Using real-world examples, evaluate policies that could be used by the government to reduce the market failure associated with negative externalities of consumption.

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Using real-world examples, evaluate policies that could be used by the government to reduce the market failure associated with Negative externalities of consumption [15 marks]

Market failure occurs when resources in a market are allocated inefficiently. It is the economic situation defined by an inefficient distribution of goods and services in the free market. In market failure, the individual incentives for rational behavior do not lead to rational outcomes for the group. Negative externalities of consumption is a type of market failure in which the good being consumed results in negative effects and externalities on third parties. However, such goods are also called demerit goods, and these goods are overconsumed and therefore represent a market failure of negative externalities of consumption. These are goods that are harmful to consumers themselves and also result in consequences for third parties as well. However, these demerit goods are usually overproduced and over consumed, a reason for this could be due to “imperfect information” in which the consumer does not know the risk that the goods could have on themselves and on third parties.

A perfect real-world example regarding negative externalities of consumption is cigarettes, these are goods that are overconsumed, and when they are consumed have negative effects on third parties, like second-hand smoking. According to Euromonitor’s estimation in 2019, it was estimated that 5.5 trillion cigarettes were consumed worldwide. Global consumption of cigarettes has increased rapidly since 1900. In 1920, 300 billion cigarettes were consumed. This shows how cigarettes are being overconsumed, and by being overconsumed, it can significantly harm society through increased medical costs and second-hand smoking.

As shown in the diagram, originally the market was producing at the market optimum (where MPB = MSC), which is at P1, and producing a quantity of Q1. However, the socially optimal quantity is at Q*. However, the quantity being consumed in the free market is Q1, which is significantly larger than Q*, therefore the good is being overconsumed and there is an overallocation of resources occurring, therefore resulting in a market failure. The overallocation of resources is (Q1 - Q*). As a result, a negative externality of ab occurs, in which it represents the negative effects the product could have on third parties, like second-hand smoking. Additionally, it creates a welfare loss of triangle abc since MSC > MSB, which represents the loss to society due to the overconsumption of this good. In conclusion, since in this situation the MPB > MSB, the good is being over-consumed as the consumers do not realize the harm this good creates for themselves and third parties.

As a result, governments must intervene in this market and correct this market failure as if it were to let the market continue to operate in such ways, it could cost the government billions and kill thousands more of its population. Therefore, there are a variety of policies the government could implement as solutions to this growing problem of negative externalities of consumption from cigarettes. The policies that can be implemented by the government as the solution to this market failure are indirect taxes, legislation and regulation, education and negative awareness campaigns, and consumer nudges.

The first possible policy the government could implement is an excise tax, which would be an indirect tax on cigarettes. A per unit tax, or specific tax, is a tax that is defined as a fixed amount for each unit of a good or service sold, such as cents per kilogram. It is thus proportional to the particular quantity of a product sold, regardless of its price. Excise taxes, for instance, fall into this tax category. What is being evaluated is the possible outcome of imposing such a tax on cigarettes. The federal tax in the United States remains at $1.010 per pack

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As seen in diagram 1, originally the cigarette market was at equilibrium at (Pe, Qe). However, an indirect tax of (x,y) was imposed, therefore causing the supply curve to shift inwards by a value of (x,y). Therefore, at the original equilibrium, there is excess demand, so the price increases until the market clear again at (P1, Q1). This is now the new market equilibrium, and the price of the cigarettes being sold increases from Pe to P1. As a result, this increases in the price of the cigarettes, and according to the law of demand, if price increases, then ...

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