Market Failure & Externalities
Allocation of Resources · 5 question types
Exam Frequency Analysis
Past paper frequency (2018 to 2024)
This topic accounts for approximately 11% of your exam marks.
Externalities and market failure corrective policies are increasingly tested; particularly in evaluate questions since 2020.
Merit and demerit goods are a different kind of market failure, arising from or misjudged personal benefits, often combined with externalities.
Merit goods
A merit good is under-consumed in a free market because consumers underestimate the benefits of consuming it (or because it generates positive externalities).
Examples: education, healthcare, vaccinations, fresh fruit and vegetables, pension contributions.
Two reasons the free market under-provides them:
- Information failure. Consumers do not fully realise how much they will gain from the good. Many young adults underestimate the value of higher education; many people skip flu vaccinations because they underestimate the personal protection it offers.
- Positive externalities. Education and vaccination produce benefits for other people (a better-educated workforce, herd immunity), and these are not captured by the price the consumer pays.
Government response: subsidies, free or subsidised state provision, compulsory consumption (e.g. compulsory schooling), and information campaigns.
Demerit goods
A demerit good is over-consumed in a free market because consumers underestimate the harm of consuming it (or because it generates negative externalities).
Examples: cigarettes, alcohol, recreational drugs, junk food, sugary drinks, gambling.
Two reasons the free market over-provides them:
- Information failure. Consumers do not fully realise the future health damage, addiction risk, or social harm.
- Negative externalities. Consumption affects others: passive smoking, drink-driving, healthcare costs paid by the state.
Government response: indirect taxes (sin taxes), regulations (minimum legal age, advertising bans, packaging warnings), outright bans on the worst products, and education campaigns.
Define a demerit good
Defining a demerit good (and why it is over-consumed) comes up, so you need to know it is a good more harmful than consumers realise — they underestimate the harm, so the market over-consumes it (cigarettes, alcohol, sugary drinks). For a demerit good, social cost exceeds private cost — the reverse is rejected.
A merit / demerit good is not the same as a . Merit goods are usually rival (one person's healthcare appointment uses up a doctor's time) and excludable (a school can refuse to enrol non-payers). The two failures sometimes overlap but are conceptually distinct.
The labels "merit" and "demerit" are descriptive, not moral judgements. The terms describe under- or over-consumption, not whether the good is good or bad in any absolute sense.