IBDP Economics 2.9 Market failure—public goods SL Paper 1 - New Syllabus
Question
(a) Distinguish between public goods and merit goods. [10]
(b) Using real-world examples, evaluate the view that price ceilings (maximum prices) are more effective than subsidies in raising the consumption of merit goods. [15]
Most-appropriate topic code (CED):
• TOPIC 2.9: Market failure—public goods
▶️ Answer/Explanation
(a) Answer:
Public goods are goods that are both non-excludable and non-rivalrous. Non-excludability means that it is difficult or impossible to prevent individuals from using the good once it is provided. Non-rivalry means that one person’s consumption does not reduce the amount available for others.
Because consumers cannot easily be excluded from using public goods, a free-rider problem arises. Individuals can benefit without paying for the good, reducing the incentive for private firms to provide it. Consequently, public goods are generally provided or financed by the government rather than being supplied solely through private markets.
Examples include national defence and street lighting. Once provided, people cannot easily be excluded from benefiting from them, and one person’s benefit does not significantly reduce another person’s benefit.
Merit goods, in contrast, are generally excludable and rivalrous and are normally sold through markets at a price. They are goods that consumers may underconsume because they may underestimate their benefits, particularly the long-term benefits to themselves and society.
Merit goods are therefore associated with positive externalities of consumption. The social benefits of consumption exceed the private benefits perceived by consumers. As a result, the free-market quantity consumed may be below the socially desirable level.
Examples include education and healthcare. A person receiving education benefits personally, but society can also gain through a more skilled workforce and higher productivity.
| Feature | Public goods | Merit goods |
|---|---|---|
| Excludability | Non-excludable | Generally excludable |
| Rivalry | Non-rivalrous | Generally rivalrous |
| Market provision | Usually not provided adequately by private markets | Normally sold in markets |
| Main market failure | Free-rider problem | Underconsumption due to positive externalities/imperfect information |
Therefore, the key distinction is that public goods are characterized by non-excludability and non-rivalry, whereas merit goods are normally private, excludable goods that are underconsumed relative to the socially desirable level.
(b) Answer:
A price ceiling or maximum price is a legally imposed maximum price that sellers are permitted to charge. A subsidy is a payment by the government to producers or consumers that lowers the effective cost of producing or purchasing a good. Both policies can be used to increase the consumption of merit goods, such as education and healthcare.
Price ceilings can increase consumption by making a merit good more affordable. If the government sets a maximum price below the market equilibrium price, the price paid by consumers falls. This can increase the quantity demanded and make the good accessible to households that would otherwise be unable to afford it.
For example, a government could impose a maximum price on certain essential healthcare services or medicines. Lower prices can increase access for low-income households and therefore improve equity in the consumption of merit goods.
However, price ceilings can create shortages. At the artificially low price, quantity demanded may exceed quantity supplied. Producers may have less incentive to supply the good because their revenue and potential profits are reduced. This can lead to shortages, waiting lists and non-price rationing.
For example, if a maximum price is imposed on a healthcare service without increasing the supply of doctors and facilities, more consumers may demand the service while providers may be unwilling or unable to increase supply sufficiently. The result could be longer waiting times rather than a sustained increase in actual consumption.
Price ceilings can also reduce firms’ revenue and therefore limit their ability to invest in research and development, improve quality or expand capacity. If the ceiling is set too low, the policy may create a loss of societal welfare despite the lower price.
Subsidies provide an alternative approach. A government subsidy to producers reduces their production costs. This shifts the supply curve to the right/downward, reducing the market price and increasing the quantity supplied and consumed.
A subsidy therefore benefits both consumers and producers. Consumers pay a lower price and consume more, while producers receive the market price plus the subsidy, increasing their revenue and providing an incentive to expand production.
For example, governments may subsidize education by providing funding to schools and universities. This reduces the cost faced by consumers and allows more individuals to consume education than would occur if it were entirely privately financed.
Subsidies can also encourage producers to invest in improving the quality and supply of merit goods. Increased revenue can support investment, expansion and research and development. Unlike a price ceiling, a well-designed subsidy can therefore increase both the demand for and supply of the merit good.
However, subsidies have significant government costs. The government must finance the subsidy through taxation, borrowing or reductions in other areas of government spending. This creates an opportunity cost: money spent subsidizing one merit good cannot simultaneously be spent on another policy.
Subsidies may also create producer inefficiency if firms become dependent on government support. Firms may have less incentive to reduce costs or improve productivity if the government continues to cover part of their production costs.
Real-world example: Government subsidies for education and healthcare are widely used to increase consumption and improve access. By lowering the effective price to consumers and supporting the supply of these services, subsidies can increase consumption without creating the immediate shortages associated with a binding price ceiling.
Equity is another important consideration. A price ceiling can be particularly effective when the primary objective is to make an essential merit good affordable to low-income households. However, if shortages occur, those who have the greatest need may not necessarily receive the good. Waiting lists and non-price rationing can disadvantage consumers who cannot afford to wait or access alternative providers.
Subsidies can be designed to target particular groups. For example, governments can provide greater financial support to low-income students through scholarships or targeted education subsidies. This may improve both consumption and equity more effectively than a general price ceiling.
The relative effectiveness also depends on supply conditions. If supply is highly responsive, a subsidy can produce a substantial increase in quantity supplied and consumed. If supply is highly inelastic in the short run, however, much of the subsidy may initially raise producer revenues rather than substantially increasing output.
Similarly, a price ceiling is more likely to create a serious shortage when supply is relatively inelastic and demand increases significantly at the lower price.
Overall evaluation: Price ceilings can increase affordability and improve access to merit goods, particularly for lower-income consumers. However, they can create shortages, reduce producer revenue and weaken incentives to expand supply and invest in quality.
Subsidies generally have an important advantage because they can lower prices while simultaneously encouraging producers to increase supply. They can therefore increase actual consumption without relying on artificially restricting the price. However, they impose a significant cost on the government and may create inefficiencies if poorly designed.
Therefore, subsidies are generally more effective than price ceilings in sustainably increasing the consumption of merit goods because they encourage both lower prices and greater supply. However, where affordability and equity are the government’s primary concerns and adequate supply can be maintained, a carefully designed price ceiling may be useful. In practice, a combination of subsidies, targeted financial assistance and appropriate regulation may achieve better outcomes than relying exclusively on either policy.
Question
(a) Explain why an increase in the demand for a good would normally lead to an increase in its price, while an increase in the price of a good would normally lead to less of it being demanded. [10]
(b) Using real-world examples, evaluate the view that public goods should always be provided by the government. [15]
Most-appropriate topic code (CED):
• TOPIC 2.9: Market failure—public goods – part (b)
▶️ Answer/Explanation
(a) Answer:
Demand refers to the quantity of a good or service that consumers are willing and able to purchase at different prices during a given period. The law of demand states that, ceteris paribus, there is an inverse relationship between the price of a good and the quantity demanded.
An increase in demand means that consumers are willing and able to buy more of the good at every possible price. This is caused by a change in a non-price determinant of demand, such as an increase in income for a normal good, a change in tastes and preferences, an increase in the price of a substitute, a fall in the price of a complement, an increase in population or expectations of higher future prices.
An increase in demand is represented by a rightward shift of the demand curve. If supply remains unchanged, the original market equilibrium becomes a situation in which the quantity demanded is greater than the quantity supplied at the original price. This creates a shortage.
The shortage creates upward pressure on price. Firms have an incentive to increase prices because consumers are competing for a relatively limited quantity of the good. As the price rises, producers increase the quantity supplied and consumers reduce the quantity demanded.
The market therefore moves towards a new equilibrium where the new demand curve intersects the existing supply curve. At this new equilibrium, both the equilibrium price and equilibrium quantity are higher.
Therefore, an increase in demand normally leads to an increase in price because the rightward shift in demand creates a shortage at the original equilibrium price, putting upward pressure on the price.
A demand and supply diagram should show demand shifting rightward from D1 to D2, causing equilibrium price to increase from P1 to P2 and equilibrium quantity to increase from Q1 to Q2.
The second part of the question concerns a different relationship: the effect of a change in the price of the good itself on quantity demanded.
An increase in the price of a good, ceteris paribus, causes a movement along the existing demand curve, rather than a shift of the demand curve. According to the law of demand, consumers normally purchase a smaller quantity when the price rises.
This occurs partly because of the substitution effect. When the price of a good rises, it becomes relatively more expensive compared with substitutes, so consumers have an incentive to switch towards alternative goods.
There is also an income effect. A higher price reduces the purchasing power of a consumer’s income. Assuming the good is a normal good, the consumer will normally reduce the quantity purchased as their real purchasing power falls.
For example, if the price of a particular brand of bottled water increases while the prices of other bottled-water brands remain unchanged, consumers may switch towards the cheaper alternatives. The quantity demanded of the original brand therefore falls.
Diagram: A movement upward along a downward-sloping demand curve should show the price increasing and the quantity demanded decreasing. This must be distinguished from a shift of the demand curve caused by a change in a non-price determinant.
Therefore, the two relationships are different. A change in demand shifts the demand curve and, with supply unchanged, normally changes the equilibrium price. In contrast, a change in the price of the good itself causes a movement along the demand curve and normally results in a change in quantity demanded.
(b) Answer:
A public good has the characteristics of non-excludability and non-rivalry. Non-excludability means that it is difficult or impossible to prevent individuals from benefiting from the good, while non-rivalry means that one person’s consumption does not significantly reduce the amount available for others.
The argument that public goods should always be provided by the government is based mainly on the inability of markets to allocate resources efficiently towards such goods. Because people cannot easily be excluded from consuming a public good, individuals have an incentive to become free riders.
A free rider is someone who receives the benefits of a good without paying for it. If a private firm attempted to charge individuals for a genuinely non-excludable public good, many people could simply refuse to pay while continuing to receive the benefit.
This creates a problem for private firms because they may be unable to generate sufficient revenue to cover their costs. As a result, the private market may underprovide or fail to provide public goods even though society values them.
Government provision can overcome this market failure. The government can collect tax revenue from households and firms and use this revenue to finance the provision of public goods. Since individuals cannot easily be excluded from the benefits, everyone can benefit even if they do not directly pay for the good.
National defence is a commonly used example. Once a country provides national defence, it is difficult to exclude individual citizens from the protection provided. One person’s protection does not normally prevent other citizens from being protected. Therefore, government provision funded through taxation can overcome the free-rider problem.
Street lighting can also have characteristics of a public good. Once street lighting is provided, it can be difficult to prevent particular individuals from benefiting from the improved visibility and safety. Government provision can therefore ensure that the service is available to the wider community.
Public goods may also generate positive externalities. The social benefits of providing the good may exceed the private benefits received by an individual. Government provision can therefore increase consumption towards a level that better reflects the benefits to society.
Government spending on public goods can also affect the wider economy. An increase in government spending is a component of aggregate demand and may increase real output and employment in the short run, particularly when the economy has spare capacity.
However, it does not follow that public goods should always be provided directly by government. Government provision involves an opportunity cost. Tax revenue and other government resources used to provide one public good cannot simultaneously be used for alternative purposes such as healthcare, education, infrastructure or reducing government debt.
Governments may also face difficulty determining the appropriate quantity of a public good to provide. Because individuals have an incentive to free ride, they may have little incentive to reveal their true willingness to pay. This makes it difficult for governments to estimate the social value of the good accurately.
There may also be uncertainty about the future benefits of government-funded projects. A government may allocate substantial resources to a project whose benefits ultimately turn out to be smaller than expected. This creates a risk of inefficient resource allocation.
Government provision can also suffer from government failure. Political pressures, bureaucratic inefficiency and imperfect information may cause governments to provide too much or too little of a particular good. Government ownership therefore does not automatically guarantee that resources will be allocated efficiently.
Furthermore, government does not necessarily need to produce every public good itself. It may contract private-sector firms to provide a service while retaining responsibility for financing, regulation and ensuring access.
For example, governments may contract private companies to construct and maintain public infrastructure. This can potentially take advantage of private-sector expertise and efficiency while allowing the government to ensure that the service is available to the public.
This means that the distinction between government provision and government production is important. A government may ensure that a public good is available without necessarily producing it using government-owned resources.
Real-world experience with national defence strongly supports government involvement because the free-rider problem makes purely private provision difficult. However, for some services, governments can use contracts with private firms if this provides the good more efficiently while maintaining appropriate access and regulation.
The argument also depends on the extent to which a good is genuinely non-excludable and non-rival. Some goods may have public-good characteristics without being pure public goods. In such cases, a mixture of private provision, government regulation and government funding may be more appropriate than complete government production.
Overall evaluation: The government has a strong economic justification for ensuring the provision of genuine public goods because non-excludability and non-rivalry create the free-rider problem and can result in market failure. Government financing can therefore ensure that socially valuable public goods such as national defence are provided.
However, the word “always” makes the view too strong. Government provision has opportunity costs and can suffer from imperfect information and government failure. In some cases, contracting out production to private firms may achieve greater efficiency while the government continues to ensure access to the good.
Therefore, public goods should generally be ensured through government involvement, but they do not necessarily need to be directly produced by the government in every case. The most appropriate method depends on the nature of the good, the extent of the free-rider problem, the cost of government provision and whether private-sector production can provide the good more efficiently.