Question

3. Externalities and second hand smoke a. What externalities are associated with cigarette smoking? In particular, i. Are they positive or negative? ii. Are they generated through production or consumption of cigarettes? ii. Provide an example of the monetary social gain or loss from cigarettes? b. Using a supply and demand model of the market for cigarettes, model the effect of externalities i. ii. iii. What is the price and level of consumption in this market, based upon the individual decision making of consumers and producers? Show on your S&D graph. What is the price and level of consumption that is socially optimal once one accounts for the externalities Show on your S&D graph. If laissez-faire principles are allowed to operate in this market is the market efficient? If not, what is the dead weight loss in this example? Be prepared to explain. c. What can be done to fix the problem? Show this remedy on your graph d. Why are taxes, which generate a loss of exchange, "efficiency improving" (or second best) in the case of cigarettes?

Answer 1

i) Negative externality i.e. passive smoking is associated with cigarette smoking.

ii) Produced by consumption of cigarettes as the people smoking do not take into account how the second hand smoke affects other people around them.

iii) Taxing cigarettes would result in an increase in tax revenues plus it would discourage smoking(as it becomes more expensive) thus reducing the effects of second hand smoking or reducing the negative externality associated with smoking.

b) At a price P1, consumers choose to consume Q1. We equate Marginal Private Benefit to Marginal Private Costs.

Accounting for the externality, we get the marginal social cost (MSC) curve which is higher than the MPC curve. At a higher price P2 > P1 consumers should decrease their optimal quantity to Q2 which is lesser than initial quantity of cigarettes Q1.

The market is not efficient if government intervention takes place because MSC > MPC which means there is overproduction of the good causing the negative externality. The triangle shows the loss in welfare from this externality.

DAT PAG MPB ラ0