Merit goods and positive consumption externalities

With education, few students will know with any precision the benefit to themselves of being educated, let alone the benefit to others. In other words, there is imperfect information.

Remedies for the under-supply of merit goods

Markets frequently fail to allocate sufficient resources to the production of merit goods; hence governments may need to intervene and create an environment in which markets for merit goods can form. The basic options are to adopt measures that increase consumer demand, or increase supply.

Measures to increase supply

Market theory suggests that supply will increase in one of two ways; either following a rise in price, which provides an incentive for private firms to enter the market, or by a subsidy, which reduces costs of supply. While a higher price encourages supply, it also discourages demand and results in less demand for a merit good. Hence, a subsidy would encourage both supply and demand.

Government could also choose to by-pass the market and take over responsibility for supplying the socially efficient quantity of merit goods. This is what happens with state education, healthcare, and national insurance.

Alternatively, the government could pay the cost of supplying a merit good, and request that the individual consumer makes an out-of-pocket contribution to these costs, such as with prescription charges.

Government could also cover some of the costs of private sector provision, such as providing free training for doctors, nurses and teachers, who may then work in private hospitals and schools.

Government could also encourage private firms to enter the market by offering incentives. For example, private hospitals could be given cash incentives to increase the number of hospital beds available to National Health Service (NHS) patients, and private schools could be given grants to take state school pupils.

Measures to increase demand

A  second approach to merit goods is to increase demand for them. This can be achieved either through lowering price, which would expand demand, or by shifting the position of the demand curve.

What price to set for a merit good is an issue facing policy makers. One option is to provide the service free at the point of consumption, as currently exists with NHS treatment. This would expand demand to its maximum, but it may encourage over-consumption, with the system becoming clogged-up with free riders and malingerers, diverting resources from the genuinely sick and needy.

With education, a voucher system is a frequently proposed option to encourage demand for merit goods provided by the private sector. This system can be used to create a quasi market. Typical voucher schemes involve parents being allocated education vouchers, which they are then free to spend on any school of their choice. Parents can combine the vouchers with their own finance to pay for a place at any school – either state or private. Supporters of vouchers argue that they allow a market to be completed effectively and in a way that enables poorer families to have access to the best schools. Over time, this will drive up the quality of all schools as they compete with each other for scarce vouchers.

Finally, demand for a merit good could be increased providing knowledge, so that the consumer can make a more informed appraisal about the benefits of consuming merit goods.


Whenever government allocates resources on behalf of citizens, a potential principal-agent problem may arise. This means that public sector managers and employees may act in their own interests, and not in the interests of the government or taxpayer. In order to solve this problem, regulation may be necessary to ensure that the highest possible standards are achieved. For example, government may establish educational standards such as the national curriculum, and may set national targets for reducing hospital waiting lists. Regulations can help achieve standards in public healthcare and education that would occur in a more competitive environment.

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