IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Diagram skill~12 min read
Merit Goods and Inward Foreign Direct Investment
Two of the biggest levers in development, and they work in completely different ways. Merit goods are things the market under-supplies because buyers do not see the full benefit. FDI is money from abroad — useful, but how much of it stays depends entirely on how the deal is structured.
📚 What you need to know
Merit goods are beneficial to society but under-provided by the market.
Governments subsidise or provide them to lower the price and raise the quantity consumed.
The three that matter most in development are education, healthcare and infrastructure.
Inward FDI occurs when foreign investment gives a foreign firm more than a 10% ownership share of a domestic firm.
FDI brings finance, employment, technology and tax revenue.
Its impact depends on how it is structured: who is hired, and where the profit ends up.
Why the market under-provides merit goods
When a family decides how much schooling to buy, they weigh the private benefit to their own child. They do not count the benefit to everyone else — a more productive workforce, lower crime, better public health. Social benefit exceeds private benefit, so the free market settles at a quantity below the socially optimal one.
Label MSB clearly and to the right of MPB. The gap between them is the external benefit, and the whole case for government provision sits in that gap.
In a development context there is a second reason the market under-provides, and it is not in most textbooks. Even where households know the benefit, they cannot borrow against a child’s future earnings. So the constraint is not just information — it is a missing credit market. That is why free provision works better than a subsidy in very low-income settings.
The three merit goods that matter most
Provision
How it helps development
The costs and limits
Education programmes
Free at the point of use from pre-school upwards, funded by taxation. Raises human capital, so productivity and output rise, wages rise, consumption rises and aggregate demand rises. This is the single most direct way to break the poverty trap
Takes a long time before productivity responds; carries a large opportunity cost; may be under-consumed anyway where children are needed to work for family survival
Health programmes
Ranges from emergency care to universal vaccination and preventative screening. Vaccination alone can lift life expectancy and productivity substantially, and better health keeps children in school
Every intervention needs government expenditure and so carries an opportunity cost; how much to provide is a normative question subject to political pressure
Infrastructure projects
Energy, transport, telecommunications, clean water and sanitation. Access to energy frees up time previously spent gathering fuel; telecoms speed the exchange of knowledge; clean water cuts disease directly
Requires very large government spending; projects take years to complete; they are subject to political pressure and to corruption in procurement
Inward foreign direct investment
FDI is not a loan and not aid. It is a foreign firm buying a lasting ownership stake — conventionally more than 10% — in a business inside the country. That distinction matters because the investor expects a return and will take it home.
This is why two identical-looking investments can have completely different development effects. The headline figure tells you almost nothing on its own.
Advantages of FDI
Disadvantages of FDI
A major source of finance where domestic savings are too low to fund investment
Weak local regulation gets exploited, leading to poor working conditions and more negative externalities of production
Generates extra national income, which raises savings and so raises funds available for domestic investment
Profits are moved offshore or returned to the home country, so less is reinvested in the host nation
Expansion of supply creates employment opportunities
Multinationals often pay very little tax to host nations, using techniques such as transfer pricing
Government receives higher tax revenue from the additional output and profit
Local firms struggle to compete with a multinational and can be driven out of business
Governments often build new infrastructure to support the investment, which benefits everyone
Multinationals have the bargaining power to keep wages low
Technology and management practices can transfer to local firms and workers
Management roles may be filled from the home country, leaving locals in unskilled work with few new skills
Transfer pricing in one line. A multinational sells goods between its own subsidiaries at prices it chooses, so profit appears in the low-tax country and costs appear in the high-tax one. The host nation gets the jobs and very little of the tax.
Worked examples
WORKED EXAMPLE 1
Two foreign firms each invest $500m and each earns $80m in annual profit. Firm A hires 90% of staff locally and reinvests 60% of profit in the host country. Firm B hires 30% locally and repatriates all profit. Compare the development impact. [6]
Step 1: profit retained
Firm A: 0.60 × $80m = $48m reinvested
Firm B: $0 reinvestedStep 2: employment effect
A’s local hiring rate is three times B’s, so far more of the wage bill circulates in the domestic economy and supports consumption.
Step 3: human capital
A’s local staff gain skills, including in management. B’s locals stay in unskilled roles, so little human capital transfers.
Step 4: the wider point
Both investments are recorded identically at $500m in the financial account, yet the development effect is entirely different.
A contributes far more; the value of FDI depends on structure, not size
WORKED EXAMPLE 2
Using a diagram, explain why a government might provide primary education free of charge. [6]
Step 1: the diagram
Draw D = MPB, S = MSC, and MSB to the right of MPB. Mark Qm where MPB meets MSC and Qs where MSB meets MSC.
Step 2: identify the failure
MSB lies above MPB because there are positive externalities of consumption — a better educated population benefits everyone.
Step 3: the consequence
The market settles at Qm, below the social optimum Qs, so the good is under-consumed and there is a welfare loss.
Step 4: the intervention
Free provision funded by taxation removes the price barrier entirely, moving consumption towards Qs.
Evaluation
It works only if the indirect cost is also addressed. Families losing a child’s earnings may still keep them out of school, which is why meals or cash transfers are often attached.
Under-consumption caused by external benefits, corrected by free provision
💡 Exam tip
Draw MSB to the right of and above MPB for a merit good. Getting this the wrong way round shows a demerit good.
Label Qm and Qs and shade the welfare loss. Both earn marks.
Say positive externality of consumption, not just “good for society”.
For FDI, always ask about profit repatriation, local hiring and tax. Those three points structure a whole evaluation.
Mention the 10% ownership threshold when defining FDI. It is a definition mark.
⚠ Common mix-up
A merit good is not a public good. Merit goods are rival and excludable; they are simply under-consumed.
FDI is not aid. The investor expects a return and will take it.
FDI is not portfolio investment. It buys lasting control, not just shares.
Free provision is not free. It is paid for through taxation and carries an opportunity cost.
Do not treat all multinationals the same. Hiring and reinvestment practices vary enormously between firms.
Up next: Foreign Aid and Development Assistance — where the money comes from, and why so much of it never arrives.
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