AS Microeconomics
chris@chrisrodda.com

There is no God of economics – different textbooks/teachers
have different explanations
innoculations

Merit goods have positive externalities in consumption.
e.g. Alcohol is a social lubricant and other people like you better at a party
when you have had a drink.
You may disagree if you are a
Muslim! Remember this is a
value judgement
Costs &
Benefits
£
welfare loss
MSC=MPC
1
2
3
MPB
Q free
market
social
optimu
m
MSB
Output (Q)

Merit goods are underconsumed because the private
benefits are not fully understood.

e.g. You are unaware that you smell and need deodorant

(Demerit goods are overconsumed because the bad effects
are not fully understood. E.g. Alcohol leading to an injury –
(or waking up with someone you rather you didn’t)

Merit goods are underconsumed because the long term benefits
are not fully understood.

E.g. You are not going to vols because you are unaware of how
important a decent A level grade is.

(demerit good – long term effect of smoking not appreciated)
• Consumers value cigarettes at MPB1
because of informational failure, but if
they knew all the facts they would
know cigarettes are bad for them and
the actual benefit to them is less than
they thought so would change their
MPB curve to MPB2 and consume less
Costs &
Benefits
£
MSC=MPC
welfare loss
MPB1 - imperfect info
Q of cigarettes
Difference between MPB1 and
MPB2 is due to INFORMATION
FAILURES – consumers are not
aware of true benefits which
differs from their perceived
benefits
Q
Q*
MPB2 - full information
The same idea can be expressed using MPC –
the consumer believes the private cost to
them at the margin is simply the cost of the
cigarettes, when in reality it is the road to
cancer…
Costs &
Benefits
£
MSC=MPC
welfare loss
MPB1 - imperfect info
Q of cigarettes
Q
Q*
MPB2 - full information
Over-consumption
Costs &
Benefits
£
Potential welfare
gain
MSC=MPC
MPB2 - full information
Q of cigarettes
Q
Q*
MPB1 - imperfect info
under-consumption

Merit goods are under-consumed and under-produced
because the long term benefits are not fully understood,
and/or there is a lack of information about their benefits
and/or the long term benefits are not appreciated and/or
there may be positive spill-over (positive externalities)
effects for third parties.

I got blind drunk and broke my arm, woke up with a really
ugly person, but it turns out later they have a fantastic
personality and I got married and now we have three
gorgeous children one of whom is now a heart surgeon and
has saved a hundred lives – I’m really happy – but have liver
cancer!
How can you possibly know all the future costs and benefits – this is poor
theory and the free market allows for millions of pieces of information to be
assembled and accumulated which is reflected in the price – leave it to the
FMS! Besides merit and demerit are value judgments anyway.

With the help of an appropriate diagram, explain why merit
goods are often underprovided. (12 marks)
10 marks maximum for written explanation
You MUST draw a diagram in order to get all 12 marks

Merit goods have positive externalities in consumption and
are underprovided by the free market. (1 mark)
or

Merit goods exist where the marginal private benefits are
greater than the marginal private costs (1)
or

Merit goods exist where the perceived maginal private
benefits are not as great as the actual marginal private
benefits. (1)
Social costs = Private costs + external costs
Marginal external cost is the spillover effect suffered by third
parties when a product is produced.
Marginal external benefit is the spillover effect enjoyed by third
parties when a product is consumed.
Definitions = 1 mark each up to a maximum of 2

Merit goods are often underprovided because consumers
only consider the private benefits (2 marks)

so the positive (consumption) externalities are not taken into
account (2)

so the MPB is less than the MSB (2)

the level of consumption ends up below the social optimum
(2)
and there is a deadweight loss of social welfare (2)

Even demerit goods must have some private benefits or else nobody would smoke
and some external benefits - Marlene Dietrich does look cool!

Informative advertising
Advertising that provides customers with information about
the price, product and where to buy it but does not appeal to
emotions.
✓

Persuasive advertising
Advertising that seeks to differentiate the product or service
from other products and make the demand for it more price
inelastic, often by appealing to emotions.
Evaluation point
X
or is it ✓?
poor use of scare resources
The world would be
dull without
different products

Asymmetric information
Where one party in a transaction has more or better
information than the other.
George Ackerlof
Nobel Prize in
Economics 2001

imagine a world where there is no information available to
buyers.

If buyers believe that half the cars are lemons and half plums
they would pay £1,000 for a lemon and £5000 for a plum

(0.5 x £1,000) + (0.5 x£ 5,000) = £3,000.
don’t sell
Only the lemons are left!
The good products drive out the bad

Adverse selection
A situation of market failure caused where buyers and
sellers have asymmetric information, and the poor
quality products (or customers) drive out the good.

Moral hazard
Any situation in which the agent makes the decision
about how much risk to take, while the principal bears
the cost if things go badly.
You tube/Channel Four video clip
Principal agent problem
concerns the difficulties in motiving the agent to act in the best
interests of the principal.

Agent
(Sir) Fred Goodwin - Agent
principal
A degree from a
good university
provides
information about
ability and attitude
to work
Offering a higher than market wage means the lazy will work
hard to keep their jobs, as the opportunity cost of losing their job
is high….BUT…….
Unemployment that results from real wages being above their market
clearing level and causing an excess supply of labour
Real
wages
Classical unemployment
AS labour
w1
w
AD labour
Employment
Qd1
E
Qs1