The consequences of merit goods, demerit goods and information failure

Overview

Consequences for government of persistent over-consumption of demerit goods, consequences of information failure for producers and moral hazard affect the cost of insurance for careful customers.

What you need to know

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Questions from this subtopic

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1. 1

   Analyse the consequences for government of persistent over-consumption of demerit goods.

   Model answer

   Treating the resulting ill health raises health spending, and associated disorder raises policing and criminal justice costs, both funded from taxation. Lost working days reduce output and therefore income tax and national insurance receipts. Against these, duties levied on the goods themselves raise revenue, and any successful reduction in consumption erodes that revenue, which creates a fiscal tension. Government also carries the political cost of restricting behaviour that many voters regard as their own business.

2. 2

   Who gains and who loses when a merit good is under-consumed? Consider each economic agent.

   Model answer

   Consumers who forgo the good lose benefits they undervalued, such as better health or higher future earnings. Producers of the good sell less than the optimum and earn less producer surplus. Third parties lose the external benefits, including colleagues, employers and the wider community. Government faces higher costs later, treating illness that prevention would have avoided or supporting workers whose skills are too low. Firms in general face a less productive workforce, so their unit costs are higher than they need be.

3. 3

   Evaluate the view that over-consumption of demerit goods is better understood as a failure of information than as an externality problem.

   Model answer

   The information argument has force: much of the harm from smoking or a poor diet falls on the consumer, and it is misjudged because it is delayed and probabilistic, so better-informed consumers would buy less. Against that, substantial costs fall on others through passive exposure, collectively funded healthcare and lost output, and those would persist even with perfect information. Addiction also means information changes little once consumption is established. Both mechanisms operate, and it is the externality element that makes the case for correction least dependent on paternalism.

4. 4

   Analyse how the consequences of under-consumption of education differ between the individual and the wider economy.

   Model answer

   For the individual the loss is lower lifetime earnings, greater exposure to unemployment and less occupational mobility, all private costs borne by the person who made the decision. For the economy the loss is external: lower aggregate productivity, a smaller tax base, less innovation and higher spending on transfers supporting low-paid or unemployed workers. The individual loss could in principle be corrected by better information; the wider loss persists because no individual has any incentive to take it into account.

5. 5

   In a country where consumption of a demerit good is concentrated among lower-income households, what are the consequences?

   Model answer

   The health damage falls disproportionately on households with the fewest resources to cope with it, so ill health reinforces low income and reduces earning capacity, deepening inequality. Any duty levied on the good takes a larger share of a low income than of a high one, so the burden is regressive even where the health objective is met. Because those households have least access to substitutes and support, the behavioural response may also be smaller, leaving the harm in place while the financial burden bites.

6. 6

   Assess whether describing a good as a demerit good is a useful basis for action.

   Model answer

   It is useful because it groups together goods where consumption exceeds the optimum for two reinforcing reasons, information failure and external harm, and it directs attention to the size of the gap. It is less useful because the label carries a value judgement that can be applied inconsistently, may reflect prevailing social attitudes rather than measured harm, and says nothing about how large that harm is or which remedy fits. The label is a starting point for analysis rather than a justification on its own.

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