Question

Using examples discuss the differences between public goods and merit goods and explain why they are considered market failures.

Answer 1

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Public goods are defined as products where, for any given output, consumption by additional consumers does not reduce the quantity consumed by existing consumers. There are very few absolutely public goods, but common examples include law, parks, street-lighting, defence etc. As there is no marginal cost in producing the public goods, it is generally argued that they must be provided free of charge, because otherwise the people who benefit less than the cost of using the public good, will not use it. That will lead to a loss of welfare.

Also the goods are mostly non-excludable, that means that if once provided everybody can use them, which when charged will lead to "free-riding". So these goods will not be provided by free markets as there is no way to charge for the usage, the solution is, that state must provide these goods and finance them from taxes collected from everybody.

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Merit goods on the other hand are products generally not distributed by means of the price system, but based on merit or need, because people although having perfect knowledge would buy  the wrong amount of them. These goods can be supplied by free market, but not on the right quantity. Merit goods are, for example, education and to some extent the health-care. They are provided by state as "good for you" . Market failure occurs when merit goods and services are under-consumed under free market conditions. Policy intervention can help either through offering financial incentives (e.g. consumer or producer subsidies) or through behavioural nudges and information campaigns designed to change our choices