This document discusses how imperfect information can lead to market failure through the concepts of merit and demerit goods. It explains that merit goods have undervalued private benefits due to information failure, leading to underconsumption. Examples include education and healthcare. Demerit goods like cigarettes have overvalued private benefits due to imperfect information, resulting in overconsumption. Both can cause market failure since consumption levels do not reflect true social costs and benefits when private estimates are inaccurate. Governments may intervene to address underconsumption of merit goods and overconsumption of demerit goods.

1. Imperfect market information
Define information failure. Incomplete or inaccurate data means consumers or producers
make different decisions than if they had full information
How can information failure cause market failure? Perfect information enables rational
decision making. Imperfect, inaccurate, incomplete, uncertain or misunderstood information
means economic agents make different decisions than if they had full information.
What causes information failure? Imperfect information can be the result of
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Misunderstanding the true costs or benefits of a product eg immunisation
Uncertainty about costs and benefits eg should young workers buy into pension schemes
when economic conditions in 40 years’ time are uncertain?
Complex information eg what is the best health care treatment?
Inaccurate or misleading information eg some advertising ‘oversells’ benefits
Addiction eg drug addicts may be unable to stop consumption of harmful substances
Asymmetric information a party in a transaction has more information than another.
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Give examples of asymmetric information. A garage can use its expert knowledge to
persuade less informed consumers to pay for unnecessary work. A sick patient fails to reveal
their illness to an insurance company.
How can asymmetric information lead to market failure? If buyers and sellers have
different information one party has an incentive to exploit the other. Ignorance causes economic
agents make different decisions than if they had full information.
Merit goods
What is a merit good? Products that have more private benefits than consumers recognise
Why are merit goods undervalued? The full private benefits of merit goods are undervalued if
consumers take decisions based on inaccurate data ie because of information failure.
Why are merit goods a source of market failure? Inaccurate information means consumers
underestimate a product’s private benefits. Given all the facts and figures they would buy more
of the item. Information failure means merit goods are under consumed
Give examples of merit goods. Examples of merit goods include
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Preventative health care eg inoculations
Education and training eg higher education
Sporting activities eg gym membership
Use a graph to show market failure through under consumption of a merit good
Consumers with inaccurate information make
different decisions than if they had full data. Eg if
potential students underestimate the increased
future earning power of graduates when
estimating private benefits, the demand curve
for degree courses is D1.
The vertical distance between D1 and D2 is the
amount by which marginal private benefits are
underestimated. True marginal social benefit is
given by D2.
The equilibrium level of output delivered by a
free market, Q1, is allocatively inefficient. SMB =
SMC at Q2. The market has under consumed by (Q2 – Q1).
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Imperfect market information |

2. Explain the link between merit goods and positive externalities. Many merit goods with
undervalued private benefits also produce positive externalities. For instance
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Preventative health provision such inoculations also reduces absenteeism
The Arts and museums also help create a sense of national identity and shared culture
Sports participation also leads to improved health and team working skills
Why do governments encourage the consumption of merit goods? Under consumption of
merit goods such as education causes market failure because:
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Private benefits are undervalued and higher than consumers realise and
Merit goods often generate positive externalities benefiting third parties
Demerit goods
What is a demerit good? Products that have less private benefits than consumers recognise
Why are demerit goods overvalued? The full private benefits of merit goods are overvalued if
consumers take decisions based on inaccurate data ie because of information failure.
Why are demerit goods a source of market failure? Inaccurate information means
consumers overestimate a product’s private benefits. Given all the facts and figures they would
buy less of the item. Information failure means demerit goods are over consumed
Give examples of demerit goods. Examples of demerit goods include cigarette smoking,
excessive alcohol consumption, illegal drugs and processed foods high in fat, salt and calories
Use a graph to show market failure through
over consumption of demerit good
The demand curve D1 for cigarettes reveals
consumer’s own of marginal private benefit.
Information failure means consumers
overestimate the benefits of smoking when
calculating willingness to pay.
MSB is found by estimating and deducting from
D1, overvalued private benefits.
The equilibrium output in a free market, Q1, is
allocatively inefficient. SMB = SMC at Q2. The
market has over consumed by (Q1-Q2).
Explain the link between demerit goods and negative externalities. Many merit goods also
generate negative externalities. For instance
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Smokers overlook the harmful impact of ‘passive smoking’ on non-smokers
Excessive alcohol consumption can cause illness, absenteeism and antisocial behaviour
Excessive consumption of unhealthy foods high in fat, salt and calories can create extra
health care costs and absenteeism from work
Why do governments discourage the consumption of merit goods? Over consumption of
demerit goods such as cigarettes causes market failure because:
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Private benefits are overvalued – the product is more harmful than consumers realise
Demerit goods often generate significant negative externalities that harm third parties
Why are merit and demerit goods controversial? Some economists argue state and
consumer estimates of private costs and benefits diverge because of differing value judgements
rather than from information failure
| Imperfect market information
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