ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

Market Failure and Externalities Analysis

Updated on July 2, 2013

Smokers Hit By 37p Cigarette Pack Rise

Source of article: Financial Times

Article can be found at: http://www.ft.com/intl/cms/s/0/8fdeb3ec-7359-11e1-9014-00144feab49a.html#axzz1tCyNaRzB

In the real world, markets are not perfect; they are unable to efficiently allocate resources in a socially optimal way, i.e., in such a manner that an optimal mix of products get supplied to the consumers at the market-determined price point. An allocatively efficient market has to ensure that resources are allocated in the best way possible from the overall society’s perspective. In such a market, the ‘community surplus’, which is the sum total of producer and consumer surpluses is maximised. It represents the total benefit to the society. The economy reaches ‘Pareto Optimal’, which implies that ‘no one can be made better off without someone else being worse off.’ When the market however ceases to be allocatively efficient, community surplus is not maximised and market failure occurs, leading to government intervention.

Market failures occur due to many reasons such as shortage of public goods, under-supply of merit goods, over-supply of demerit goods and existence of externalities. (Blink, Dorton 141). In the instant case, a market failure has taken place because of over-supply of cigarettes, which is a demerit good, being ‘bad both for people who consume them and for the society as a whole.’ These goods are ‘overprovided by the market’ and therefore ‘over-consumed’. (Blink, Dorton 141). Further, production and consumption of cigarettes causes ‘negative externalities’ as third parties are put to harm. Besides air pollution in general, non-smokers suffer health issues, which poses an external cost. The total cost to the society is therefore more than the private cost to the consumer or producer. The government steps in to tax the good in such a way that the society’ total cost is reflected in the pricing of that good.

To understand the situation in case of cigarettes on which the UK government has imposed higher tax burden, let’s look at the graph below.

In diagram 1.1, at the price point of £ 7.09 per packet of cigarette, Q1 quantity is supplied and consumed. The negative externalities of consumption make the marginal social benefit (MSB) in this case less than the marginal private benefit (MPB). MSB is the aggregate of the incremental benefits that accrue to the private consumer and the society as a whole. MPB is the incremental benefit enjoyed by individuals. Smokers enjoy private benefits, but this creates external costs for other people in terms of discomfort and diseases, which could even be fatal such as lung cancer and bronchial illnesses.

At the prevailing price, smokers over-consume cigarettes with demand pegged at Q1. Given the negative externality, the community surplus is not at its maximum. The socially efficient level of output, at which the MSB equals to MSC, is at Q* with price point at P*. Since Marginal Social Cost (MSC), comprising the cost of production plus the cost to society due to the negative externality, is greater than MSB, there is a welfare loss, shown by the shaded area. The society fails to achieve the maximum utility and a market failure occurs.

As there is a market failure, the government can rectify the same by imposing a higher tax on cigarettes so that the external cost is passed on to the producers in part or full, thereby either reducing the ‘deadweight burden’ or eliminating it. In the latter case, the government would have ‘internalised the externality.’ In UK, George Osborne, Chancellor announced “ An increase to the tobacco duty escalator - the formula used to tax tobacco by 5% above inflation each year - up from 2%”. The government imposed an indirect tax on cigarettes, which raised the price from £7.09 to £7.47.

In diagram 1.2, imposing indirect taxes will shift the MSC curve upwards to MSC + Tax. This will reduce consumption to the socially efficient level of output at Q*, but the price to the consumers will be £7.47. According to the Chancellor ‘there was clear evidence that tobacco price rise helped cut national smoking rates’. This can generate to the government additional amounts of tax revenue, which can be used for correcting negative externalities of smoking.

However, we know that cigarettes are addictive goods. Price increase will help the government to raise higher tax revenue, but it might not decrease the demand proportionately as the cigarettes are price inelastic. Consumers may still like to buy them and therefore the decline in demand would be less than proportionate to the price hike due to the additional tax.

Governments can use the additional tax revenues of £ 260 million over the next five years to educate and advertise the dangers of smoking to reduce the negative externality as well as to meet health costs, thereby pushing the overall ‘community surplus’ towards its maximum.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://hubpages.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)