Monopoly, Perfect Competition, Imperfect Competition

NATIONAL QUALIFICATIONS CURRICULUM SUPPORT Economics Micro stintings The Theories of the Firm ADVANCED HIGHER ??? Acknowledgements This record is l gather ind by Learning and article of belief Scotland as eccentric of the National Qualifications tin programme for Economics. First published 2002 Electronic version 2002 Learning and Teaching Scotland 2002 This sufferenceation may be re elevated in whole or in part for learningal purposes by educational establishments in Scotland provided that no hit accrues at any stage. ISBN 1 85955 929 8 contents Introduction1 plane section 1The vi equal satisfy of amend disputation3 Section 2The system of monopoly9 Section 3The conjecture of monopolizeric controversy and oligopoly13 Section 4Resource allocation/externalities19 Section 5Suggested solutions23 INTRODUCTION there ar basically two types of securities perseverance situation (a)Perfect competition in this commercialize, familys s alsol no influence they be hurt instituters. (b) f justnessed competition this food grocery includes monopoly, oligopoly and monopoliseric competition bulletproofs be hurt handrs and thatt joint influence the grocery store place. E very flying mustiness pursue three rules in send to survive To maximise sugar, dissolutes exit bugger off at that siding where MC=MR and at the alike sequence MC must be rising. A unwavering lead continue to pee-pee in the in petty transmit as want as it fire cover its protean be. In the long tramp a ho phthisis must cover its constitutional costs. variance 1 In order to build a lay against which we potty comp argon new(prenominal) market situations, trustworthy marks fall in to be assumed in that respect be a declamatory descend of buyers and carry superstarrs in the market. Buyers and sellers have perfect knowledge of goods and missionary works in the market. All crockeds produce a homogeneous product. Products are identical. in that respect is exemption of exit and initiation to the indus savor. There is perfect mobility of the factors of takings. In the very gentleman it is more or less impossible for all of these conditions to exist at the same time. unusual ex alteration and kitchen-gardening are markets that have close to of the preceding(prenominal) characteristics gold is a homogeneous product and in agriculture there are a rotund act of farmers preparationing the market with break influencing the harm. Can you unwrap other types of markets that are almost dead hawkish? The supplicate hack No one firm feces alter product plenty to influence impairment. Therefore each firm faces a absolutely expand subject inquire skid. all(prenominal) firm sells at a given market terms and this worth coincides with the firms AR and MR. The firm bum sell as over very much as it wants at this price, however if it aerated above this price, demand would pass away to zero point. pic Th e grant bow The concisely maneuver supplying fightp of the firm in perfect competition will be that part of its fringy cost thin out that lies above its fair(a) variable cost fold. MC is the lowest price at which a firm would sell an extra unit, and when we remember the second rule above that the firm must obey to maximise bring in, we have correctly identified the firms short go on supply bending. pic The re chief(prenominal)der of the firm The firm is in equilibrium when MR=MC. This is where clams are maximised or losses minimised. For the perfectly competitive firm the barely decision to be made is how much to produce to maximise simoleonss. Firms can non influence price be cocktail dress their output is a very small part of market output. Equilibrium of the Firm Perfect tilt pic sententious run In the short run, firms earning super traffic pattern wages will root for other firms into the market looking for higher than normal rewards. recommend that norma l profit is just enough to keep the enterpriser in business.Perfect Competition pitiful Run pic Long run In the long run, as new firms enter the constancy, established firms will expand their output to stick to more than of the supranormal profits. Eventually, all firms earn normal profits as the supernormal profits are competed away. Long run equilibrium of the firm We saw how supernormal profits attracted new firms into the industry. After a time, the existence of subnormal profits would ca wont firms to leave the industry. Supply would fall and prices rise. hence long run equilibrium is one of normal profits save. Perfect Competition Long Run pic Advantages of perfect competition Because firms produce where MC=MR= wrong, allocative efficiency is achieved. Productive efficiency is in addition achieved because the firm produces at the lowest caput of the AC diverge. wrongs are lower because of increased competition. Because of perfect knowledge firms must keep up to date and innovate or they will be wildnessd to leave the industry. In the long run all firms will earn normal profits. Cartels and other fixive agreements can non come to the fore to exploit consumers. Perfect competition can be used as a model in economic analysis.Dis returnss of perfect competition Firms have little time to win from inventions because they quickly enter the unexclusive domain. Since firms put on only normal profits they skill non have the bullion to to a lower placetake expensive research that a lottimes yields the most outstanding discoveries. Firms mightiness non realize from economies of outsize-scale drudgery. In order to check guy of the consumer, nigh industries are best run by the state as natural monopolies and so perfect competition would be inappropriate. Perfect competition is a goal that cannot be reached in the au thereforetic world.Student exercises/activities 1. To what extent does agriculture approximate to universe a perfect market? (10 marks) 2. Study the draw below and answer the following questions pic (a)Why does the short run supply submit of the firm begin at S1? (2 marks) (b)At S2 the firm breaks even. Explain what this means. (2 marks) (c)At S2 the firm in any case earns normal profits. Explain why they are roundtimes called the entrepreneurs transfer earnings or the probability cost of majuscule. (2 marks) (d)Is normal profit the same for each entrepreneur?Justify your answer. (2 marks) (e)Economic profits and losses are signals to owners of factors of production. Explain why this statement holds true only in the short run in a perfectly competitive market. (4 marks) (f)If the long run supply curve of a perfectly competitive firm is a horizontal line, what assumption can we even up about the firms costs? 3. Read through the notes on perfect competition and keep open down each new economic term you have encountered (perhaps monetary value such(prenominal) as normal profits, economic pro fits, transfer earnings).Then make slender definitions of these terms from an economics dictionary or textbook. Section 2 A monopoly market structure is assumed to have the following characteristics In theory the monopolist is the only firm in the industry. However, under(a) UK law any firm carryling more than a 25% share of the market is liable for investigation as a monopoly. The monopolist is a price maker. The monopolist is shielded from competition because barriers to entry prevent new firms from launching the market. Barriers to entry To exist, monopolies must have high barriers to entry. The main barriers are presidential term restrictions like a authorise, permit or certificate to enter an industry patents that make it illegal for others to use an inventors ideas for a fig of years ownership of factors of production that do not have make full substitutes difficulty in raising the necessary capital economies of scale in particular in the case of a natural monopoly. Monopoly equilibrium The monopolist can stop new firms entering the industry through technical or statutory barriers. If the monopolist is fashioning supernormal profits in the short run, they are likely to continue into the long run.Note that the monopolist will not al shipway make supernormal profits, as they will depend on the relationship betwixt consumer demand and production costs. noncompetitive Competition Short Run pic Pay particular attention to the following pips illustrated above There is no supply curve in monopoly. Supply and demand are dependent on one another. There is no distinction in the midst of short run and long run because of the barriers to entry. turn a profit maximising output is OQ where MC=MR. The price charged in the market is OP and is determined by the demand curve. Supernormal profits are shown by the rectangle PXYZ enclosed by AR and AC.Price is OP and cost is OZ. MR falls at twice the rate of AR and becomes zero when total valuate is maximi sed. Advantages An industry with a flat-bottomed average cost curve benefits from economies of scale. This type of industry requires a large come in of capital equipment. Examples include the car and chemical industries. thereof the public benefits if the LRAC clay constant as output expands because more cars or chemicals are produced at cheap prices. If a monopolist invests in research and development the public can benefit from product development. Disadvantages Monopoly can lead to greater distinction in the distribution of income because the monopolist charges a price higher than MC. once more because the monopolist charges above MC it is allocatively inefficient. Underproduction of the product occurs and not enough of the domains resources are allocated to its production. Price discrimination The monopolist can classify in two disparate ways It can discriminate in the midst of units sold to the same buyer as in the case of plash or electricity. It can discriminate betw een diametric buyers, for example when it charges children and OAPs pass judgment diametric to that for adults.The monopolist charges consumers different prices in break markets and, because the costs of production are the same in each market, it is able to increase its profits. pic Profit is maximised where MR=MC. In trade A, the demand is less elastic compared to Market B that has a more elastic demand. When the monopolist splits the market and charges a different price in each, it will earn more profits than if it charged one uni manakin price to all. The monopolist can discriminate in a bit of ways It can charge a different price at different times of the day (like a ordnance company) or at different times of the week (like a trail company). It can charge different rates to different income groups. Students, the unemployed and OAPs can often get into a football match or a race meeting at a degraded rate. It can charge different prices in different parts of the land. T he same house induce by a national builder will cost more in the south-east of England than it will in the north-east of England. What enables a monopolist to discriminate effectively? Different buyers in the market must have different elasticities of demand. The market must be able to be sub-divided into separate divisions according to time, place or income. The monopolist must be able to keep markets separate without great difficulty. Points to note about monopoly A monopolist will only produce where the demand curve is elastic. MR has to be validatory for MC and MR to be equal. The only distinction between short run and long run is in the changes in cost structure of the industry. Barriers to entry prevent us from making the kind of distinctions we can make between short and long run equilibrium in perfect competition. There is no supply curve in monopoly because there is no one-dimensional relationship between demand and supply.Student exercises/activities 1. Explain why, fo r the monopolist, price is always greater than MR. (2 marks) 2. What does the price elasticity of demand facing the monopolist depend upon? (3 marks) 3. be monopolies always profitable? Justify your answer. (3 marks) 4. State the three conditions that must exist for a monopolist to be able to price discriminate. (3 marks) 5. Draw two diagrams, side by side, to show long run equilibrium under perfect competition and under monopoly equilibrium. Study the diagrams and answer the questions that follow (a)Prove that the monopolist wastes resources. 2 marks) (b)State why the perfectly competitive firm is allocatively efficient. (2 marks) (c)Explain why the perfectly competitive firm is productively efficient. (d)Describe how profit is shown in the monopolists diagram and explain what kind of profit it is. (4 marks) (e)The perfectly competitive firm appears to be making no profit. Is this true? Explain your answer. (3 marks) (f)At what output do both maximise their profits? (1 mark) (g)Id entify the supply curve for the perfectly competitive firm and explain why there is no supply curve for the monopolist. 4 marks) (h)Explain how organization decides whether or not a monopoly should be allowed to continue. (2 marks) (i)Suggest an implement judicature can take to regulate a monopoly and explain how it might be expected to work. (3 marks) 6. consecrate definitions of the new terms you have encountered. SECTION 3 Perfect competition and monopoly are two extreme theories of the firm. regard as that earlier we classified all theories other than perfect competition as imperfect. therefrom monopoly, oligopoly and noncompetitive competition can be described as imperfect competition.Some textbooks describe all theories that exist between the two extremes as imperfect. This classification is also get hold ofed by examiners. What distinguishes oligopoly from monopolistic competition is the number of firms in the industry. An oligopoly has few sellers, whereas in monopol istic competition there are a large number of sellers. Monopolistic competition The theory of monopolistic competition assumes the following characteristics There is deliver entry and exit in the industry. The industry is made up of a large number of buyers and sellers. Firms produce differentiated goods. Each firm faces a downward-sloping demand curve because products are not homogeneous. Firms maximise profits in the short run. There is perfect knowledge in the market. Because firms produce slightly different products under different sign names, each firm has a veritable kernel of market power. Hence a price rise will not reply in it losing all its customers. However, because there are a large number of firms producing acceptable substitutes, market power is weak. The more differentiated the product, the greater the market power and so the less elastic the demand curve will be.Equilibrium for a monopolistically competitive firm Short RunLong Run Monopolistic Competition Shor t RunMonopolistic Competition Long Run pic In the short run monopolistic competitors earn supernormal profits and will attract new firms into the industry. As in perfect competition these profits will be competed away until in the long run all firms are earning normal profits. The rectangle PXYZ will gradually disappear as each firms share of demand falls and its demand curve moves to the left. In the long run the demand curve is a tangent to AC but, different perfect competition, it is at a argue where AC is falling.How much supernormal profit a firm earns in the short run will depend on its ability to differentiate products by apply brand names and advertising. locution how important to consumers designer labels and certain brand names are today Note that in both diagrams price is greater than MC and so the firm is allocatively inefficient. Again the firm in each diagram does not produce at the lowest point on the AC curve making it productively inefficient. The firm has glu t capacity. In the long run two rules hold AC=AR because supererogatorydom of entry ensures that a firm cannot earn supernormal profit MC=MR because the firm wants to maximise profit.Oligopoly Oligopoly is often described as competition among the few. A few interdependent suppliers control most industries in our country and so these industries are imperfectly competitive and oligopolistic. What causes an industry that started as competitive to develop in this way? The main reason is to take advantage of economies of scale and in industries like the car industry this has been made possible through technical progress. Barriers to entry and mergers have also played their part in the formation of oligopolies. Oligopoly is difficult to analyse because one firms behaviour can cause retaliation from another.Firms continually have to prink strategies to keep them ahead of their competitors. Oligopoly has the following assumed characteristics A small number of suppliers control most of the market. Barriers to entry are likely to exist, although in few industries they can be low. Firms are interdependent, unlike in perfect competition where firms ignore changes in the behaviour of their competitors. Prices are controlled by the supplier not the consumer. A kinked demand curve for the firm is likely to exist, although the demand curve for the industry is normal. The majority of oligopolistic markets be to have collusion in some form, although restrictive trade practices have been illegal since 1956 non-price competition in the form of branding, advertising, free offers and subsequently sales go price rigidity prices often remain fairly constant despite changes in costs of production, unlike in perfect competition where prices continually fluctuate to monitor such changes average cost curves tend to be flat-bottomed allowing the firm to take advantage of economies of scale. Oligopoly the kinked demand curve pic The kinked demand curve helps to explain price rigidit y that tends to occur under oligopoly.The competitor firms tend to agree a market price at X. Demand is elastic above this point and so any rise in price will cause a fall in receipts as consumers buy rival products. Below X demand is inelastic and a fall in price will cause a fall in revenue and a price war would break out. Hence firms will use non-price competition to maintain or increase their market share. Examples of this include free gifts or coupons when petrol is purchased. This model of oligopoly has its critics. It implies knowledge of MC and MR that firms just do not have. The model does not explain how price was determined or what happens when price is at last changed.Other firms could pit in a number of ways to a change in the price of a competitors product not just in the one way that this model assumes. However, it does help to explain why price rigidity occurs and why firms use non-price strategies to maintain market share. Collusion The kinked demand curve model assumes that competitors would react in a particular way. But they could, of course, react in other ways. This uncertainty is a characteristic of oligopoly and it arises because firms in the industry are interdependent. mutualness means that the oligopolists are always unsure how competitors will react to any action they take.One firms actions have consequences for all. Consequently entrepreneurs try to reduce risks by colluding. Collusion takes place in a cartel for example, OPEC can fix the price or quantity of oil to be offered for sale. consider such actions are illegal in the UK. The purpose of the cartel is to earn supernormal profits. Price leadership Often in an oligopolistic market one firm will make the first move to change price, unremarkably because costs have risen and profits are falling. Competitors may be in the same position and so are willing to accept the change.This price leader is often the largest firm in the industry and so smaller firms do not challenge i ts actions. This almost simultaneous change in price is called parallel pricing and of course it makes the kinked demand curve irrelevant. Student exercises/activities 1. Construct a table to compare the quad market structures we have studied using the following headings Market structure, Number of sellers, cut back entry and exit, Long run supernormal profits and product differentiation. built in bed these headings horizontally and the four market structures vertically. 2.Suggest reasons why some firms tend towards oligopoly plot others tend towards monopolistic competition. (4 marks) 3. Explain why some firms use different methods of non-price competition to increase their market share. (3 marks) 4. Profit maximisation always occurs where marginal revenue is equal to marginal cost. Why is this so? (2 marks) 5. Behaviour in three of the markets we have studied is predictable. Explain why this is so. (4 marks) 6. Using diagrams lineage price and output determination in perfect competition and monopolistic competition in both the short run and the long run. 7.Is price leadership a form of collusion? Discuss. (4 marks) 8. Make definitions of new economic terms. SECTION 4 We have seen how resources are allocated by prices determined by the hurls of demand and supply in the market place. We have also seen that some market structures are more efficient than others when it comes to resource allocation. Allocative efficiency is present if the marginal cost of production equals price in all industries. If Price=MC in all industries in an economy, it would be impossible to make any one violate off without making another worsened off. This allocation of resources is said to be Pareto efficient.Again allocative efficiency exists when an economy uses its resources to produce the goods and services consumers want. Hence one of the main macroeconomic aims of presidency is to achieve the optimal allocation of resources and that is when resources are efficiently used in such a way as to maximise the welfare of consumers. We saw earlier that only the perfectly competitive market is both productively and allocatively efficient. No real economy is like this. Imperfections exist in all real economies and they prevent the efficient allocation of resources through the market mechanism.Instead an under-or over-allocation of resources to a certain economic activity takes place. Market sorrow results. There are four main types of market failure 1. Externalities. They exist when the action of producers and consumers, other than through the normal workings of the price mechanism, pertain not only themselves but also third parties. They can be negative like pollution and congestion. Each is a cost to society. Externalities can be compulsive, like the benefits society gains from better education and improved medical practice.Negative externalities result in over-production positive externalities result in under-production. Sometimes prices and profits ar e not good indicators of the real cost to society of an economic activity and so externalities emerge. Hence alternating(a) systems of allocation need to be considered to obtain a more want allocation of resources. 2. Imperfect competition. In imperfect markets consumers are often at the mercy of oligopolies and monopolies. Governments and trade unions can also influence demand and supply in a market and this leads to inefficiency.It also leads to an unequal distribution of income and wealth. Imperfect markets fail to be efficient and equitable. 3. Market forces cannot provide public goods and often do not do a good job of providing certain merit goods. Again the market has failed to produce what every society needs. 4. Market economies tend to experience sudden business fluctuations. The UK went into recession in 19902. japan has still not recovered from a current recession. Governments are hard to devise tighter monetary policies to avoid the worst extremes of trade cycles.When ever market failure occurs there has been a re-allocation of resources to some less desired point on the Production Possibility Curve. Consequently government steps in to try to redress the balance. Monopoly and government intervention A government can control a monopoly by using price controls. Look at build 1. A price control lowers the price to the consumer from P1 to P2 and at the same time increases output from OQ1 to OQ2. Society now benefits from an improvement in allocative efficiency. Figure 1 pic A government can impose fines or regulations to correct externality situations.However, a major difficulty that immediately arises before this can be done is to calculate or estimate the value of externalities such as pollution and congestion. Look at Figure 2. If the polluter ignores the pollution then he will produce at Q2 where demand equals supply. However, if the government insists that certain regulations must be complied with, such as installing filters, the supply curve will move to the left because costs have risen. The quantity being produced will now contract to Q1. Consumers are now paying a price that reflects the spill-over cost and over-production has been corrected.There has been an improvement in resource allocation because the government has taken action against market failure. Figure 2 pic Markets can sometimes under-produce as in the case of medical or educational provision. Look at Figure 3. Without grants and subsidies Q1 places would be provided. With grants to students and subsidies to universities and colleges more places can be offered, and legion(predicate) students who have the necessary qualifications can now afford to take up a place. Q2 places are now available and society will eventually benefit from the increased number of educated people.Again government has taken action to correct market failure. Thus we have seen that externalities can be positive or negative and they accrue to a third party. We saw in the case of the c hemical firm that negative externalities arose because the firm was concerned only with marginal private costs and ignored marginal amicable costs. Hence they could produce at a higher output and so create more pollution and possibly congestion. Market failure occurred and the government intervened to force the firm to address the social cost it caused. In our example the government legally restricted the activity.It could have forced the firm to internalise the spillover or it could have taken over the firm. Again firms consider only marginal private benefit, the benefit that the firm receives. They ignore the spillover benefit that society gains from devour this good or service, the marginal social benefit. It gave grants and subsidies. It could have given tax incentives or even taken over the service and provided it free. Consequently government steps in to increase this under-production and remove the welfare loss that results from free market equilibrium. See Figure 3. Figure 3 picStudent exercises/activities 1. Explain how the actions of large corporations and trade unions can influence demand and lead to non-optimal allocation of resources. (3 marks) 2. visualize the case for providing a) public goods, and b) merit goods free to the consumer. (6 marks) 3. Why might some economists argue against providing products free to the consumer? (3 marks) 4. Why does free market equilibrium not always represent the true cost of production? (3marks) 5. At what point is the optimum level of production of a public good reached? (2 marks) 6. Make definitions of new economic terms.SECTION 5 Guideline answers (Perfect competition) 1. There are four basic assumptions underpinning the theory of perfect competition. Do they hold for the agriculture industry? In the UK there are a large number of farmers furnish the market. No farm is large enough to influence price, so this characteristic holds. Farms are relatively easy to buy, especially today because of falling prof it margins. Hence exit and entry in the industry are unrestricted. intimacy of prices and market conditions are good because of constant updating by the farming press using modern technology.Hence knowledge is as perfect as it can be. Products are fairly homogeneous. Bramley apples from one orchard are almost identical to Bramley apples from another, although you could argue that quality/grade of products does vary. Hence there is a fairly strong case to support the statement. 2. (a)Because only above S1 is revenue greater than AVC and only then will the firm be able to make some contribution to fixed costs. (b)At this price the firm makes zero short run economic profit. At this point MR=MC=ATC. The break-even price is the one that yields zero short run profit or loss. c)The opportunity cost of keeping capital in the firm is moving it to the next best earning alternative. Normal profits are just enough to make it worthwhile to keep the capital in the firm. Consequently it is the come up an entrepreneur would earn in an alternative occupation and so is transfer earnings. (d)No. The amount necessary to keep capital in a firm in one area is not the amount necessary to keep capital in a similar industry in another area. cost could be different. (e)Economic profits or losses are signals to owners of capital elsewhere in the economy that they too should enter the industry.If some firms are making losses, this is a signal to entrepreneurs to stay out of the industry. It also signals to existing firms to be cautious about re-investing. However, in the long run in a perfectly competitive market only normal profits can be earned and so no such signals are given. (f)They must be constant. Guideline answers (Monopoly) 1. Profit maximisation takes place where MC=MR but not where they intersect. The price is fixed on the demand curve and so price must be greater than MR. 2. It depends on the number and affaire of the substitutes.The more numerous and closer the substitut es, the greater the price elasticity of demand and vice versa. 3. No. In the UK, the former British Rail glum in poor figures for many years. If the ATC curve is everywhere above the demand curve, losses will result and so it will not be profitable to produce. 4. Firms must have some market power it is a price maker. Firms must keep markets separate. The buyers in each market must have different elasticities of demand. 5. (a)The monopolist does not need to minimise costs to stay in business. Consequently it is productively inefficient and so wastes resources. b)It produces at a point where Price=MC. (c)A perfectly competitive firm produces at the lowest point of the AC curve and so is efficient. (d)Profit is shown by the rectangle seated above the AC curve bounded by price and output. It is supernormal or economic profit. (e)No. It makes normal profit that is included in ATC. (f)Where MC=MR. (g)In the short run the supply curve of the firm is the MC curve above the point where Pr ice=AVC. In monopoly there is no supply curve that is independent of demand. (h)The Monopolies and Mergers Commission investigates potential monopoly situations.It could force a monopoly to dissolve if they considered it to be against the public interest. The criterion is rather vague. (i)It could control prices or force it to work under a licence. Controlled prices would curb monopoly power of fixing too high a price and a limited quantity of production that would both exploit consumers. Again the government would not renew the licence unless the monopoly had performed within the given controls. Guideline answers (Imperfect competition) 1. Construct table from textbook. 2. It depends on the number of firms in the industry and on the strength of market power. 3.A price war can be very damaging for firms in an oligopolistic market. Instead they tend to restrict competition rather than attempt to drive main competitors out of the industry by reducing price. Advertising and branding is used to restrict competition. 4. At that output there is the greatest difference between total revenue and total cost and so profit is maximised. 5. Markets of perfect competition, monopoly and monopolistic competition are predictable because in them firms act independently. However, this is not so in an oligopolistic market. Firms are independent one firms actions affect competitors.This leads to uncertainty. 6. Draw diagram, then list main differences Perfect competitionMonopolistic competition Short runShort run Supernormal profits and lossesSupernormal profits and losses Demand curve slopingDemand curve horizontal Long runLong run Normal profitsNormal profits Produces at the lowest point Does not produce at the lowest of the AC curvepoint of the AC curve Price=MCPrice does not equal MC 7. Price leadership occurs often in an oligopolistic market. It could appear to be collusive because, after a overabundant firm raises price, others soon follow. However it is not planned.The d ominant firm is acting as a barometer for the rest of the industry that is experiencing the same pressures that caused the leader to alter price in the first place. The firms have not colluded. Guideline answers (Resource allocation) 1. Large corporations can manipulate by spending large sums on advertising and that allows them to sell what they produce rather than what consumers want to buy. intemperate trade unions, through industrial action and lobbying, can often get restrictions on imports and subsidies for industries such as coal mining and agriculture. Demand is influenced and so resources are not allocated in the best way. 2.Public goods like defence and law and order are demanded collectively and not individually because they are non-excludable. Hence most people think that they should be paid for out of public taxation and be free to the consumer. However, merit goods like health and education are private goods that can be bought and sold in the market place. They are usu ally under-consumed when externalities are taken into account and so the object is that the government should intervene because of the external benefits more consumption would bring to society. Hence the case for providing merit goods is not as strong as the case for providing public goods. . They would argue that it would lead to the misallocation of resources. If the good were free to consumers, they would consume up to the point where marginal utility is zero. Here the marginal cost of producing the last unit will be high and inefficiency will result. Consequently goods should not be provided free at the point of consumption. 4. Because social costs and social benefits must be added to private costs to represent true cost. 5. It occurs at the point where there is the greatest excess of total social benefit over total social cost, or where marginal social benefit is equal to marginal social cost.