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

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 -

The shaded region represents the tax which will be imposed to ivade the welfare loss.