OxfordAQA International AS and A-level Economics: Merit goods, imperfections, equity (9640)

This guide is written for OxfordAQA International AS and A-level Economics (9640), specification version 1.2. It teaches sections 3.1.5.4 (merit and demerit goods), 3.1.5.5 (market imperfections) and 3.1.5.6 (an inequitable distribution of income and wealth). All of section 3.1 is International AS content, and the full International A-level builds on it.

Public goods and externalities (3.1.5.2 and 3.1.5.3) and the policy responses (3.1.5.7 and 3.1.5.8) sit in other pages. Here you learn why these three sources of market failure arise. All figures below are invented and illustrative. Hub: OxfordAQA A-level Economics. Checklist: printable checklist. Companions: revision notes and practice questions. Check your level with the free diagnostics.

Outcomes at a glance

Section	Outcome
3.1.5.4	Explain why classifying merit and demerit goods is a value judgement; link them to externalities in consumption and to imperfect information; illustrate misallocation on demand and supply diagrams; explain why not every consumption externality makes a merit or demerit good
3.1.5.5	Explain how imperfect and asymmetric information, monopoly power, factor immobility and price instability can cause market failure
3.1.5.6	Distinguish income from wealth and equality from equity; explain why an unregulated market is likely to give a very unequal and inequitable distribution; explain how this misallocates resources

Market failure is a market outcome that misallocates resources. For every cause below, ask which resources end up in the wrong place.

Merit and demerit goods (3.1.5.4)

A merit good is one that society judges people ought to consume more of than they would choose to. A demerit good is one society judges people consume too much of. The classification rests on a value judgement. Someone can accept every fact about a good and still reject the label.

Two reasons are usually given for the misallocation:

1. Externalities in consumption. Consuming a merit good may give benefits to third parties (positive externalities), and a demerit good may impose costs on them (negative externalities).
2. Imperfect information. Consumers may underestimate the benefit of a merit good or the harm from a demerit good, so private demand does not reflect true benefit.

Diagrams without MSC/MSB. The specification says you do not need MSC/MSB curves. Use two demand curves with one supply curve. The market demand curve shows what consumers think a good is worth. A second demand curve shows what it is really worth. For a merit good the second curve lies to the right, so the market outputs too little. For a demerit good it lies to the left, so the market outputs too much.

Worked example: a merit good

Adult evening literacy classes in Country A (illustrative). Price is in dollars per session, quantity in hundreds of sessions.

• Market demand (perceived benefit): Qd = 120 − 2P
• Supply: Qs = 20 + 2P
• Demand if people knew the full benefit: Qd* = 160 − 2P

Market equilibrium: 120 − 2P = 20 + 2P, so 4P = 100, P = 25 and Q = 70.

Full-benefit equilibrium: 160 − 2P = 20 + 2P, so 4P = 140, P = 35 and Q = 90.

The market underprovides by 90 − 70 = 20 hundred sessions. At Q = 70 the full-benefit demand curve is at price (160 − 70)/2 = 45, while supply is at (70 − 20)/2 = 25. Each of those sessions is worth 20 more than it costs. The gap shrinks to zero at Q = 90, so the net benefit lost is a triangle: ½ × 20 × 20 = 200 (in the diagram’s money units).

Step	Merit good result
Market output	70
Socially desirable output	90
Underprovision	20
Net benefit lost	200

Worked example: a demerit good

Late-night gambling machines in Town B (illustrative): market demand Qd = 130 − 2P, supply Qs = 2P − 10, and “informed” demand Qd* = 100 − 2P.

Market: 130 − 2P = 2P − 10, so P = 35 and Q = 60. Informed: 100 − 2P = 2P − 10, so P = 27.5 and Q = 45.

Overconsumption is 60 − 45 = 15. At Q = 60 informed demand is at price (100 − 60)/2 = 20, supply at (60 + 10)/2 = 35, so each unit costs 15 more than its worth. The loss is ½ × 15 × 15 = 112.5.

Not every externality makes a merit or demerit good

A product can have spillovers in consumption without being a merit or demerit good, as the specification points out. The test is whether consumers are judged to under- or overvalue it.

• Car journeys cause congestion, a negative externality in consumption. Fully informed drivers who ignore other road users are not misjudging their own benefit, so there is no value judgement that the good is “bad for them”. Congestion is a market failure, but car travel is not automatically a demerit good.
• A neighbour who plants a hedge that everyone enjoys creates a positive externality. Nobody argues that people should be pushed to plant more for their own good, so it is not a merit good.

Evaluation

• Who decides? Governments, doctors and campaigners may differ, and tastes change over time.
• Paternalism: people may resent being told what is good for them.
• Evidence: how large is the information gap, and how large are the spillovers?
• Measurement: nobody can observe the “true” demand curve, so the size of the misallocation is only an estimate.

Market imperfections (3.1.5.5)

Imperfect and asymmetric information

Information is imperfect when buyers or sellers lack some knowledge. It is asymmetric when one side knows more than the other. The specification says economic agents may not have access to the same information, and markets can then operate inefficiently.

Worked example. In a second-hand van market in Country A, a sound van is worth 12,000 to a buyer and a faulty one 6,000. A quarter of the vans offered are sound. Buyers cannot tell them apart, so the most a buyer will pay for a random van is 0.25 × 12,000 + 0.75 × 6,000 = 3,000 + 4,500 = 7,500. Owners of sound vans will not sell for less than 10,000, so they withdraw. Only faulty vans remain, and buyers realise this, so the price falls toward 6,000. Mutually beneficial trades in sound vans never happen: a misallocation caused by asymmetric information.

Monopoly and monopoly power

A monopolist can restrict output to raise price above marginal cost, so too little is produced and consumers pay more than the cost of producing the last unit.

Worked example. A sole supplier of a local bus service faces demand P = 84 − Q with constant marginal cost 24.

• Competitive outcome: P = MC, so 84 − Q = 24, Q = 60 and P = 24.
• Monopoly: marginal revenue is 84 − 2Q. Setting MR = MC gives 84 − 2Q = 24, so Q = 30. Then P = 84 − 30 = 54.
• Monopoly profit: 30 × (54 − 24) = 900.
• Consumer surplus: ½ × 60 × 60 = 1,800 under competition, but ½ × 30 × 30 = 450 under monopoly.
• Total surplus: 1,800 under competition, but 450 + 900 = 1,350 under monopoly. The deadweight loss is 450, which also equals ½ × (54 − 24) × (60 − 30).

Evaluate: monopoly can bring economies of scale and funds for innovation, and may face a threat from new entrants. The size of the harm depends on how much power the firm really has.

Immobility of factors of production

Occupational immobility means workers cannot easily switch between jobs because their skills do not transfer. Geographical immobility means they cannot easily move to where jobs are, because of housing costs, family ties or missing information. Where labour cannot move, a region of closing factories has unemployed workers while another region has unfilled vacancies. Output is lost and resources are not used where they would be most valuable. Capital can also be immobile: a specialised machine or a derelict site may have no alternative use.

Price instability

Prices of agricultural and other primary products can swing widely because supply depends on weather or other shocks, while demand and supply are both inelastic in the short run.

Worked example. Suppose the price elasticity of demand for a crop is −0.4. A poor harvest cuts supply by 10%. As a rough guide, the price must rise by 10 ÷ 0.4 = 25% to choke off 10% of demand.

• Poor harvest: revenue index = 1.25 × 0.90 = 1.125, so growers’ revenue rises 12.5%, though those with failed crops gain nothing.
• Bumper harvest (supply +10%): price falls 25%, revenue index = 0.75 × 1.10 = 0.825, a fall of 17.5%.

Unstable incomes make farmers less willing to invest, and unstable prices raise uncertainty for processors and consumers. That is the market failure: resources are misallocated by risk and uncertainty, not by choice. Buffer stocks and other responses belong to the intervention unit.

Inequitable distribution of income and wealth (3.1.5.6)

Income is what a household receives over a period: earnings, rent, interest and benefits. Wealth is what it owns, net of what it owes, at one moment.

Worked example. A household in Country A receives 28,000 a year. It owns a flat worth 180,000 with a mortgage of 95,000, savings of 12,000 and a van worth 8,000, and owes 4,000 on a loan. Assets are 180,000 + 12,000 + 8,000 = 200,000 and debts are 95,000 + 4,000 = 99,000, so net wealth = 101,000. The 28,000 is a flow; the 101,000 is a stock.

Equality means everyone has the same. Equity means fairness and justice, which involves a value judgement. Take three workers on 20,000, 40,000 and 120,000. The mean is 60,000 but the median is 40,000. Equal incomes would be 60,000 each; many would call that unfair if effort and skill differed, and many would call the original gap unfair if it came from inheritance or background.

Quintile of households	1st (poorest)	2nd	3rd	4th	5th (richest)
Share of income, Country A	5%	9%	14%	22%	50%

The shares sum to 100%. The richest 20% receive 50 ÷ 5 = 10 times the poorest 20%’s share. The degree of inequality can be measured; whether the distribution is fair cannot be settled by measurement.

Why markets tend to produce inequity. Factor incomes depend on who owns what and what the market pays for it. Skills, inherited assets, location and luck differ, and wealth earns income, which can be saved to build more wealth.

Why this is market failure. In a market economy, consumption depends on income and wealth, not need. Low-income households may be unable to afford housing, nutrition, education or healthcare even where the benefit exceeds the cost, while resources are directed to goods that high-income households can pay for. Economic welfare is affected by the distribution of income and wealth, so a very unequal distribution means a misallocation of resources.

Evaluation. Equity and efficiency may conflict if redistribution weakens incentives, but extreme inequality can also waste talent. Which balance is right is a value judgement.

Common errors

• Calling any good with an externality a merit or demerit good.
• Writing that a merit good is simply “good for you” without saying consumers undervalue it.
• Mixing up asymmetric information (one side knows more) with imperfect information (someone lacks some knowledge).
• Treating monopoly as market failure only because profit is high; the failure is restricted output and price above marginal cost.
• Using “equal” and “equitable” as synonyms.
• Treating income and wealth as the same thing.

Official syllabus

Source: the OxfordAQA International AS and A-level Economics specification (9640), version 1.2, from Oxford International AQA Examinations. Covered here: 3.1.5.4, 3.1.5.5, 3.1.5.6.