Question

In a restaurant that allows smoking, your consumption of cigarettes may have a negative effect on my enjoyment of a restaurant meal. Yet you do not in any way pay for this negative effect on me.

a. (5 points) From this information, decide on the type of externality your consumption creates in the market for cigarettes. Explain in detail, using words and an appropriate graph, the nature of the externality.

b. (5 points) In your graph denote the magnitude of the excess burden (deadweight loss) arising from this externality.

c. (5 points) Now assuming that this externality is the pre-existing distortion in the market, there is an additional tax imposed on the buyers of cigarettes. What do you expect would happen to the excess burden (deadweight loss) of this tax? Describe in words how the graph would alter with the tax and draw a new graph to show the effect on the excess burden (deadweight loss).

d. (5 points) Discuss if the theory of second best holds in this case.

Answer 1

a)

Negative externality of consumption When the consumption of an individual affects the health of those who are not compensated by the consumer.

This is an example of a negative consumption externality, whereby consumption of a good reduces the well -being of others, a loss for which they are not compensated. When there is a negative consumption externality, SMB ! PMB " MD, where MD is the marginal damage done to others by your consumption of that unit. For example, if MD is 40¢ a pack, the marginal damage done to others by your smoking is 40¢ for every pack you smoke.

In Figure shows supply and demand in the market for cigarettes. The supply and demand curves represent the PMC and PMB. The private equilibrium is at point A, where supply (PMC) equals demand (PMB), with cigarette consumption of Q1 and price of P1 . The SMC equals the PMC because there are no externalities associated with the production of cigarettes in this example. Note, however, that the SMB is now below the PMB by 40¢ per pack; every pack consumed has a social benefit that is 40¢ below its private benefit. That is, at Q1 units of production (point A), the social marginal benefit is the private marginal benefit at that point (which is equal to P1 ), minus 40¢ (point B). For each pack of cigarettes, social benefits are 40¢ lower than private benefits, since each pack consumed imposes 40¢ of costs on others for which they are not compensated.

b) in same figure ,

Market Failure Due to Negative Consumption Externalities in the Cigarette Market • A negative consumption externality of 40¢ per pack of cigarettes consumed leads to a social marginal benefit that is below the private marginal benefit, and a social optimum quantity (Q2) that is lower than the competitive market equilibrium quantity (Q1). There is overconsumption Q1 " Q2, with an associated deadweight loss of area ACB. The social -welfare -maximizing level of consumption, Q2 , is identified by point C, the point at which SMB ! SMC. There is overconsumption of cigarettes by Q1 " Q2 : the social costs (point A on the SMC curve) exceed social benefits (on the SMB curve) for all units between Q1 and Q2 . As a result, there is a deadweight loss (area ACB) in the market for cigarettes.

c)   Negative externality taxes aim to make consumers / producers pay the full social cost of the good. This decreases consumption and produces a result which is more socially efficient. If a good has a negative externality, without a tax, there will be over-consumption (Q1 where D=S) because people ignore the external costs.

A tax should be placed on the good equal to the external marginal cost. It means that consumers will end up paying the full social marginal cost. In figure p0 is the new price after imposing tax. After the tax is implemented, the output of the good will fall from Q1 to Q2. Q2 is socially efficient because at this level the social marginal benefit (SMB) = Social marginal cost (SMC). The restaurant might seek to tax the good with negative externalities to achieve a more socially productive outcome. That means consumers are paying close the full social expense. If demand is inelastic, then higher taxes will not reduce demand much. Taxes will cause inequality. A tax on cigarettes takes a higher percentage of income from those on low-income.

d) Tax on Negative Externality. Negative externality taxes aim to make consumers / producers pay     the full social cost of the good. ... If a good has a negative externality without a levy, overconsumption can occur (Q1 where D = S) as people disregard the external costs. If goods or services have negative externalities, then we will get market failure. This is because individuals fail to take into account the costs to other people. So I think theory of second best hold in case. The Government might seek to tax the good with negative externalities to achieve a more socially productive outcome. That means consumers are paying close the full social expense.