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Market Failure » Public Goods, Merit Goods, Demerit Goods and Monopoly

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 2.9.2, 2.9.3

What public goods, merit goods and demerit goods are
Why the free rider problem stops the market providing public goods
Why merit goods are under-consumed and demerit goods are over-consumed
How a monopoly can abuse its power and cause market failure

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Public goods

Street lights are a classic public good: non-excludable and non-rival, so one walker's light doesn't dim anyone else's

You have seen that external costs and external benefits cause market failure. This lesson looks at four more causes. The first is public goods.

Think about a street light in the town of Orlea. It lights the road for everyone who walks or drives past. The council cannot easily stop one person from enjoying the light, and one person using the light does not leave less for anyone else.

Key terms:

Public good: a good that is non-excludable and non-rival.
Non-excludable: people cannot be stopped from using the good, even if they have not paid for it.
Non-rival: one person using the good does not reduce the amount left for others.
Free rider: someone who uses a good without paying for it.

Other examples are lighthouses, flood defences, national defence and clean public streets.

The free rider problem

Suppose a private firm builds a flood wall to protect a coastal town. Once the wall is built, every home behind it is protected. The firm cannot stop anyone from being protected, because the good is non-excludable.

So why would anyone pay? Each household can think, "The wall protects me anyway, so I will let my neighbours pay." Everybody thinks the same, so nobody pays. This is the free rider problem.

💰 What the firm sees

No one pays, so there is no revenue and no profit. The firm will not build the wall.

🏢 What society loses

The wall would give big benefits to everyone. Without it, the town stays unprotected.

This is market failure. The market does not provide public goods at all, or provides far too little. For this reason, public goods are usually paid for by the government through taxes.

Merit goods

Education is a merit good - it benefits society as well as the student, but would be under-consumed if left to the market

A merit good is a good that is good for people and gives benefits to society, but is under-consumed if it is left to the market. Education and healthcare are common examples.

There are two reasons why merit goods are under-consumed:

Information failure. People may not know how good the good is for them. A teenager in the town of Pavlin might skip dental check-ups because they do not realise how much they protect their health later. They underestimate the private benefits.
Ignoring external benefits. Buyers think only about their own gain. A person who learns first aid helps others in an emergency, but they do not think about this when they decide whether to take the course. The external benefits are ignored.

Because of this, the amount bought at the market price is lower than the amount that would be best for society. Resources are misallocated.

Demerit goods

A demerit good is a good that is bad for people and for society, but is over-consumed if it is left to the market. Examples are cigarettes, alcohol, gambling and harmful drugs.

Demerit goods are over-consumed for similar reasons, turned the other way round:

Information failure. People may not know, or may not believe, how much harm the good does to them. They underestimate the private costs, such as damage to their health.
Ignoring external costs. A smoker thinks about their own cost, not about the smoke that harms people nearby or the cost to public hospitals. Buyers ignore the external costs.

The result is that more is consumed than is best for society. Again, the market has failed.

Quick comparison

Public good: the market provides too little or none, because of free riders.

Merit good: consumed too little, because benefits are underestimated or ignored.

Demerit good: consumed too much, because harm is underestimated or ignored.

Monopoly and abuse of power

A monopoly is a firm that is the only seller of a good or service in a market, or a firm that has a very large share of the market (you will study monopoly markets in full in a later lesson).

A monopoly has little or no competition, so it has market power. It does not have to worry that customers will go to a rival. If it uses that power in ways that harm consumers, this is the abuse of monopoly power.

Imagine Tolvane has only one company that supplies piped water to homes. Because customers have nowhere else to go, the company might:

Charge higher prices than it could in a competitive market.
Restrict output or offer a poor quality service, because customers must still buy.
Reduce choice, since no rival product exists.
Invest less in improvements, because it does not face competition.

Resources are not allocated efficiently. Consumers pay more and get less than they would in a competitive market, so the price mechanism has failed.

Common mistakes

Saying a public good is "any good the government provides". The key features are non-excludable and non-rival. A government can also provide merit goods like schools.
Writing that free riders are "criminals". A free rider is simply someone who benefits without paying, and it is often perfectly legal.
Mixing up merit and demerit goods. Merit goods are under-consumed. Demerit goods are over-consumed.
Writing that a monopoly is always bad. The market failure comes from abuse of power, such as high prices or poor quality.

Exam-style question

In the country of Sandovia, the government is deciding how to provide street lighting, school meals and a gambling industry. Answer the questions.

(a) Define the term 'public good'. [2 marks]

(b) Explain why a private firm would be unlikely to provide street lighting on its own. [4 marks]

Model answer

(a) A public good is a good that is non-excludable, so people cannot be stopped from using it (1), and non-rival, so one person's use does not reduce what is left for others (1).

(b) Street lighting is non-excludable, so people can use the light without paying (1). This leads to the free rider problem, because each person hopes that others will pay (1). Few people would pay, so the firm would get little or no revenue (1). The firm would not make a profit, so the market fails to provide the good (1).

(c) Gamblers may not know or may underestimate the harm that gambling does to them, such as losing money and damaging their health (1). This is information failure (1). They also ignore external costs, such as the harm to their families and the cost to the government of treating addiction (1). Because they consider only their own private costs, more gambling takes place than is best for society (1).

Exam tip

In (b), always use the words 'non-excludable' and 'free rider'. Examiners look for them as the link in your chain of reasoning.

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