Sample Paper 1 Econ
a. Explain the difference between merit goods, demerit goods and public goods (10 marks) Merit goods, demerit goods and public goods could all cause market failure, which is a situation where goods and services in a free market are not allocated efficiently. The ways in which these 3 kinds of goods cause market failure are different and will be explained below. Firstly, merit goods refer to goods with positive externalities. This means that its consumption or production can create unintended positive consequences for third parties.
An example of a merit good is education. Education is likely to increase the income of the consumer. Furthermore, education raises one’s productivity, which in turn benefits the society as a whole by increasing national income. Due to positive externalities, the social marginal benefit of merit goods is greater than its private marginal benefit. Consumers in a free market only consider private benefits when purchasing and will therefore underconsume merit goods. This scenario can be shown in the diagram 1 below.
As shown in diagram 1, the socially optimal output occurs at Q2, which is when
SMB=SMC. However, the equilibrium in the free market occurs when D=S at Q1. Between
Q1 and Q2, SMB>SMB. Hence, the under-consumption of Q2-Q1 results in welfare loss, which is equal to the shaded area.
Secondly, demerit goods are goods with negative externalities, which has unintended negative consequences to its consumption or production. One example is cigarettes, because smokers create pollution and harm the society as a whole. As a result of negative externalities, demerit goods’ marginal social benefit is less than marginal private benefit.
Thus, consumers will over-consume demerit goods, like shown in diagram 2 below.
In a free market, demerit goods are over-consumed by a quantity equal to Q1-Q2.
Between Q1-Q2, SMC>PMB. Thus, there is welfare loss equal to the shaded area.
Thirdly, public goods refer to goods which total cost of production
An example of a merit good is education. Education is likely to increase the income of the consumer. Furthermore, education raises one’s productivity, which in turn benefits the society as a whole by increasing national income. Due to positive externalities, the social marginal benefit of merit goods is greater than its private marginal benefit. Consumers in a free market only consider private benefits when purchasing and will therefore underconsume merit goods. This scenario can be shown in the diagram 1 below.
As shown in diagram 1, the socially optimal output occurs at Q2, which is when
SMB=SMC. However, the equilibrium in the free market occurs when D=S at Q1. Between
Q1 and Q2, SMB>SMB. Hence, the under-consumption of Q2-Q1 results in welfare loss, which is equal to the shaded area.
Secondly, demerit goods are goods with negative externalities, which has unintended negative consequences to its consumption or production. One example is cigarettes, because smokers create pollution and harm the society as a whole. As a result of negative externalities, demerit goods’ marginal social benefit is less than marginal private benefit.
Thus, consumers will over-consume demerit goods, like shown in diagram 2 below.
In a free market, demerit goods are over-consumed by a quantity equal to Q1-Q2.
Between Q1-Q2, SMC>PMB. Thus, there is welfare loss equal to the shaded area.
Thirdly, public goods refer to goods which total cost of production