Public and merit goods are special kinds of goods, first described around 1750 by A. Smith. These goods cannot be adequately produced by private individuals in completely free markets. An example of a public good will be defence. As everyone is automatically benefiting from the defence existence, no-one wants to be the one who produces it for others. Once it is there, however, no-one wants to pay for it, in hope that others will. Some extremely important goods in our society are either public or merit. Thus the issue of how exactly should the society provide them is of great importance. Furthermore, inside a society there must be a uniform collective agreement of how to pay for them. In present time, it is the tax system. But in order for the tax to work, everyone should pay as much as required. In 1950-s and 60-s the only feasible way to provide the public goods was to have state producing them, but looking at the recent success of privatisation, have we now found another way?
Before I can answer that I will define the public and merit goods more formally. The former are goods that, once produced, are free to be used by everyone. Furthermore, usually no-one can be excluded from consuming them, once they are there. Even when people can be excluded, the extra consumption by an extra person will not increase the cost to others. A bridge is one example. It is quite hard and expensive to exclude people from using the bridge; when it is not congested, the extra person crossing it will not increase the costs. Merit goods, on the other hand, produce externalities to the society when consumed. Consuming a merit good will benefit other people as well as the one that consumes it at the same time. So the benefit to the society arising from merit goods is greater than the benefit to the individual. Education and health-care are two famous examples here. When people are healthy it will help to reduce epidemic disease spreading, and when they are educated it will increase the economic growth.
In more economical terms, the public goods usually have very high fixed cost (set-up costs). Marginal costs of using it, however, are close to zero. Thus the production of public goods by private companies using profit maximisation will lead to large dead-weight losses. Suppose a charge of £1 would be made for crossing the bridge. It would cost nothing to the firm who built the bridge to let extra people cross. Now suppose I am prepared to pay 50p for crossing the bridge. Although it would be profitable for the firm to let me cross, I cannot do that, because then other people would demand to cross for 50p as well, thus incurring losses to the company. I am then a part of the dead-weight loss. Or graphically:
Profit maximising would be to equate marginal cost (MC) and marginal revenue (MR) and charge as much as possible (i.e. up to the demand curve AR). However the people who are prepared to pay 50p cannot cross. The est outcome will be to charge a Price=MC, but at that output the firm will be making losses, because average costs (AC) are higher than average revenue (AR)
Merit goods are quite similar to public goods. Here, however, it costs to provide one extra person with the merit good. The social benefit arising from provision is, on the other hand, smaller to the individual than it is to the society. So many rational people will think the costs are bigger than the benefits and thus will not buy the merit goods. Thus merit goods will be provided in a free market, but to a lot lesser quantity than socially optimal.
Furthermore, it is often the case that people undervalue even their actual personal benefit. This is the case with education. Parents do not realise how much a good education will benefit their child in the future. Thus there is free education now for everyone up to the age of 18. However, the free education is mostly of lower quality than the more expensive private education. It is argued that the state education is going to reduce the number of people in private schools. This happens because some people will think that the state education is enough, and although they have money for better private education, they will spend it elsewhere. Voucher system was invented to fight with this effect, however its usage haven't started. I will discuss this voucher system later on.
The demand for merit goods tends to be quite inelastic in lower quantities - there are people realising the true benefit and want the good, however much it costs. However the price pays an important role in higher quantities. Then people will suddenly start buying more when price rises. Supply on the other hand is quite elastic, as marginal costs are little. But the fixed costs are also high, so the first unit to be supplied costs a lot. We can now see how the state subsidy would help to increase the number of people using the merit good, and how the private education is only about 8% of the total education in England:
A subsidy of ab would increase the number in education by muchmore (cd).
Before getting into specific microeconomic examples I would like to introduce the broad overall macroeconomic ideologies towards the public goods. When the word public good was first used in the 18th century, the state did not provide anything but defence. There were taxes only to maintain the King, who then defended the country. This is the capitalist free market extreme. When we explore the society at that time it was evident that education, infrastructure and health-care were not provided adequately. The advantage, however, was that there was no cost of bureaucracy (other than that deliberately introduced by the King).
The other extreme is the all state provision in communist regimes. Here the state plans all the provision of goods. It should in theory lead to the most Pareto optimal allocation of production, because the social costs are taken into account in full. It turned out during 1940-88, however, that this regime did not work. The central planning authority was often out of date. The education and health-care were provided to everyone and the unemployment was eliminated. On the other hand, people had very little choice in life and the costs of maintaining the bureaucracy were enormous. At the end the economic growth was very moderate and the new inventions were introduced very slowly. State also spend too much money on defence and investment goods, not on consumption goods.
Nowadays in most Western countries a mixed set of both state and private provision is used. The idea was originally called the welfare state, because the essential health-care and education were provided free of charge first. Recently, however, the trend is to reduce the state's stake by privatisation and contracting out. In UK state still produces about 40% of GDP. So one cannot talk, even in today's changing times, about a full market provision of public goods in near future. But should we in general enlarge the state provision, reduce it or contract out its services to private providers while still retaining control?
Let me now look at some examples of dealing with public goods, firstly by contracting them out. By contracting out I mean that the public would still retain the full control of provision. Taxes would still be used to finance it. But instead of state providing them, it will pay to a private firm, selected through a competitive bidding process, to do so. An example of such a behaviour is the contracting out of rubbish collection by local authorities. They will advertise the job and select the lowest offer. Main advantage of this kind of provision is the retaining of competitive market environment. Firms will have an initiative to come up with cost-reducing ideas. They will also have a lot less bureaucracy and administration. However, it has been argued that the job satisfaction and security is damaged by this kind of competition. People can never be sure inn their jobs, because someone might come up with a cost-reducing idea and undercuts them. There is also much scope for bribing in this case, so the management might have to be increased to make sure the competition is fair.
There is also a theory of the second best, that deals with the market provision of public goods. It suggests that we are never in the best position, i.e. where all the dead-weight loss is eliminated (crossing the bridge is free). So we have to look at ways in reducing it. An obvious solution, for the bridge problem discussed above, would be to tax all people a bit and then lower the price of crossing the bridge. This will eliminate much of the dead-weight loss. But it will introduce some new dead-weight loss, arising from taxes:
New equilibrium E* will occur after the introduction of tax. Total tax revenue is abE*d.
The gain in the bridge example would be to redistribute this tax to a subsidy to the bridge owner. If the first dead-weight loss is smaller than the gain arising from the subsidy then the project would go ahead. However, there are redistributive costs involved in collecting taxes and paying subsidies. Also we are at present already in a taxed economy, when we increase the tax rate, then according to these diagrams the dead-weight loss will go up not proportionately, but exponentially:
In conclusion, the redistribution is not likely to achieve much more gain in this case. However it can do with different demand and supply curves.
Another problem arises with measuring the dead-weight loss by a survey. Rational people, in this case, are likely going to lie about their preferences. This happens, because they will anticipate that at the end the project is going to be financed by the tax money, not by individual payments. Thus people will exaggerate their claims. They will say they are prepared to pay huge sums for their street's lighting; at the end it is going to be provided out of taxes anyway, they assume. And their proportion in that extra tax is going to be much smaller than the benefit they receive. So it makes sense to make sure the project goes through.
Another set of issues face the merit good provision. Again, should state provide 100% or should other means be used?
I talked about the voucher system before. Instead of providing free state education, people will be given vouchers worth the same money that they can use on whatever form of education they like, including to top up private fees. This scheme will not distract people from going to the private schools. However, it has been argued that this scheme will make the income and education distribution more unequal, and will involve large and expensive structural changes in the short run. Less people would go to state schools. That would leave them less money. Also several schools will be closed down because of the lack of students. However, private schools will be facing economies of scale and can provide cheaper education. They will also have to enlarge themselves and will buy up the unused state school buildings.
National Health Service (NHS) privatisation can be looked as a good example of what will happen if a merit good is provided in competitive market conditions. NHS was liberalised t increase its efficiency. Competition was introduced with internal markets, where GP-s "shop" for the health-care for their patients, with the money they get from the government. This has reduced the cost of health-care without apparently lowering the life expectancy. UK spends very little on health-care as a proportion of its GDP. However, a number of problems have arisen. Management had to be doubled in NHS to deal with the administration. Waiting lists have also grown enormously for non-urgent treatment. This all casts a light of suspicion to the supremacy of free market provision in essential welfare services.
Private pension schemes are the last merit good example I would like to look at. They were introduced as a supplement to state pension. People have to choose their own scheme and pay into it accordingly. However, many people have found it difficult to deal with the math of the pension schemes. Much promotion has been going on around them, which have made people confused. There have been no major bankruptcies so far, but there is always the danger. Also the private schemes reduce the job immobility, as they are attached to a particular job. People cannot thus change jobs easily. Recently many regulations have been introduced to increase the mobility of the schemes.
There is still much to debate on the provision of public and merit goods, despite the fact that the state importance in the economy is declining. There is unlikely to be a single exact position and attitudes towards the provision of public goods. The degree of state involvement is likely to depend on special historical and cultural background and present realities. However, the black and white - completely private or completely nationalised - provision of these goods is unlikely to be successful. The solution in the present time at England is a "grey" welfare society. But how grey should it be?