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

You may disagree if you are a Muslim! Remember this is a value judgement

Costs & Benefits

£

Output (Q)

MPB

Q free market

MSC=MPC welfare loss

social optimu

m

1

2

3

MSB

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)

MPB2 - full information Q Q*

• 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

Difference between MPB1 and MPB2 is due

to INFORMATION FAILURES – consumers are not aware of true benefits which differs from their perceived

benefits

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

£

Q of cigarettes

MSC=MPC welfare loss

MPB1 - imperfect info

MPB2 - full information Q Q*

Costs &

Benefits

£

Q of cigarettes

MSC=MPC welfare loss

MPB1 - imperfect info

Over-consumption

MPB2 - full information

Q Q*

Costs &

Benefits

£

Q of cigarettes

MSC=MPC

Potential welfaregain

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.

X poor use of scare resources

Evaluation point

or is it ✓?

The world would be dull without different products

Asymmetric informationWhere 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.

Xdon’t sell

Only the lemons are left!

The good products drive out the bad

Adverse selectionA situation of market failure caused where buyers and sellers have asymmetric information, and the poor quality products (or customers) drive out the good.

Moral hazardAny 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 problemconcerns the difficulties in motiving the agent to

act in the best interests of the principal.

Agent

principal(Sir) Fred Goodwin - Agent

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…….

A degree from a good university

provides information about ability

and attitude to work

A degree from a good university

provides information about ability

and attitude to work

Unemployment that results from real wages being above their market clearing level and causing an excess supply of labour

Employment

AS labour

AD labour

Real wages

w1

w

EQd1 Qs1

Classical unemployment