Suppose that demand for a cigarettes (in millions of cartons) is given by Q=20 - ½ *P. Supply of cigarettes is given by Q=P.

Suppose that demand for a cigarettes (in millions of cartons) is given by Q=20 - ½ *P. Supply of cigarettes is given by Q=P. There is a negative consumption externality from cigarettes, in the amount of $2 per box.

a. Draw the market for cigarettes, labeling the private marginal cost (PMC), social marginal cost (SMC), private marginal benefit (PMB) and social marginal benefit (SMB).

b. What quantity of the good is consumed under the private market equilibrium?

c. What is the socially optimal level of consumption of the good?

d. Indicate the deadweight loss from this externality on your graph from part (a) and explain what it is.

Solutions

Expert Solution

Given Q = 20 - 1/2P , Q = P, Consumption externality of $2 per box

In private market equilibrium PMB = PMC

20 - 1/2 P = P

3/2 P = 20

P = 40/3

Since Q = P

Q = 40/3

Externality is of 2 per box, new demand function [SMB] becomes

P = 40 - 2Q - 2

P = 38 - 2Q

In equilibrium

38 - 2Q = Q

3Q = 38

Q = 38/3 is socially optimal consumption

Area abc is dead weight loss. This is misuse of resources in private market equilibrium

Rahul Sunny answered 1 year ago

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