Question

Suppose the government has some fixed budget for drug enforcement, please use the example to explain what is the market failure being addressed? (Hint: externalities, paternalism, etc)

Answer 1

Consumption of drugs give rise to an external cost, which reduces private marginal benefit (PMB) by the amount of this external cost, to social marginal benefit (SMB). As a result, socially efficient output will be less than unregulated market output.

In following graph, market outcome is at point A where PMB intersects private marginal cost (PMC) with market price P0 and market output Q0. The negative externality associated with drug consumption shifts PMB leftward to SMB, which intersects PMC at point B with efficient price P1 (lower than P0) and efficient output Q1 (lower than Q0). Unless this externality is internalized, a socially inefficiency loss equal to area of triangle ABC arises. However, government can impose a Pigouvian tax on consumption, equal to vertical distance AE, to internalize this externality.