Microeconomics Coursework - Minimum wage

        P1

        

        P2

        

                        

                

        Q1    Q2

                Quantity of tobacco (hundreds of tonnes)

MSB is the marginal social benefit (social demand). It is the demand curve showing social demand for tobacco. MPB is the marginal private benefit (individual demand). The vertical distance between the two demand curves is the negative externality, i.e. P3-P2. When MSB = MPB, there is no market failure as the good is not being overproduced anymore. Therefore to decrease the negative externality, it must be incorporated into the price, thus decreasing the quantity demanded to equal the MSB equilibrium quantity (Q1).

Tobacco is thus a demerit good. It is not only supplied in the form of cigarettes but also in the form of tobacco pouches that can be used in roll-up cigarettes. Consumers are switching from cigarettes to roll-ups because the tax on tobacco pouches is less than that on cigarettes.

        The UK government has levied an average tax of 75 – 90% on a packet of cigarettes whereas the tax on roll-up tobacco is ‘just below 70 percent’. One solution to reduce the consumption of tobacco is to increase the tax on tobacco as a whole instead of on cigarettes or tobacco pouches. The supply will therefore shift to the left. This is shown in the diagram below.

Market for tobacco

        S2

        D                

        S1

 

P1

P2

P3

        

        Q2    Q1

         Quantity of tobacco (thousands of tones)

Because the tax is an ad-valorem tax, supply will be steeper because as the price increases, the tax also increases. The vertical difference between the curves at any point will be the tax at that price on the original supply curve (S1). At the original price P3, the tax charged is P1-P3. Consumers pay only £P1-P2 (striped region) and the remaining tax (£P2-P3-checked region) is paid by the firm. This causes the price to rise, which causes a movement along the demand curve. Therefore the total quantity consumed is reduced.

This method of levying an indirect tax has several advantages and disadvantages. The external cost is hard to calculate and therefore deciding on a value for the tax is difficult. However, studying the effects of taxes levied on cigarette packets may allow an estimate to be made. Taxation has an added advantage of raising revenue for the government to fund its expenditure. This increase in price may also cause black markets to emerge, as taxes in other countries are lower. The government would therefore have to control the sale of tobacco strictly.

        Taxation itself would not be effective enough. Other measures like legislation against smoking in public places and advertising against tobacco would aid in decreasing demand. During the recession, people already have an incentive to quit smoking because of rising prices and with this little push the consumption of tobacco could be greatly reduced.

        This theory of negative externalities is directly relevant to the issue of tobacco consumption. However, there are certain drawbacks. The market diagrams for these will be extremely hard to construct. Data will need to be collected from a great number of people for the demand curve to be accurately drawn. Also, this theory assumes all other factors that affect demand and supply to be constant. The negative externality, in many cases, is not possible to quantify. Therefore it is not possible to accurately calculate by how much the demand would need to be decreased by. It is, however, useful to have this theory applied because it does tell us that demand needs to be decreased, though extremely roughly. Therefore, it is crucial to look at the matter from an economic perspective to gain insight as to how to move forward to solve these issues.

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