BY: HAMAEL AAMIR

Explain the term market failure and how merit and demerit goods may become
a source of market failure in a free market? (10)
Merit goods are socially desirable goods with positive side effects when
consumed whereas demerit goods are socially undesirable goods with negative
effects when consumed. Disequilibrium in the quantity demanded and quantity
supplied of these goods leads to market failure. It is a situation where the price
mechanism leads to an inefficient allocation of scarce resources. This is when the
production of merit and demerit goods is done at a level which is not socially
optimal i.e unfavorable for the society. Market failure occurs as a result of
information failure, externalities, income inequality, monopoly creation etc.
Consequently, there is a dead weight loss of economic welfare which a cost to
society i.e is a loss in both consumer and producer surplus.
Merit goods are under produced as well as under consumed, becoming a subject
to market failure due various reasons. The first cause of this is information failure
i.e lack of full or complete information available to the consumers as well as the
producers. The consumers might be unaware or have imperfect knowledge
regarding the potential positive impacts of merit goods which may result in
irrational decision making. In a free market system, the core objective of
producers is profit maximization and to achieve it, biased and partial information
could be provided to the consumers. For example a poor quality educational
institute might provide misleading information to students to take admission
leading to serious consequences in the future including but not limited to
restricting students in perusing higher educational needs and getting appropriate
jobs. Also, merit goods possess positive externalities meaning they are capable of
providing greater benefits to society than to individuals. Due to lack of awareness
regarding this matter, consumers and producers base their decisions purely on
self-interest. For example if producers became aware of the fact that education
would also help to create a highly skilled and efficient workforce in the company,
there would be a rise in the production of educational facilities. Another reason is
the unequal distribution of income. Since the main aim of producers is profit
maximization, premium prices will be charged for goods which lower income
groups won’t be able to afford resulting in a decline in the consumption of merit
goods.
In contrast to this, demerit goods are often overproduced and over consumed
becoming a source of market failure. The basic cause of this is the lack of
awareness and insufficient knowledge. Consumers might not be fully aware of the
long term consequences of demerit goods resulting in uninformed decisions. For
the producers to maximize returns, deceiving information could be provided
through appealing advertisements to convince consumers to purchase the
product. Since demerit goods are habit-forming, once consumers purchase these
for the first time they are likely to make multiple purchases in the future resulting
in overconsumption. Demerit goods have negative externalities which are not
taken into account by market forces when determining the demand and supply of
the product. For example consumers and producers might be unaware of the
negative impacts of cigarettes on the rest of the society i.e passive smoking,
making irresponsible decisions based on self-interest. Producers will overproduce
to increase sales whereas consumers will over consume for personal satisfaction.
As a result, scarce resources are inefficiently allocated leading to market failure.

In conclusion, irrational decisions taken for short term benefit results in long run
consequences i.e inefficient outcomes. In order to prevent goods from becoming
a source of market failure, better information could be provided and income
equality established. However if market failure takes place, the government has
to intervene to tackle the situation through policies and regulations for example
taxation, price controls etc.
B) Taxes are not the best way to discourage the consumption of demerit goods
like cigarettes so alternate methods should also be used by the government. Do
you agree with this statement? (15)
An indirect tax is an example of direct government intervention in markets to
generate revenue for its functioning and more importantly to influence allocation
of resources among competing uses. When government imposes an indirect tax
on the consumption of a good, the cost of production of the firm rises sifting the
supply curve to the left. As a result, a decrease in quantity supplied leads to an
increase in the price of the good or service reducing the amount consumed.
However, the effectiveness of the imposition of an indirect tax on consumption
depends on the price elasticity of demand of the good. It is most likely to be
effective when the good has an elastic PED i.e greater than 1 as a rise in price will
lead to a more proportionate decrease in quantity demanded. Since demerit
goods are habit forming, the PED for them is highly inelastic i.e an increase in
price will result in a less proportionate decrease in quantity demanded.
Therefore, the imposition of indirect taxes on demerit goods becomes ineffective
as the quantity demand only decreases by an insignificant amount. It might have a
relatively greater impact on the consumption of low income groups since a larger
proportion of their income would be spent on these goods. As far as the higher
income groups are concerned, there will little change in the demand for demerit
goods. Therefore, I agree with the above statement that taxes are not the most
effective way to discourage demerit goods and hence alternate methods could be
used. These are discussed in the proceeding paragraphs.
The government can use awareness campaigns including seminars, exhibitions
and public lectures to discourage the use of demerit goods. These can be used to
educate the consumers about the negative impacts of demerit goods to change
their attitude towards them. It can be used to spread awareness about how the
actual disadvantages of demerit goods are greater than the perceived ones.
Campaigns can be used to emphasize on how such goods do not only harm the
health of consumers but also negatively impact the society for example passive
smoking which could lead to consumers looking at the bigger picture and being
more responsible and informed in their decisions as they could impact others.
Also the government shouldn’t only focus these campaigns on regular consumers
of demerit goods but also target fairly young children. In this context, educational
institutes can launch awareness programmers to help children develop mental
resistance against these goods from an early age.
Similarly, the government can also use negative advertising to discourage the use
of demerit goods. For example in order to discourage cigarette consumption, anti-
smoking ads could be played on television portraying strong graphics of the
adverse effects of smoking to generate thought and concern among the general
public. Also personalized stories of victims could be incorporated in
advertisements to influence the perceptions of demerit goods further. Such
adverts are extremely persuasive as they trigger the emotions of people making
them reflect upon the negative impact of such goods. Strong imagery of health
issues can also be imprinted on the packaging of demerit goods to influence the
decision of consumers while making the purchase. It could help them rethink and
reconsider their decision as well as providing awareness to vulnerable people in
the society.
Other alternate methods involves legislation i.e the construction of legal policies
to discourage the use demerit goods. Only producers given legal permits should
engage in the production of such goods. Similarly, specific firms possessing a legal
license to sell such goods should be the only providing them to the consumers. If
otherwise is done, strict legal action must be taken against the illegal suppliers.
This will ensure, demerit goods are not readily available and easily accessible to
the general public especially the minors. Also, an age limit could be imposed on
the consumption of demerit goods i.e only people above a certain age can access
them. If a limit has already been imposed, the minimum age for consumption
could be increased. This will reduce the use of such goods among the youth as
well as young adults. Resultantly, the overall consumption of demerit goods will
fall. An article by “centers for disease control and prevention” stated that “after
all states adopted an age 21 MLDA, drinking among persons aged 18 to 20 years
declined from 59% in 1985 to 40% in 1991” (1). Also the use of these goods
should be completely banned in public places such as restaurants, public
transports and those found violating the law should be charged with heavy fines.
This will also prevent nonusers of demerit goods getting influenced by the
consumers of these goods in public areas. Besides public places, use of demerit
goods could also be banned at workplaces to discourage their consumption
among the employees. Since the working population makes a significant part of
the overall population, reduction in consumption among employees will reduce
the overall use of demerit goods in the country. A 2018 study found that “the
odds of smoking were significantly lower among indoor workers reporting a 100%
smoke-free policy at their workplace than workers with a partial or no smoke-free
policy at their workplace” (2).
All in all, it is difficult to apply taxes as well as the above discussed policies by the
government to discourage consumption of demerit goods due to various reasons
such as a decrease in economic activity as a result of reduced demand. The
imposition of indirect taxes will only be effective in the short run as in the longer
run the consumers might switch to cheaper alternatives or become less sensitive
to change in prices. However, alternate methods such as awareness programs are
likely to change the consumer habits and behavior in the long run.
REFRENCES
(1) https://www.cdc.gov/alcohol/fact-sheets/minimum-legal-drinking-age.htm
(2) https://www.tobaccofreekids.org/assets/factsheets/0198.pdf