Question

Smoking induces secondhand smoke, imposing costs on non-smokers. (a) Draw a graph for demand curve, supply curve and social-value curve. Briefly explain the difference between market equilibrium and socially optimal equilibrium (10 points). (b) What problem does this market cause? Shade the area on your graph for that problem. Briefly explain why that problem occurs.

Answer 1

a.)

Here, DD is the demand curve and S is the supply curve. The equilibrium occurs at E.

Smoking creates a negative externality for the society. Hence, the social cost curve is above the supply curve because it takes into account the external costs imposed on society by smoking. The optimum level is thus Qoptimum.

For the same reason of negative externality, the market equilibrium is more than the optimum level. Here, inefficiency occurs because the market equilibrium reflects only the private costs of production.

b) This market failure causes deadweight losses. Here, producers do not take responsibility of of external cost. They are passed on to the society. Thus, producers have lower marginal cost than they would otherwise have. Hence they face the supply curve marked by S. Here the supply increases, producing and selling more than the optimal level. Here, social cost curve is marginal cost and demand curve is marginal benefit curve. Since, marginal cost exceeds marginal benefit at E, deadweight loss occurs.

The deadweight loss (or, the net welfare loss) is shown by the shaded triangle.