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 demand decreases, therefore the consumption of cigarettes will decrease, effectively then reducing the negative externalities from the consumption of the cigarettes.
Therefore, what this does to the market failure is that it shifts the MPC and MSC curve to the left until it intersects the MPB curve at the socially optimal quantity of Q*. Therefore, now when the consumers consume where their MPB = MSB since the price increased from P1 to P2, the quantity being consumed now is Q*. As a result, the socially optimal level is now achieved and the market failure is removed.
The advantages of using this policy as a solution to the overconsumption of cigarettes are that not only does it remove the market failure and get rid of the negative externalities caused by the overconsumption, but it can also raise significant revenue for the government. Additionally, another possible outcome is the substantial revenue the government makes by implementing this tax. As seen in Diagram 1 above, area (P1, x, a, C) represents the revenue the government makes from this tax. Furthermore, the price elasticity of demand for cigarettes is below 1, meaning it is relatively inelastic. What this means is that an increase in price causes a decrease in demand less in proportion, which is why the tax makes good revenue for the government. Since the increase in price causes a very small reduction in the consumption of cigarettes, therefore the government makes a lot of revenue from this tax. Every state in the United States that has implemented this cigarette tax has enjoyed substantial increases in revenue, even while reducing smoking.
However, some disadvantages and some unintended consequences of using this policy is that it has a regressive nature and its effectiveness can be limited. There is opposition by the consumers of cigarettes who feel that they are too addicted to quit smoking, as a result, the increase in prices is making it even more difficult for them and decreases their real income substantially. They feel they are being harmed significantly due to the huge increase in the cigarette tax, however, it affects the poor disproportionately. Additionally, the tax on cigarettes unproportionally affects the poor. The rich and poor pay the same amount of tax, yet it is a much larger share of the income for the poor people, therefore they suffer much more and they are disproportionately affected. Those same cigarette taxes are an entirely different animal for poor people, partly as a result, poor New Yorkers spend close to a quarter of their income (23.6%) on tobacco. Therefore an indirect tax on tobacco will severely damage the minorities however not damage the rich and make it even more difficult for minorities to feed their families since they will be paying even a larger proportion of their income on cigarettes. Another unintended consequence is that the producer revenue will decrease. Their original revenue was Pe *Qe, but their new revenue is C *Q1 which is much less. Therefore, the employees in the industry will decrease since the tax will shrink the size of the industry. Therefore, this will increase unemployment.
Another thing to evaluate is the short term vs. long term effects of this policy. Cigarettes are very inelastic, therefore the demand is very unresponsive to changes in price. As a result, in the short term, the effects might not be felt significantly as cigarettes are addictive and price inelastic. However, in the long-term, it could have more significant effects as people could have had time to change their habits and therefore are more responsive to the change in price.
The legislation is the process in which a government makes laws to prohibit certain things and regulation is the act of enforcement of the law. This is used to stop the consumption of demerit goods as a government can set a minimum age of consumption and even outlaw consumption in certain areas. Alternatively, the government can simply ban the product altogether which stops consumption entirely.
To continue on with the example of cigarettes. Many countries around the world have placed legislation on cigarettes. For example, in 2019 the United States passed the “Tobacco 21 Laws” which raised the legal age to consume tobacco products from 18 to 21. This is very common across the world, with not only cigarettes but other demerit goods, to have a legal age of consuming the product. Similarly, in Canada, the consumption of cigarettes is banned in indoor public spaces, public transport areas, and the workplace. This includes restaurants, bars, and casinos.
Through legislation, the MPB curve would shift inwards as demand would decrease. This shifts the MPB curve to MPB+Legislation and shifts the quantity demanded from Q1 to Q2 and the price from P1 to P2. Through reducing the quantity consumed, the welfare loss triangle falls from triangle abc to triangle cde. This means that the quantity of the product consumed is closer to the socially optimal level.
The advantage of legislation is that it is an effective way for a government to lower consumption without using revenue. However, some disadvantages are that producer revenue falls and utility of consumer use falls as well due to it being harder to consume. Through legislation, the people worse off are the producers, consumers, and workers. Consumers are worse off as they are able to consume the product less and in fewer places. Producers are worse off as legislation will lower the demand which in turn lowers the producer’s revenue. Finally, workers are worse off as with less demand there will be less need for workers in that industry. Taxpayers and the government are not affected directly by legislation, however, taxpayers may be better off as they are not paying extra taxes and the government hasn’t used any revenue to combat the problem. In addition, the government may be better off from a political view.
In the short run, a producer may make less money from selling the product. In the long run, the nation will have healthier youth which is much more socially optimal. To continue, people may stop consuming the good as it is harder to do so. However, in the long run, the emergence of black market selling places may emerge to counter the legislation.
Some unintended consequences of legislation are as stated before the emergence of a parallel, or black, market. This will continue to sell the goods to everyone without the effects of the legislation which in turn moves the MPB curve away from the socially optimal point. In addition, legislation can also make the consumer switch to a good that’s even worse from a socially optimal view. For example, if legislation is placed on cigarettes, consumers may just switch to a hard drug instead which is worse than the consumption of cigarettes.
An educational campaign is used to showcase the negative effects when consuming a good. This can be done with things such as advertising and teaching. This would shift the MPB closer to the MSB as fewer consumers would use the product due to now being aware of its negative effects.
This can be seen in real life as many countries around the world showcase the negative effects of cigarettes. This is seen when the food and drug administration (FDA) in the US made videos explaining the negative effects the chemicals in cigarettes have when smoking them. This can also be seen as many countries around the world also require schools to teach students about the negative effects of cigarettes in health programs.
Through education about the negative effects, the MPB curve shifts inwards as demand decreases. This shifts the MPB curve to MPB+Education and shifts the quantity demanded from Q1 to Q2 and the price from P1 to P2, the same way legislation does. Through reducing the quantity consumed, the welfare loss triangle falls from triangle abc to triangle cde. This means that the quantity of the product consumed is closer to the socially optimal level. The graph is very similar to that of legislation as they are both decreasing demand to make it closer to the socially optimal point.
The advantage of education is that it is an effective way of informing consumers of the negative effects of the good, shifting the MPB curve closer to MSB. However, the disadvantages of the campaign largely outweigh the advantages. To begin, it is very similar to legislation as producers and workers are both worse off with a decrease in demand as there are fewer jobs and producer revenue decreases. Governments also have an opportunity cost as they are spending a large amount of revenue to educate the public when something else can be done with the money. Finally, taxpayers are also worse off as they may have to pay more in taxes to fund these types of programs.
Through education in the short run, the public will be more aware of the negative effects of the good which helps stop the consumption of the good. This is similar to the long run as more people would have been aware and spread the word of the negative effects making the demand less in the future. These would both shift the MPB to be closer to the MSB.
An unintended consequence of educating the public about the negative effects of consumption is that in fact, more people may try the product that wasn’t aware of the product in the first place. This shifts the MPB further away from the socially optimal point of MSB.
Even another possible policy the government could implement to reduce the market failure and negative externalities associated with cigarettes and their negative externalities of consumption is to implement consumer nudges. Nudge theory suggests consumer behavior can be influenced by small suggestions and positive reinforcements. Proponents of nudge theory suggest that well-placed 'nudges' can reduce market failure, save the government money, encourage desirable actions, and help increase the efficiency of resource use. As seen above, there is an overconsumption of cigarettes and an overallocation of resources in the market to cigarettes as it causes negative externalities, therefore, a market failure is created.
But, consumer nudges can help correct this market failure! A major reason why cigarettes are overconsumed is due to imperfect information about their potential harms. Consumers are also subject to peer pressure and enjoy conforming to things that appear to be enjoyed by others in society, which is also another reason for the overconsumption of cigarettes. However, consumer nudges can help decrease the demand for this product, essentially then reducing market failure.
Building on the example of cigarettes, if you consume them, it provides internal harms for you, but more importantly, also provides negative effects to society and to third parties through second-hand smoking. As a result, laws have been put into place requiring cigarette packs to be a plain dull color with graphic images showing the dangers of smoking. This is designed to nudge consumers to choose differently.
This essentially shifts the MPB curve to the left, closer to the MSB curve as it will be consumed less.
Further, as seen in the graph, shifting the MPB curve to the left (decreasing demand) through the use of consumer nudges significantly reduces the welfare loss of triangle abc and now the quantity of the good being consumed is much, much closer to the socially optimal level of Q*. The overallocation of resources has significantly reduced from (Q1 - Q*) to (Q2 - Q*). This shows how consumer nudges could be used to reduce or to correct market failure in the situation of demerit goods that create a market failure of negative externalities of consumption.
The advantages to such a solution are that it needs very minimal government spending and does not affect consumers negatively. It can significantly change consumer behavior without regressively affecting the poor, and without any opportunity cost or government spending. Consumer nudges have proven to have worked and there is a very minimal amount of resources or money that need to be used by the government to make this work. It is a simple, easy, and efficient way to reduce market failure as seen above.
However, some disadvantages is that it does not raise any government revenue like how the indirect tax does. Additionally, its actual effect could be debated as people who are really addicted to cigarettes and have been consuming it for years and are really addicted won’t stop because of small things like consumer nudges. While consumer nudges could have effects and could reduce the market failure associated with the overconsumption of cigarettes (negative externalities of consumption), it might take a very, very long time to see any changes in consumer behavior.
In conclusion, from a government and health, taxes are the most effective in just reducing the negative externality However, it could have several negative effects on the consumers and producers. Consumer nudges, on the other hand, do not negatively affect the consumers as severely, yet they are not as effective in reducing the negative externality, and effects are only seen in the long term.