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Market Failure and Externalities Analysis

Updated on July 2, 2013

Smokers Hit By 37p Cigarette Pack Rise

Source of article: Financial Times

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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.


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