Question

Consider the market for cigarettes where the market demand is given by Q”(P) = 200 – P and the supply by QS(P) = 20 + 5P. Suppose that the consumption of cigarettes creates a health externality. The externality causes a marginal social loss of 6 per cigarettes. a) (3) What is the market equilibrium price and quantities? b) (3) Show graphically why the market equilibrium is not socially efficient. c) (4) Find the socially efficient level of output. d) (4) Propose two different policies which could lead to the efficient level of output.

Answer 1

Answer

a. Quantity 170 Price 30

At equilibrium Supply quantity = Demand Quantity

Qd=Qs

or,200-P=20+5P

or,P=30

200 - 30 = 170 = Q

b. A social loss of 6 per cigarette will shift the supply curve

the new supply curve will be Q=20+5P-6=14+5P

Price 40 + Supply Externality (169, 31) Supply 30 (170, 30) Demand 120 10 o 160 170 180 Quantity

The supply curve should be the green curve here, but instead its the blue curve.

c.. Quantity 169 Price 31

At socially efficient scenario

14+5P=200-P

thus P=31

200-31=169=Q

d.

Policy 1 :Price Ceiling at P =31

This will shift the price up and lower the quantity

Policy 2: Impose a per unit tax increase of $1

This will shift the price up and lower the quantity

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Price 40 + Supply Externality (169, 31) Supply 30 (170, 30) Demand 120 10 o 160 170 180 Quantity