Public, Merit and Demerit Goods

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Public, Merit and Demerit Goods

The first point to note is that public goods are not called public goods because they are provided by the public sector (i.e. the government). Although they do tend to be provided by the public sector, this is not the reason for the name!

All public goods have two important characteristics: Non-excludability and Non-diminishability.

Non-excludability. A public good is one where it is impossible to exclude anyone from consuming it. I suppose this is why they are called public goods - they are open to the public!

Non-diminishability. Some textbooks call this one non-rivalry. I prefer the former because its title explains what the definition is all about more clearly. If, say, ten people are consuming a certain public good. The arrival of an eleventh person (who cannot be excluded) will not diminish the amount that the existing ten people can consume.

This all sounds a little confusing until we look at some examples. The best one is defence. Whether you like it or not, as a citizen of the UK you are defended by the army, the air force, the navy, etc. Even if you go on a CND march, you cannot exclude yourself from being defended. Equally, if the UK experiences a period of net immigration, the new entrants will be defended, and their arrival does not diminish the amount by which you are being defended. You are either defended or not defended. You cannot be half defended!

The key point about public goods is that they are 'good' things, so theyneed to be provided, but because of these two characteristics, they have to be provided centrally, by the government.

Imagine that the government did not provide an army, navy, air force, etc. A private company might have the idea of forming a national army and to raise the required money, they decide to ask everyone for £10. If you were that person on the CND march, and you did not want to be defended, then you would not pay. There may be a lot of people who refuse to pay for this reason. Also, there may be some people who do quite want to be defended, but take the risk of not paying on the assumption that there will be some people in the UK that will care enough to pay the inevitable increased price. This is the free-rider problem. The people who do not pay, for whatever reason, are having a free ride.

Anyway, this private company finds that their predicted revenues are not nearly enough to afford a full defence system, so they give up. The government can provide these goods because they can force people to pay through taxation and raise enough money to do the job properly.

Another good example is street lighting. One cannot stop anyone from benefiting from a street light. Equally, the benefit that one person receives does not diminish the benefit of others. Again, if a private company tried to finance a set of street lights down a given road by knocking on the doors of the inhabitants of the street, lots of people would not pay relying on someone who cares enough to fork out for the amenity. So, again, governments (normally via local government) must provide street lighting.

To sum up, the reason why public goods come under the topic 'Market failure' is that the free market would fail, horribly, to provide defence and street lighting if left to themselves. The government has to intervene to correct this market failure.

Merit goods

Merit goods are also things that are 'good' for you, but unlike public goods they can be provided privately. The problem is that if they are provided solely by the private sector then they tend to be under-consumed, so, again, the government has to step in to correct the market failure.

The best two examples are health and education. Both of these goods can be provided privately. Some of you may be at a private school (or independent school, as they are called), or your family may have a private health insurance scheme. But, if the government did not step in and provide state schools and the NHS, then numerous families would not be able to afford either. This would cause increased crime and reduced productivity from an underclass of the non-educated, and increased health problems which can also cause problems for the labour market.

There may also be another section of people who can afford to pay for, say, health insurance, but just feel that it is a waste of money. They are young, fit and healthy - why bother? Of course, if they get knocked down by a bus they need the cover pretty quickly, but it is too late. Also, if they have survived the bus and feel they need cover as they get older, they may find that the premiums are higher than they would otherwise have been, or they are not covered for various ailments they have picked up on the way (like a bad back, for example).

In other words, people find it difficult to think long term. A £30 a month premium may seem a lot when you're young and healthy, but it will save you a lot of money over the long term.

Pensions are another example. Although the UK is moving towards a system where everyone has to think of putting something away privately, many people don't start until they are in their 40s, and this is often too late. The earlier you start, the longer your initial premiums have to grow with the stockmarket. So, because 'pensions' tend to be under-consumed, the government steps in and provides the state pension.

This pension, though, is becoming smaller and smaller in real terms. Twenty years ago, the government of the day changed the way the state pension was indexed. Instead of increasing it each year by the rise in average earnings,it started to link the pension to the inflation rate. Although technically this means the pension is maintaining its real value, average earnings nearly always rise faster that the price level, so pensioners' incomes have fallen back relative to workers. This effect gets worse every year. In 2000 the government got a lot of stick for raising the pension by only 75p.

The government provides health and education free at the point of use, but the general public does pay for them via taxation. Also, in the case of education, it is seen as so socially desirable that the government legislates to force all children to attend up to the age of 16.

Demerit goods

Merit goods are 'good' for you. Demerit goods are thought to be 'bad' for you. Examples are alcohol, cigarettes and various drugs.

Public, Merit and Demerit Goods

In this case the market fails because these goods are over-consumed if left to the free market. Again, the government must step in to stop this over-consumption. In the case of alcohol and cigarettes, the government imposes quite heavy taxes and duties. This means that their price rises significantly in the hope that this will deter people from consumption. But given that both goods have very inelastic demand curves, the fall in demand is small relative to the tax rise. One wonders if the government keeps raising these taxes because they care about our health or whether it's just a good source of tax revenue!

Some demerit goods are seen as so destructive that the government bans them altogether, illegal drugs being the obvious example.

It is important to note that, just as merit goods provided positive externalities that the government wanted to encourage, demerit goods cause large negative externalities that the government are keen to avoid. The additional costs of demerit goods are there for all to see: an increased burden on the NHS, increased crime and the fact that labour productivity is affected in a negative way, which is bad for the economy as a whole.