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

This guide follows the AQA AS and A-level Economics specification (version 1.3, 29 June 2022). It covers two parts of the A-level sub-section The market mechanism, market failure and government intervention in markets (numbered 3.1.8 on the AQA website and 4.1.8 in the combined PDF): Merit and demerit goods, and Market imperfections. The content is examined in Paper 1, and Paper 3 assesses all content. All countries, firms and figures below are invented.

Related pages: the revision notes, the practice questions, the wider individuals, firms, markets and market failure guide, the AQA A-level Economics hub, the printable checklist and the free 10-minute diagnostics.

What this unit covers

Specification point	What you must be able to do
Classification rests on a value judgement	Explain why merit and demerit goods are not objective categories
Externalities in consumption	Link merit goods to positive and negative externalities in consumption
Imperfect information	Explain under-provision of merit goods and over-provision of demerit goods
Diagrams	Draw and use marginal private and social benefit and cost curves
Not all externality goods qualify	Explain why some products with consumption externalities are neither
Imperfect and asymmetric information	Explain how they cause market failure
Monopoly and monopoly power	Explain how they cause market failure
Immobility of factors of production	Explain how it causes market failure

Merit and demerit goods: a value judgement

A merit good is one that people, or the government on their behalf, judge to be good for consumers, so that it would be consumed more under free-market conditions if consumers took full account of its benefits. A demerit good is one judged to be bad for consumers, so that too much would be consumed. Both definitions contain the word judged. Nothing in the market tells you whether a product is a merit good: someone has to decide that more (or less) of it would be better for people. Societies and political parties disagree, and views change over time.

Merit and demerit goods are market failures because the free-market quantity is not the quantity that maximises social welfare. They are usually partial market failures: a market exists but misallocates resources.

Two causes are in the specification. The first is externalities in consumption: consumption affects third parties. The second is imperfect information: consumers misjudge the benefit or harm to themselves.

Merit goods: the diagram and a worked example

Put quantity on the x axis and money value per unit (price, benefit or cost) on the y axis. The curves are:

Curve	Meaning	Position
MPB (demand)	Benefit consumers think they get	Lowest benefit curve
True private benefit	Benefit with full information	Above MPB by the information gap
MSB	True private benefit plus external benefit	Highest curve
MPC = MSC	Cost of supply (no production externality assumed)	Upward sloping

The market settles where MPB meets MPC, which is below the social optimum where MSB meets MSC. Output is too low. The deadweight welfare loss is the triangle between MSB and MSC from market output up to the optimum.

Worked example 1 (illustrative). In Country A, a community health-screening scheme is sold by private clinics. Output Q is in thousands of sessions and values are in currency units (cu). Perceived marginal private benefit is P = 40 − 2Q. With full information, private benefit would be 44 − 2Q, and external benefit is 8 per session, so MSB = 52 − 2Q. Marginal cost is 10 + Q.

1. Market equilibrium: 40 − 2Q = 10 + Q, so 3Q = 30. Q = 10, P = 20.
2. Social optimum: 52 − 2Q = 10 + Q, so 3Q = 42. Q = 14, where marginal cost is 24.
3. At Q = 10, MSB = 52 − 20 = 32 and marginal cost is 20, a gap of 12. This is the information gap (4) plus the external benefit (8).
4. Welfare gain from reaching the optimum = ½ × (14 − 10) × 12 = 24 thousand cu.

The same triangle is lost whether the cause is information, externality or both. Say which gap is which.

Demerit goods: the mirror image

For a demerit good, consumers overvalue the product, or ignore harm to others. Marginal social benefit lies below marginal private benefit. The market quantity is higher than the optimum, so the good is over-provided.

Worked example 2 (illustrative). In Country B, a heavily sweetened drink is sold at a market price. Perceived marginal private benefit is 42 − 2Q. Consumers who knew the long-term health effects would value it at 39 − 2Q (an information gap of 3). Second-hand harm to others in consumption adds a further 6, so MSB = 33 − 2Q. Marginal cost is 6 + Q.

1. Market: 42 − 2Q = 6 + Q, so 3Q = 36. Q = 12, P = 18.
2. Optimum: 33 − 2Q = 6 + Q, so 3Q = 27. Q = 9, where marginal cost is 15.
3. At Q = 12, marginal cost is 18 but MSB = 33 − 24 = 9. Each extra unit costs 9 more than it is worth to society.
4. Deadweight loss = ½ × (12 − 9) × 9 = 13.5 thousand cu.

In words: output is too high and resources are pulled into a product whose use does not justify its opportunity cost.

Imperfect information as a cause

Consumers may under-provide themselves with merit goods because the benefits come years later, are hard to see, or because they have never experienced the good. Consumers may over-consume demerit goods because the harm is delayed, uncertain, or concealed by advertising or addiction. In both cases their willingness to pay does not reflect true private benefit, so demand misstates the real benefit. The first diagram shows this as a gap between perceived and true benefit.

A good can be a demerit good mainly through information (a harmful additive nobody knows about) or mainly through externalities (heavy drinking leading to violence), but in both cases the judgement that the consumer is also harmed by their own choice is what makes it a demerit good.

Not all externality goods are merit or demerit goods

The specification says that not all products with positive or negative externalities in consumption are merit or demerit goods. A test:

1. Is there an external benefit or cost in consumption?
2. Do you (or society) judge that the consumer would be better or worse off if their own choice were different?
3. Is the issue the consumer’s own misjudgement, rather than only a spillover?

If the answer to the second question is no, it is an externality case only. A householder’s well-kept front garden gives neighbours a positive externality, yet nobody calls a garden a merit good. Driving a car creates congestion and emissions for others, yet few people say the driver is harming themselves by driving, so a car is not usually a demerit good. Vaccination, by contrast, benefits others and is also thought to be undervalued by individuals: it is both.

Imperfect and asymmetric information

Imperfect information means buyers or sellers lack complete knowledge of price, quality or consequences. Asymmetric information means one side knows more than the other, usually the seller. It is a market failure when decisions based on poor information misallocate resources.

Worked example 3 (illustrative). In a market for used tractors in Country C, 50 are good and 50 are poor. Buyers value a good tractor at 8,000 and a poor one at 4,000. Sellers of good ones will accept nothing below 6,500; sellers of poor ones accept 3,000 or more. Buyers cannot tell them apart.

1. A buyer’s expected value = 0.5 × 8,000 + 0.5 × 4,000 = 6,000.
2. Buyers will pay no more than 6,000, below the 6,500 good-tractor sellers need, so good tractors leave the market.
3. Buyers now expect only poor tractors, worth 4,000, which still exceeds the 3,000 reserve, so poor ones trade.
4. Lost gains from trade = 50 × (8,000 − 6,500) = 75,000 cu.

A mutually beneficial exchange has failed to happen, which is a misallocation. Other consequences: consumers buy too much or too little of goods whose quality they cannot judge; markets may be missing altogether (complete market failure), as with insurance when insurers cannot assess risk; and a professional (an agent) may know more than the client. Evaluation points are that sellers can signal quality, consumers can use reviews and warranties, and regulation can require disclosure. Information problems are larger for complex, rarely bought or long-term products.

Monopoly and monopoly power

A pure monopoly is a single seller; monopoly power exists where a firm with a large market share can influence price. Monopoly power is influenced by barriers to entry, market share and the number and size of rivals. The failure comes from restricting output and raising price above marginal cost, so allocative efficiency (price equal to marginal cost) is not achieved. A firm facing no pressure may also be productively inefficient (not producing at lowest average cost) and may allow slack, called X-inefficiency.

Worked example 4 (illustrative). A single firm in Country D faces demand P = 120 − 2Q and has constant marginal cost 20 and no fixed cost. Q is in thousands.

1. If the market were competitive, P = MC: 120 − 2Q = 20, so Q = 50, P = 20.
2. The monopolist sets MR = MC. MR = 120 − 4Q, so 120 − 4Q = 20, Q = 25, and price from the demand curve is P = 70.
3. Supernormal profit = (70 − 20) × 25 = 1,250.
4. Deadweight loss = ½ × (50 − 25) × (70 − 20) = 625.
5. Check with consumer surplus: competitive ½ × 50 × 100 = 2,500. Under monopoly it is ½ × 25 × 50 = 625, which together with profit 1,250 and the deadweight loss 625 totals 2,500.

Evaluation matters. A monopoly with large economies of scale may have much lower unit costs. If, in the same market, a fragmented industry had marginal cost 80, competition would give Q = 20 at P = 80, whereas the monopolist (marginal cost 20) gives Q = 25 at P = 70. The monopoly beats competition on price only if rivals’ cost exceeds 70, which is the monopoly price. Also consider dynamic efficiency (profit funds research), the threat of entry, and any regulation.

Immobility of factors of production

Factors are immobile when they cannot move easily to where they are most valuable. Occupational immobility means skills do not transfer between jobs; geographical immobility means housing costs, family ties and information costs stop movement between areas. Capital can be immobile too: specialised machinery has little alternative use.

Worked example 5 (illustrative). Region A in Country E has a labour force of 12,000 and 300 unemployed. A mill closes and 600 more workers lose jobs.

1. Unemployment rate before = 300 / 12,000 = 2.5%; after = 900 / 12,000 = 7.5%.
2. Region B has 400 vacancies but needs skills the former mill workers lack.
3. Output lost each year if the 600 stay idle, at 30,000 each = 18 million cu.
4. If 150 are retrained at 9,000 each (1.35 million), they regain 4.5 million of output a year, so the cost is recovered in 0.3 of a year, about 3.6 months. 250 vacancies remain unfilled.

Consequences are structural unemployment, wasted resources inside the production possibility frontier, shortages elsewhere and persistent wage and regional differences. The market failure is that prices (wages) signal where labour is needed but resources cannot respond.

Common errors

• Calling any product with an externality a merit or demerit good.
• Presenting classification as fact rather than as a value judgement, with no discussion of who judges.
• Shifting the wrong curve: information problems move perceived demand away from true benefit, not supply.
• Labelling the welfare triangle from the wrong quantities, or using price rather than the vertical gap between MSB and MSC.
• Calling any large firm a market failure without stating the output restriction and the price above marginal cost.
• Treating immobility as only a labour issue.

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. Sections: Merit and demerit goods and Market imperfections within The market mechanism, market failure and government intervention in markets.