Implications of misallocation of resources in relation to the under-consumption of merit goods and goods with external benefits

Allocation of Resources – Market Failure

Learning Objective (AO1‑AO3)

Explain the implications of a mis‑allocation of resources when merit goods and goods that generate external benefits are under‑consumed, and evaluate the range of government interventions that can correct this market failure.

Key Terminology (Cambridge IGCSE 0455 – Section 2.9)

TermDefinition (one‑sentence) (AO1)
Merit goodA good whose social benefit exceeds the private benefit perceived by the consumer (e.g., education, vaccination). (AO1)
Demerit goodA good whose social cost exceeds the private cost to the consumer (e.g., cigarettes, alcohol). (AO1)
Public goodA good that is non‑rival and non‑excludable (e.g., national defence, street lighting). (AO1)
External benefit (positive externality)A benefit received by third parties that is not reflected in the market price. (AO1)
External cost (negative externality)A cost imposed on third parties that is not reflected in the market price. (AO1)
MonopolyA market structure in which a single firm supplies the whole market and can set price above marginal cost, leading to under‑output. (AO1)
Private marginal benefit (PMB)The benefit to the individual consumer from one more unit of a good. (AO1)
Social marginal benefit (SMB)The total benefit to society from one more unit of a good (private + external benefits). (AO1)
Information failureWhen consumers or producers lack the knowledge needed to make efficient choices (e.g., unaware of health benefits of vaccination). (AO1)

Causes of Market Failure (AO2)

  • Public‑good provision – non‑rivalry & non‑excludability lead to free‑rider problem and under‑supply.

  • Externalities – positive (under‑consumption) and negative (over‑consumption).

  • Monopoly power – price‑setting above marginal cost reduces output below the socially optimal level.

  • Information failure – consumers underestimate private benefits or costs.

Why Merit Goods and Positive Externalities Are Under‑Consumed (AO2)

  1. Consumers decide on the basis of private marginal benefit (PMB) only.

  2. For merit goods and goods with external benefits, PMB < SMB. The market equilibrium quantity (Qm) is therefore lower than the socially optimal quantity (Qs).

  3. Information asymmetry or lack of awareness can depress demand further.

Diagrammatic Requirement (AO2)

Students must be able to draw and label the following:

  • Two demand curves – PMB (private demand) and SMB (social demand) – intersecting the marginal‑cost (MC) curve at Qm and Qs respectively.

  • Subsidy diagram – upward shift of private demand (or downward shift of MC) moving the equilibrium from Qm to Qs.

  • Maximum‑price (price ceiling) diagram showing a shortage when the ceiling is set below the market price.

  • Minimum‑price (price floor) diagram showing a surplus when the floor is set above the market price.

  • Regulation / quota diagram – vertical supply restriction and its effect on price and output.

Mathematical Illustration of Dead‑Weight Loss (DWL) (AO2)

The welfare loss from under‑consumption is the area between the SMB and PMB curves from Qm to Qs:

\[

\text{DWL}= \int{Qm}^{Q_s}\bigl[SMB(Q)-PMB(Q)\bigr]\,dQ

\]

In exam situations the integral is rarely required; the same area can be calculated as a triangle:

\[

\text{DWL}= \frac{1}{2}\,(P{SMB}-P{PMB})\,(Qs-Qm)

\]

Worked Example (AO2)

VariableValue
Market price (PPMB)£30
Social price (PSMB)£45
Quantity supplied in market (Qm)200 units
Socially optimal quantity (Qs)300 units

Triangle formula:

\[

\text{DWL}= \frac{1}{2}\,(45-30)\,(300-200)=\frac{1}{2}\times15\times100=£750

\]

Hence the economy loses £750 of total welfare because the merit good is under‑consumed.

Implications of Mis‑allocation (Under‑Consumption of Merit Goods & Positive Externalities) (AO3)

SectorEffect of Under‑ConsumptionPotential Economic Consequences
HealthFewer vaccinations, lower immunisation rates.Higher incidence of preventable disease; increased public‑health spending; loss of labour productivity.
EducationReduced enrolment in primary/secondary schooling.Lower human‑capital formation; slower long‑term economic growth; higher inequality.
EnvironmentInsufficient investment in green spaces, pollution control, renewable energy.External health costs, loss of biodiversity, reduced quality of life, future remediation expenses.
InnovationUnder‑investment in research & development.Slower technological progress; loss of competitive advantage in global markets.

Government Intervention Tools (AO2 – AO3)

All of the following can be used to correct the under‑consumption of merit goods or to internalise positive externalities. The relevance of each tool depends on the specific good, the size of the external benefit and practical considerations such as fiscal space.

  • Subsidies – lower the price faced by consumers; shift the private demand curve upward toward the social demand curve. (AO2, AO3)

  • Direct public provision – the state supplies the merit good itself (e.g., free schooling, NHS services). (AO2, AO3)

  • Regulation / Mandatory requirements – legal obligations such as compulsory vaccination or school‑attendance laws. (AO2, AO3)

  • Information campaigns – aim to raise awareness of the social benefits, moving perceived private benefit closer to the social benefit. (AO2, AO3)

  • Maximum price (price ceiling) – prevents the price from rising above a set level; useful when a merit good becomes unaffordable. (AO2, AO3)

  • Minimum price (price floor) – can support producers of merit goods where market price is too low (e.g., minimum farm‑gate price for organic produce). (AO2, AO3)

  • Indirect tax (negative subsidy) – generally applied to demerit goods, but a “negative subsidy” can be used to internalise external costs. (AO2, AO3)

  • Quotas – limit the quantity of a good that can be produced or imported, ensuring a minimum provision of a merit good. (AO2, AO3)

  • Privatisation / Nationalisation – changing ownership of a firm to improve efficiency; relevant when a monopoly causes under‑ or over‑supply. (AO2, AO3)

Evaluation of Intervention Strategies (AO3)

Policy ToolAdvantagesLimitations / Drawbacks
SubsidiesCost‑effective; retains consumer choice; can be targeted to low‑income groups.Fiscal burden; risk of over‑consumption if set too high; may create market distortion.
Direct public provisionGuarantees universal access; economies of scale; easier quality monitoring.Large public expenditure; potential inefficiency and bureaucracy; crowding‑out of private sector.
Regulation / Mandatory measuresEnsures a minimum level of consumption; tackles severe externalities directly.May be seen as paternalistic; enforcement costs; possibility of non‑compliance or evasion.
Information campaignsLow cost; empowers consumers; can complement other policies.Effectiveness depends on public receptiveness; rarely sufficient alone to change behaviour.
Maximum price (price ceiling)Keeps merit goods affordable; prevents price gouging.May create shortages; can lead to black‑market activity or reduced quality.
Minimum price (price floor)Supports producers; can encourage supply of socially valuable goods.Risk of surplus (waste); may require government purchase of excess stock.
Indirect tax (negative subsidy)Internalises external costs; generates revenue for the treasury.Regressive impact on low‑income households; can reduce overall consumption too much.
QuotasEnsures a minimum provision; can be combined with licences to control quality.Administrative complexity; may create rent‑seeking behaviour.
Privatisation / NationalisationCan improve efficiency and innovation if the market fails to deliver the good.Risk of monopoly power persisting; public opposition if essential services are privatised.

Public‑Good Provision – Why Under‑Supply Occurs (AO2)

  • Non‑rivalry: One person’s consumption does not reduce the amount available to others.

  • Non‑excludability: It is impossible (or too costly) to prevent anyone from using the good.

  • Result – the free‑rider problem: individuals rely on others to pay, leading to zero or very low private demand and thus under‑supply.

  • Typical government response – direct public provision or financing through taxation.

Negative Externalities – Complementary Perspective (AO2)

Although the focus of this topic is under‑consumption, the syllabus also expects a brief understanding of over‑consumption caused by negative externalities (e.g., pollution, traffic congestion). The usual corrective tools are:

  • Indirect taxes (Pigouvian tax) – raises private marginal cost to equal social marginal cost.

  • Regulation – emission standards, caps, or bans.

  • Tradable permits – creates a market for the right to pollute.

Information Failure – Example & Policy (AO2‑AO3)

Example: Many parents underestimate the health benefits of childhood immunisation, leading to lower vaccination rates.

Policy response: Government‑funded information campaigns, school‑based vaccination programmes, and, where necessary, compulsory vaccination laws.

Mixed‑Economy Argument (AO3)

A mixed economy combines market mechanisms with government intervention. Advantages include:

  • Efficient allocation of most goods through the market.

  • Ability to correct market failures (merit goods, externalities, public goods).

  • Flexibility – the state can intervene where the market is unlikely to deliver socially optimal outcomes.

Disadvantages include:

  • Potential for government failure – inefficient bureaucracy, political bias, or misallocation of resources.

  • Fiscal constraints – subsidies and public provision require taxation, which can crowd out private investment.

  • Risk of over‑regulation, reducing incentives for innovation.

Link to Sustainability (AO3)

Many merit goods have a sustainability dimension (e.g., renewable‑energy subsidies, public transport, conservation programmes). Under‑consumption of these goods can lead to:

  • Higher carbon emissions and climate‑change costs.

  • Depletion of natural resources.

  • Long‑term economic losses through reduced ecosystem services.

Thus, correcting the market failure is not only a matter of immediate welfare but also of inter‑generational equity.