.

When an insufficient number of people receive the flu shots this creates spillover costs for the society and this represents a market failure, because the number of people receiving the shot is equal to MPB and not the MSB.

Activity 3: Education

The diagram to the left illustrates the market for a merit good, education in a free market. 

(a) What are the private benefits of a university education?

Enhanced future financial and career prospects.

(b) What are the social benefits to society of university education?

Society benefits from a better educated and hence more productive workforce.

(c) In a free market how many students will enter university and what level of tuition would be charged?

Q1 students paying P1, where the marginal private benefit equals the marginal private cost.

(d) What is the socially optimum level of students receiving a university education?

Q2, where the marginal social benefit equals the marginal social cost.

Activity 4: Providing a subsidy to correct market failure

In an effort to correct market failure many governments will provide education either free of charge or heavily subsidized.

(a) Redraw diagram 1 showing the size of the subsidy and the new equilibrium level of students and tuition fee.

After the government subsidy the number of students attending Higher Education is at the socially optimum level (Q2) is reached.  To achieve this the government provides a subsidy equal to the green rectangle - as a result of the subsidy each individual student pays only price P3 with P3 – P2 paid by the government.

(b) Outline disadvantages of the policy.

One obvious disadvantage of this policy is the difficulty of calculating the exact size of the externality and therefore, deciding on the level of subsidy to provide. 

The policy can also be unpopular politically with some tax payers unwilling to see tax revenue diverted towards the provision of services that they may not benefit from themselves.

Activity 5: The market for clean energy

The following table represents the current cost of generating electricity in the USA, if left up to the free market.

Use this diagram to explain whether governments should intervene in the market for energy generation?

Outline the arguments for and against such a decision.

The arguments for governments intervening in the market are obvious.  Without significant help from governments the cleaner renewable energy sources may never compete financially with conventional sources.  For example, as the table illustrates, electricity generation from coal is around one third or half of the price of the same volume of electricity generated from solar or wind sources.  Hydro electric power is more competitive but supplies of suitable locations for generation are more limited. 

Furthermore, with the price renewable energy falling the price gap between sources may close in the near future given sufficient government help.  Supplies of conventional energy will also eventually diminish forcing up the price of energy.  If we wait until conventional energy is exhausted, therefore, we may end up paying a great deal more for energy in the future, making an investment in clean energy now a wise long term economic decision.

On the other hand as Milton Freedman identifies history is littered with instances where government intervention in the market has made matters worse rather than better.  Is it also fair that citizens today should pay a higher price for energy today, simply to pay for supposed benefits in the future?  Lastly, might the resources diverted towards correcting this market failure now, not be better spent on investing in energy saving products?

Activity 6: Group exercise

Imagine you are given the keys to the treasury of your government.  Your first task is to decide which of the following public services you wish to provide free at the point of delivery, which to subsidize and which not to fund at all.  Remember that every $ you spend on services must be collected out of taxation.

Public serviceProvide free SubsidizeDon't fund
Medical care (emergency services)
Non essential medical care
University education
Public transport
Food stamps for low income families
Subsidized housing
Pensions / out of work benefits

Activity 7

Complete the following table which includes some of the public services provided by many governments. Which can be considered public goods, which can be considered merit goods and which fulfil neither category?

Public goodPrivate goodMerit good
Schools / university

Medical services


Fire service

Public transport

National parks and beaches

Public housing

√ or

Street lighting

Activity 8: Public funded health care programmes

In USA most University and health services are paid for by the consumer at the point of sale. By contrast in most European countries those services are paid for out of general taxation. Discuss the merits of both American and European systems of providing those services after watching the following video:


The video highlights the following strengths of the UK universal health care system.  Firstly, the cost which is around 3% of total income earned.  This is considerably cheaper than private medical care systems in the USA which spends twice this figure.  The system is also compulsory so that everyone in the country is covered - whether they pay into the system or not?  Once leaving hospital the prescription drugs are also available at a subsidized price, making them affordable to all households.

By contrast the video also highlighted disadvantages of the UK model.  Like any service offered free at the point of delivery health care in the UK is over subscribed and waiting lists for treatment are common.  The patient in the video waited one month for surgery while waiting lists for non essential treatments can be much longer.  The comfortable private rooms, which are common place in expensive American private hospitals, are also much rarer in government sector hospitals - this patient shared a ward with only three other patients but many other patients will share a room with a number of other patients, while recovering from surgery.

Activity 9: Over crowded public services

Watch the following short video and then explain using a supply and demand curve why the provision of free public services is likely to lead to excess demand.

With the budgets for public services such as health and education fixed by governments, the supply of services is more or less fixed.  By contrast demand for those services follows the normal inverse rule of price and quantity demanded, leading to over crowding for many of the government's subsidized services.

The diagram illustrates the market for hospital beds in the UK.  The number of available beds is fixed at Q, with D representing the demand for the service.

In a market system, such as the USA's health care service, supply would equal demand at Q, with patients paying Pm. 

Under the NHS, with price = 0, demand for healthcare services would exceed supply by Q-Qd.

Activity 10: Links to TOK

(a) Given that all public goods are merit goods and that medical services are merit goods then surely all medical services are also public goods? Is this statement true and if not, why not?

Medical services are not public goods because they are neither non excludable or non rivalrous.  They do, however, provide a positive external benefit when they are consumed.

(b) How can we calculate the external costs of producing and running items such as light bulbs or motor vehicles?

Calculating the total MSC and MSB is very difficult, making it very difficult for governments to correctly assign an appropriate level of subsidy, or even decide which products should be subsidized. For instance Hybrid cars, which many governments choose to subsidise because they consume less energy to run, actually consume more energy to produce.  This is also the case for low energy light bulbs.   Some brands also contain materials that are harmful to the environment such as mercury.

Activity 11: Link to the assessment

A typical paper one question may ask candidates to consider the benefits enjoyed by the consumption of merit goods and evaluate / discuss policies that a government could employ to increase the consumption of merit goods, e.g.

1. (a) Describe the internal and external benefits of receiving a university education.  [10 marks]

Command term: Describe

Responses should include the following:

A definition of merit goods as a good or service which consumers will often undervalue but which provide positive externalities. 

A description of positive externalities as the benefits enjoyed by a third-party when a consumer makes a purchasing decision, in this case a university education.

A supply and demand diagram showing the private and external benefits of a university education, including the external benefits from increased university participation rates.  A simple diagram showing the MSB and the MPB of a university education would be suitable.

A recognition that the private benefits of a university education include improved employment prospects and therefore increased financial prospects, the development of improved skills making the graduate more employable e.t.c.

A recognition that as a merit good attending university also provides external benefits to society.  These might include the benefits from improvements in the quality of the workforce, lower unemployment, higher rates of productivity and therefore higher wage levels.

(b) Using real world examples, evaluate the policies a government might use to increase the number of young people receiving a university education. [15 marks]

Command term: Evaluate

Key terms to define: merit goods.  Candidates that have successfully defined merit goods in the first part of the question do not need to repeat this definition in part (b) of the question.  But responses should refer to their definition in part A in order to gain credit.

Real life examples might include a comparison of university funding systems in Europe, where Higher education is subsidised and the USA where private universities operate without government funding.

A recognition that as a merit good university education tends to be under demanded in a free market situation, with potential students considering only their private benefits when deciding whether to apply for university or not? 

This can be illustrated by a supply and demand diagram showing the number of students going to university represented by the output level where MPB=MPC and a recognition that this is likely to be below the socially optimum number of students.

A supply and demand diagram (to the left) showing the impact of a government subsidy on the number of young people attending university.  This is represented on the graph by a rise in numbers from Q1 to the socially optimum level of Q2.  An illustration on the diagram of the distinction between the marginal social benefits of attending university as well as the private benefits.

An explanation of some of the other policies designed to increase the number of students attending university.  Examples of suitable policies might include financial support for students, promotion of university education e.t.c. (including relevant diagrams) as well as appropriate examples from nations which implement similar policies.

A conclusion which considers the relative merits of each policy including the opportunity cost of each decision.

An essay template for the above question can be downloaded at:  Section A essay template

Section B essay template

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