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.  

Answer 1

SOLUTION:-

a) The market for tobacco can be represented by the simple demand and supply curve. Here it is mentioned that tobacco is highly addictive it means that people cant easily decrease the consumption of tobacco even if the price increases. So th demand curve will be less elastic which will be drawn steeper. This shown in the first part of the figure below.

b) Since tobacco use causes negative externality. This means that here in case of consumption of tobacco the Marginal private cost (MPC) is lower than the Marginal social cost (MSC). So in order to reach the efficient allocation we need to take into account the MSC. This is shown in the second part of the above graph.

c) The new allocation at price = P3 and quantity = Q1, showed above is most efficient outcome because this also takes into consieation the marginal external cost shown in the graph, So since the MSC or the external cost is also included so the externality is removed or compensated.

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