Question

1. The marginal cost of producing a pack of cigarettes is $5. The external costs of smoking total $2 per pack. A smoker damages her health by the equivalent of $3 per pack of cigarettes she smokes. Market demand for packs of cigarettes is given by Q = 20 − P , and the market for cigarettes is perfectly competitive.

(a) Walter is a smoker who is willing to pay $6 for a pack. Is it privately efficient for Walter to buy a pack of cigarettes?

(b) Is it socially efficient for Walter to buy a pack of cigarettes?

(c) Draw supply and demand curves for packs of cigarettes and find the market equilibrium price and quantity.

(d) Draw the marginal social cost curve.

(e) Find the socially optimal quantity of cigarettes.

(f) Find the optimal Pigouvian tax on packs of cigarettes.

(g) On your diagram, shade the deadweight loss society bears under the market outcome.

Answer 1

A) in private eqm,

Marginal External Costs ( MEC) & Marginal External damages ( MED) of smoking are ignored

So then Price of cigarette = $ 5

& Willingness to pay = $ 6

Thus as Price < WTP, so it's efficient to buy the pack

.

B) now in social efficient eqm

Price per pack will also include MEC & MED

So socially efficient price = 5+2+3 = $ 10

So as now socially efficient price > WTP

so it's not efficient to buy

.

c) graph

D) MSC curve : P = 10

E) now at socially efficient eqm

P = 10

Qs = 20-10 = 10

.

f) optimal pigouvian tax = ( MEC+ MED ), at socially efficient eqm

so t= $ 5 per pack

g) deadweight loss