Question

Question 1: We are dealing with the market for tobacco. Tobacco use is known to cause several diseases. It is also known to be highly addictive.

a) Draw a graph for the tobacco market using supply and demand curves. Find the equilibrium. Label the consumer surplus and the producer surplus. (Tip: Keep in mind that tobacco is extremely addictive. What would this imply for the demand curve?)

b) Tobacco use is one of the traditional examples of negative externalities. Can you show the most efficient allocation in this market through graphing?

c) Why is the allocation you showed above is the most efficient outcome? Explain by labeling the total surplus in both cases using two different graphs. Label the additional surplus we get with the efficient allocation, compared to the market allocation.  

Question 2: We continue dealing with the market in the first question.

d) One of the policy decisions we discussed in class to correct for these types of market failures is taxing. Now assume the government decided to correct the market above through taxing buyers of tobacco. Can you show how such a tax could correct for the market failure above and help us reach the optimum allocation?

e) Even though the tax is on the b-=paying the most?

f) Would you advise the government to use this policy? Is there a deadweight loss due to this tax? Is there a welfare gain? Show. (Tip: You actually graphed this somewhere above.)

Answer 1

Ans 1) We're dealing with the tobacco market. And the use of tobacco is known to cause various kinds of diseases. And therefore, it's also known to be highly addictive.

Ans (a) Consider a Diagram drawn below in order to find out the demand and supply curves for the tobacco market and to determine what would be then Consumer Surplus and Producer Surplus for the Tobacco market.

While determining Consumer Surplus for the Tobacco market, we'll consider the case of Negative Externalities in Consumption. And as and whenever Tobacco is considered to be harmful for any third party which doesn't even purchase or sell tobacco, this is considered as negative externalities in consumption. Now, observe the diagram above, Q(Eq-bm) is the quantity of tobacco which is assumed to be consumed in a free market, at a situation where Marginal Social Costs of Tobacco exceeds its Marginal Social Benefits. And high and most of the quantity of tobacco is being produced as well as consumed at this point of equilibrium, Q(Eq-bm), and hence this leads to the loss of the total welfare of the economy (which is shown equal to slanting-lined-triangle in the above diagram). At this point, resources are observed over-allocated towards the production and consumption of tobacco by a free market. And hence, this is a case of Market Failure as well.

Also, consider a case of Negative Externalities in Production. Let's now consider a Diagram-2 for the understanding of this particular case as well.

Negative externalities in production also tend to cause an increase in Marginal Social Cost than Marginal Private Cost (in layman language, we can say that MSC exceeds MPC). At point of Equilibrium, the level of output, Qeq-bm, produced and delivered to sell by a free market is allocatively inefficient. And in this second diagram, we assumed for the time that there are no negative externalities arising out from consumption.

Ans (b) Tobacco is one of the known traditional examples of negative externalities. The most efficient allocation in the Tobacco Market is shown labelled as points A, C and F of Pareto Efficiency. (For better understanding, see Diagram-3 pasted below)

Ans (c) The allocation I showed above are the most efficient outcomes as here in this case, we observed Pareto Efficiency, which further implies that resources are allocated in a very judicious/wise manner (thereby, one can also prefer it to as resources are used/utilised in the most economically efficient way). But it doesn't mean equality or fairness in any sense. And the economy is always meant to be in a Pareto Optimum State only and when any occurrence of economic changes would make one individual better off whereas, by making at least one another person worse off in the economy.

The most efficient allocation outcomes in the Tobacco market are shown as points A, C and F, where the productive inputs aren't feasibly re-allocated in a way such that the output of one product rises while the output of all other goods either would rise or remains the same. (Context of Pareto Efficiency in allocation of the resources)

Ans 2)

Ans (d) Yes, imposition of taxes (another form of Government intervention in the market) can help correcting Market Failures and help us reach the optimum/efficient allocation state. (as shown in Diagram-4)

Ans (e) Yes, imposition of taxes by the Government intervention in the market shifts the supply curve leftwards as well as increasing the price of the tobacco in the market. And causing the use of tobbaco more costly in the economy.

Ans (f) Yes, there would be deadweight loss in the Tobacco Market after taxes being imposed by the Government in that particular Market. This is also known as the situation of excess burden in the market. (Shown in Diagram 4) It is the implicit loss that is directly linked with the imposition of taxes by the Government and that deadweight loss, as we can see in the diagram as well, is the large amount of loss that is paid above the amount of taxes to the Government. It's another way in which the Government prefers to generate greater amount of revenues. Government should stop industries/markets to produce such harmful products and should ban its use for the non-productive uses in the society which further results in the loss of total welfare in the economy.