IB Economics Higher Level Paper 1 (8, May 2006)

a. Carefully distinguish between merit goods, demerit goods and public goods
b. Evaluate the view that governments should always intervene in markets for
such goods as cigarettes and alcohol

a. 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 ones 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 under-consume merit goods. This scenario can be
shown in the diagram 1 below.

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 Diagram 1: The Free Market for Education

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.
Diagram 2: The Free Market for Cigarettes

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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 does not increase
with the number of consumers. The two main features of public goods are non-rivalry
and non-excludability. An example of public good is national defense.
Non-excludability refers to the fact that it is impractical in real life to stop people from
consuming public goods, which makes it also impossible for producers to make profits.
Non-rivalrous means that an additional unit of consumption does not increase
marginal costs. For allocative efficiency to be achieved, MC=MB. However, a
non-rivalrous good have a MC of 0, which means that price must also be 0 in order for
allocative efficiency to be achieved. Due to the above reasons, public goods does not
allow for profits to be made and will not be produced in a free economy, which is a
case of market failure.

b) As mentioned above, a cigarettes and alcohol are demerits good, which are
overconsumed in a free-market. Governments can intervene the market in various
ways to reduce equilibrium quantity and move it closer to the socially optimal level.
However, all government policies has its costs. The two most common way for
governments to intervene for the alcohol and cigarettes market is through
advertisement/education and by imposing indirect taxes.

By educating and advertising to consumers on the harms of cigarettes, the

government can change the consumers preference and reduce the market demand
for cigarettes. In effect, the demand curve will shift to the left and the welfare loss will
decrease. An example of such advertisements is in Hong Kong, where government
print on all cigarette boxes that cigarettes cause lung cancer. One disadvantage of
advertisement and education is that it must be large-scale in order for it to be effective,
which also implies a high cost. It is also difficult to measure the effectiveness of
various advertisements because of its disperse nature. Moreover, it will take a long
time to significantly reduce the demand for cigarettes and alcohol, because they are
addictive goods. Furthermore, the fall in output of cigarette could cause
unemployement and a reduction in national income in the long run. For a country with
high production of cigarettes, such as China which is the largest producer of
cigarettes globally, this could reduce national income and cause unemployment.
Labourers who work in the supply chain of cigarettes could suffer from structural
unemployment, where their skills cant be matched to jobs in the job market. On the

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other hand, one advantage of education over tax is that the decline in output for
education is more gradual, which allows more time for the economy to restructure and
absorb the unemployed workers. Another advantage of advertisement over tax is that
it does not reduce addicted smokers disposable income.

An indirect tax is a fixed amount of tax that consumers pay for consuming a good or a
service. Imposing indirect tax on cigarettes and alcohol is equivilent to increasing
producers cost. In effect, the supply curve will shift to the left and quantity will fall to a
level that is nearer to the socially optimal point. The indirect tax will have an
immediate effect of increasing price and reduce quantity. However, it is important to
note that price elasticity of demand (PED) is generally lower in the short run than in
the long run. Thus, quantity should increase by a relatively small amount in the short
run and by a larger amount in the long run. The main advantage of tax is that it
generates revenue for the government and could be a feasible solution for a
government on a budget deficit, such as the U.S government. Tax revenue is likely to
be high in the short run and gradually decrease over the long run. This is because
PED is lower in the short run. If PED is low, then consumers will respond less to an
increase in price, which means that many consumers will continue to purchase
cigarettes and pay tax to the government. Similar to education, the main concern to
tax is that it will reduce output and can cause unemployment. Moreover, because tax
could reduce output in a relatively short period of time, the economy will have less
time to restructure and absorb the unemployed workers. Lastly, indirect tax could
reduce the disposable incomes of addictive smokers who will continue to smoke even
if price rises. In lower income regions such as in poorer provinces in China with many
addictive smokers, the tax could reduce smokers welfare by reducing their
disposable income.

Both solutions mentioned could reduce welfare loss in the case of market failure
arising from demerit goods. However, there are also costs associated with each
solution, such as unemployment and reduction of disposable. It is important for
governments to evaluate the economic environment of their countries before making
a decision on whether or not to intervene. If the addicted smokers in a country are
usually lower income individuals, then the government should lower the amount of tax
to impose. If the national income is highly dependent on cigarette and alcohol
production, a government should choose to use advertisement instead of tax so that
more time would be allowed for the economy to restructure. In conclusion,
government intervention is beneficial for the economy in the long run, but it should be

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implemented sensibly and carefully to reduce costs and short run shocks to the
economy.

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