Question

Taxation of cigarettes is often justified on the grounds that cigarette smoking creates externalities. What is meant by the term “externalities” in this context?

Give two examples of externalities created by cigarette smoking and explain how a tax on cigarettes could potentially address both of these.

Using a fully labelled and explained diagram explain how a tax can increase efficiency in the cigarette market. What size tax should be levied to maximise efficiency in this market? (Indicate the efficient tax size on your diagram – no actual number required).

Answer 1

Answer - The term externality means the impact a certain activity has upon the third party. This can be the person , group of persons or the society as a whole. The smoking of cigarette also imposes an externality called "negative externality" which means that it posses the negative impact upon the third party. The externality are -

1 - The party in close contact with the smoker is the victim of passive smoking and he has the chance of gaining lung problems due to passive smoking.

2 - The smoke from the cigarette is also released into the environment causing bad quality of air.

This may be reduced by imposing the tax upon the supply so as to reduce the market output to the efficient level. This will ultimately lead to fall in supply and rise in price. This can be shown in graph as follows -