Pigovian Taxes and Cigarettes

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Q 1. Cigarettes are often cited in economics texts as an example of a particular type of market failure. Identify that market failure, and illustrate the failure using an appropriate diagram. Ans. Cigarettes represents a market failure of externatilities. They are sited as negative externality as they affect the wellbeing of the bystander and the person neither pays nor receives any compensation for that negative effect. A smoker enjoys the puff of the smoke and the bystander inhales the fumes of the cigarette and indirectly suffers health hazards. And if the bystander fells sick because of the smoke as one reason he will not be compensated by the smoker for the ill- health and therefore, smoking has a negative impact on a person who has not paid for the cigarette and still has suffered a loss. This reduces the MSB by the extent of the negative effect on bystander; hence the socially efficient smoking is less than the free market level of smoking. A Negative Externality in Consumption can be analyzed by a decrease in the marginal social benefit of consumption below the marginal benefit to consumers. (If a smoker benefits $8.20 and non-smokers lose $4.00, then society as a whole benefits $4.20)

S = MC
D = MB

0
5,000
10,000
15,000
E

Price of a pack of cigarettes
Quantity of cigarettes
$14
12
10
8
6
4
2
MSB

MSB curve shifts downward by the amount of the externality --- the marginal external effect

Q 2. Many economists believe that a Pigovian tax is the most efficient mechanism for offsetting this market failure. Explain what is meant by the term ‘Pigovian tax’ and contrast the effectiveness of such a tax with a command and control approach to market failures. Ans. Pigovian tax is levied to correct the negative externalities of a market activity. Pigovian tax:-

1. cause consumers and firms to internalize the externalities associated with production and consumption
2. The tax or subsidy would be equal to the dollar amount of the...
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