Question

2. Assume the market for cigarettes is perfect competition with ordinary demand and supply curves. Assume there are no production externalities, but there are substantial negative consumption externalities, including a variety of lethal diseases and a general threat to health for both smokers and people exposed to second-hand smoke.

A. Show the market in equilibrium in a graph, explain why this is not the socially optimal equilibrium.

B. Show the optimal equilibrium and identify any efficiency gains relative to the equilibrium on part A (use a separate diagram).

C. Either of these policies would help: 1) a unit tax placed on the production of cigarettes, 2) a unit tax placed on the consumption of cigarettes. Show how these policies would help, and argue why one is better, or why they are the equivalent.

Answer 1

A)

Negative consumption externalities are harmful impacts on third party. In such case, consumer tends to overconsume and produce negative impact on others.

following is diagram:

In above diagram, optimal consumption is Q while consumer is consuming at Q 1 which is overconsumption.

B)

Following is optimal consumption:

In above diagram: Q* optimal level of cosumption.

shaded area is gain

C)

Cigarettes create negative consumption externalities. Hence, its consumption should be taxed. Tax on consumption would deter more consumption of cigarettes which would drag down its consumption to optimal level.