Merit goods are goods and services where the social benefits exceed the private benefits.  Merit goods are underprovided by the market mechanism, as individuals don’t take into account the positive externalities that arise from consumption.  This will lead to the market equilibrium quantity being lower than the social optimum.

One reason for the underprovision is that individuals find it difficult to make rational choices when the costs arise today and the benefits are only received in the future.  Healthcare and pensions are two examples of merit goods where money has to be spent (or saved) today, but the benefits aren’t reaped for a number of years.

Empirical evidence has suggested that if left to market forces young people wouldn’t make the necessary provisions for sickness or unemployment (retirement) in old age.  Young people tend to be healthy and in work therefore they find it difficult to appreciate that on day they will be ill and out of work.  The cost of healthcare and pensions are so great that you could only afford them if you start saving at a young age.  It therefore makes sense for the government to intervene and force individuals to make contributions that will safeguard them against illness and retirement.

The beneficiary of the education will often not be the person who has to pay for it. This could lead to a conflict of interests as parents may wish to minimise their expenditure on education, whilst it would be in the child’s best interests to receive the highest quality of education available.  In addition to the external benefits the child/student will gain society as a whole will also be better off.  Somebody who is unable to read or write could be deemed as a burden on society as they would more than likely need supporting, whereas an educated individual would contribute to the welfare of the nation.

This leads to the case for some form of government intervention to encourage increased consumption of merit goods.  It might take the form of an explicit government subsidy to reduce the private costs of consumption and cause an expansion of demand.  Higher government spending on these merit goods should yield a positive social rate of return which leads to an improvement in total economic welfare.