AQA A-level Economics: Merit and demerit goods and market imperfections (7136) – Revision Notes

These notes condense the AQA AS and A-level Economics specification (version 1.3, 29 June 2022), parts Merit and demerit goods and Market imperfections of the A-level sub-section The market mechanism, market failure and government intervention in markets (3.1.8 on the AQA website, 4.1.8 in the combined PDF). For full explanations and longer worked examples use the study guide, then test yourself with the practice questions. See also the AQA A-level Economics hub, the printable checklist and the free 10-minute diagnostics. All figures are invented.

Definitions to know

Term	Short definition
Merit good	A good judged to be good for people; under-consumed in a free market
Demerit good	A good judged to be bad for people; over-consumed in a free market
Value judgement	An opinion about what is better or worse, not testable as fact
Externality in consumption	A cost or benefit to third parties from someone’s consumption
Imperfect information	Incomplete knowledge of price, quality or consequences
Asymmetric information	One party knows more than the other
Monopoly power	A firm’s ability to raise price over marginal cost by cutting output
Occupational immobility	Skills do not transfer easily between jobs
Geographical immobility	Barriers to moving between places
Partial market failure	Market exists but misallocates resources
Complete market failure	The market is missing

Diagram reminders

Axes: quantity on the x axis; money value per unit on the y axis.

Case	Curves	Market output versus optimum	Welfare loss triangle
Merit good	MSB above MPB; MPC = MSC	Too low	Between MSB and MSC, from market output to optimum
Demerit good	MSB below MPB; MPC = MSC	Too high	Between MSC and MSB, from optimum to market output
Monopoly	AR, MR, MC	Output below P = MC level	Between demand and MC, from monopoly output to competitive output

Rules for drawing: label every curve, mark market output and the optimum on the horizontal axis, and shade one triangle. The gap between MSB and MPB is the external benefit (positive externality) or, for a demerit good with a negative externality in consumption, the external cost. Where information is the cause, add a line for true private benefit between the two.

Method: merit or demerit good calculation

1. Set MPB equal to MPC and solve for market output and price.
2. Set MSB equal to MSC and solve for the optimum.
3. Find the vertical gap between MSB and MSC at market output.
4. Welfare triangle = ½ × (difference in output) × gap from step 3.

Reminder (illustrative). MPB = 30 − 2Q, MSB = 38 − 2Q, MC = 6 + 2Q. Market: 30 − 2Q = 6 + 2Q, so Q = 6, P = 18. Optimum: 38 − 2Q = 6 + 2Q, so Q = 8, where MC = 22. At Q = 6, MSB = 26 and MC = 18, a gap of 8. Gain = ½ × 2 × 8 = 8.

Demerit reminder. MPB = 48 − 4Q, MSB = 40 − 4Q, MC = 8 + 4Q. Market: 48 − 4Q = 8 + 4Q, so Q = 5, P = 28. Optimum: 40 − 4Q = 8 + 4Q, so Q = 4, MC = 24. At Q = 5, MC = 28 and MSB = 20, a gap of 8. Loss = ½ × 1 × 8 = 4.

Merit and demerit goods: chains of reasoning

Merit good: consumption brings external benefit and/or consumers underestimate private benefit, so MPB lies below MSB, so the market produces less than the optimum, so resources are misallocated. Typical examples are education and vaccination.

Demerit good: consumption brings external cost and/or consumers overestimate benefit or underestimate harm, so MPB lies above MSB, so too much is produced. Typical examples are tobacco and gambling.

Classification check. A product is a merit or demerit good only if there is a judgement about consumers’ own interests. Externality alone is not enough.

Product	Consumption externality?	Judged to be good or bad for the consumer?	Label
Vaccination	Positive	Yes, undervalued	Merit good
Tobacco	Negative (second-hand smoke)	Yes, harmful	Demerit good
Private car use	Negative (congestion)	Not normally	Externality only
Well-kept private garden	Positive (neighbours)	Not normally	Externality only

Information failure

Imperfect information causes consumers to misjudge benefits, so MPB differs from true private benefit. Asymmetric information gives the better-informed party an advantage and can cause adverse selection.

Adverse selection reminder (illustrative). 30 of 100 used goods are good; buyers value good at 600 and poor at 300. Good sellers’ reserve is 540; poor sellers’ is 240.

• Expected value to buyers = 0.3 × 600 + 0.7 × 300 = 390.
• 390 is below 540, so good goods leave; only poor goods trade (300 above 240).
• Lost gains from trade = 30 × (600 − 540) = 1,800.

Other effects: missing markets, agents with more knowledge than clients, and over- or under-provision of products whose quality is hard to judge. Responses to weigh in evaluation: reputation, branding, reviews, warranties, disclosure rules.

Monopoly and monopoly power

Failure: output is restricted and price set above marginal cost, so allocative efficiency (P = MC) is lost. Possible productive inefficiency and X-inefficiency. Possible gains: economies of scale, funds for research (dynamic efficiency), and contestable pressure.

Reminder (illustrative). Demand P = 80 − 2Q, MC = 16 constant. Competitive: Q = 32, P = 16. Monopoly: MR = 80 − 4Q = 16, so Q = 16, P = 48. Profit = (48 − 16) × 16 = 512. Deadweight loss = ½ × (32 − 16) × (48 − 16) = 256.

Evaluating monopoly: scale of cost savings, whether the market is contestable, whether it is regulated, how fast technology changes, and who benefits from profit.

Immobility of factors of production

• Occupational: retraining needed. Geographical: housing, family, information costs.
• Capital and land also immobile (specialised equipment, fixed sites).
• Effects: structural unemployment, idle resources, shortages elsewhere, regional gaps.
• Unemployment rate = unemployed / labour force × 100. Example: labour force 8,000, unemployed 320 gives 4%; if 240 more are laid off, 560 / 8,000 = 7%.

Reminder (illustrative). 200 workers are retrained at 5,000 each, a cost of 1,000,000. Each then produces 25,000 a year, so output regained is 5,000,000 a year. Payback = 1,000,000 / 5,000,000 = 0.2 of a year, or 2.4 months.

Evaluation toolkit

Each line gives a judgement you can build on. State which side you take and why.

• Merit and demerit goods: who decides the classification, and on what evidence? A government may be paternalistic and override preferences that are well informed. Evidence about harm or benefit may change over time. The size of the external effect and the quality of information matter more than the label.
• Information failure: the problem is larger for complex, long-term or rarely purchased products, and smaller where reputation, repeat purchase, reviews or guarantees let buyers check quality. Whether better information changes behaviour is itself uncertain.
• Monopoly: the harm depends on how far price is above marginal cost, how elastic demand is, and whether entry is a real threat. Gains from scale and research can offset static losses, but only if the firm passes some on.
• Immobility: it is greater for older workers, specialised skills and areas with high housing costs. It is smaller in the long run, or where firms train staff or remote work widens the labour market.
• Time: many effects are short run, so a conclusion may differ between the short run and the long run.

Quick self-test

1. State why classification as a merit good is a value judgement.
2. Give one reason, other than externalities, why a merit good is under-consumed.
3. Using MPB = 30 − 2Q, MC = 6 + 2Q, find market output.
4. In question 3, if MSB = 38 − 2Q, find the optimum output.
5. Why is a private car not usually called a demerit good, despite congestion?
6. Define asymmetric information.
7. Monopolist: P = 80 − 2Q, MC = 16. Find profit-maximising output and price.
8. Using question 7, find supernormal profit.
9. Give one reason a monopoly might be better for consumers than competition.
10. Name two types of labour immobility.
11. Labour force 8,000, unemployed 560: find the unemployment rate.

Answers

1. Because whether a good is good or bad for people is an opinion, not a measurable fact.
2. Consumers may underestimate long-term benefits (imperfect information).
3. 30 − 2Q = 6 + 2Q gives Q = 6.
4. 38 − 2Q = 6 + 2Q gives Q = 8.
5. Few judge that the driver harms themselves by driving, so it is an externality case only.
6. One party to a transaction has more or better information than the other.
7. MR = 80 − 4Q = 16, so Q = 16 and P = 48.
8. (48 − 16) × 16 = 512.
9. Economies of scale lowering unit cost, or profits funding innovation.
10. Occupational and geographical.
11. 560 / 8,000 = 7%.

Where marks are usually lost

• Labelling every externality good as a merit or demerit good.
• Stating a classification as if it were a fact.
• Drawing MSB on the wrong side of MPB, or not naming the optimum.
• Shading the whole area under a curve rather than the triangle.
• Forgetting that a monopolist sets MR = MC, then reads price from demand.
• Using price instead of marginal cost for the height of the monopoly deadweight loss.
• Describing information problems without saying what quantity is misallocated.
• Calling immobility a labour-only issue and giving no consequence.
• Offering evaluation that is a list rather than a judgement with reasons.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, for first teaching from September 2015, published by AQA. Parts used: Merit and demerit goods and Market imperfections.