Q 1. Cigarettes are often cited in economics texts as an example of a particular type of market failure. Identify that market failure, and illustrate the failure using an appropriate diagram.
Ans. Cigarettes represents a market failure of externatilities. They are sited as negative externality as they affect the wellbeing of the bystander and the person neither pays nor receives any compensation for that negative effect.
A smoker enjoys the puff of the smoke and the bystander inhales the fumes of the cigarette and indirectly suffers health hazards. And if the bystander fells sick because of the smoke as one reason he will not be compensated by the smoker for the ill- health and therefore, smoking has a negative impact on a person who has not paid for the cigarette and still has suffered a loss. This reduces the MSB by the extent of the negative effect on bystander; hence the socially efficient smoking is less than the free market level of smoking.
A Negative Externality in Consumption can be analyzed by a decrease in the marginal social benefit of consumption below the marginal benefit to consumers. (If a smoker benefits $8.20 and non-smokers lose $4.00, then society as a whole benefits $4.20)

S = MC
D = MB

0
5,000
10,000
15,000
E

Price of a pack of cigarettes
Quantity of cigarettes
$14
12
10
8
6
4
2
MSB

MSB curve shifts downward by the amount of the externality --- the marginal external effect

Q 2. Many economists believe that a Pigovian tax is the most efficient mechanism for offsetting this market failure. Explain what is meant by the term ‘Pigovian tax’ and contrast the effectiveness of such a tax with a command and control approach to market failures.
Ans. Pigovian tax is levied to correct the negative externalities of a market activity.
Pigovian tax:- 1. cause consumers and firms to internalize the externalities associated with production and consumption 2. The tax or subsidy would be equal to the dollar amount of the externality.
Compared to the command and control approach to pollution control, the tradable emissions allowance system is more efficient, because firms with low costs of pollution control would pollute the least and sell their extra permits to other firms with higher costs of pollution control.
Command and control approaches are based on the uniform reductions i.e. a set of amount of reduction of pollution by all the firms despite the size and amount of pollution produced. This is ineffective in targeting firms producing high pollution as it does not consider the cost in reducing the pollution for each firm. Often, the firm which must undertake high reductions are those who can do it with ease as compared to other firms, by this the pollution is reduced at a lesser overall cost.
Pigovian taxes are levied on firms for every unit of pollution. The firms which would opt for the tax will be the ones who find it more expensive to reduce the pollution. All other firms will make policies to reduce their pollution, which would be cheaper than paying the tax. Total surplus is maximal (optimal) when marginal social benefit equals marginal cost. A Pigovian tax on consumers lowers their marginal benefit to equal MSB, and so equilibrium quantity is optimal.

S = MC
D = MB

0
5,000
10,000
15,000

Buyers’ price of a pack of cigarettes
Quantity of cigarettes
B
$14
12
10
8
6
4
2
MSB

Pigovian tax = $4 per unit
A

Q5. Other policies designed to reduce the incidence of smoking related illness include bans or restrictions on the advertising and promotion of tobacco products. An unintended short run consequence of bans on tobacco advertising has been a short run increase in the profits of tobacco company profits. Identify and explain a plausible reason for this effect.
Ans. The tobacco companies had a short run increase in their profits after the restrictions on the advertising and promotion of tobacco products is because they do not have to incur huge expenses on promotion and advertisement. Thus, the cost saved on promotion is the addition to the profits of the companies. Moreover, the companies can save up heaps even when not advertising because tobacco is more of an addiction and person will go up to any extent to get a cigarette which means if a smoker wants a cigarette he will not tend to check price but will just pay up and get his pack. Hence, when the companies had restrictions on tobacco promotions their sales were still the same as they addiction products tend to have and inelastic demand in spite of change in price and they also saved up on the advertising and promotion costs.

Q 7. Identify a purpose for smoking bans (or licences) which is not directly related to the market failure normally discussed in our study texts.
Ans. Market failure is not just because of the externalities but also because of irrational thinking. In economics it is assumed as consumer is rationale but when it comes to addictions the consumer becomes irrational. The main thing which he sees is the product which he is addicted to. If we take smoking as an example, the packs of tobacco products clearly states that it is hazardous to health and is doing no good to a person. But still the smoker buys the pack and enjoys the drag.. In case of smoking consumers are shortsighted as they tend to ignore or do not think about the long term effects of the smoking on their health as well as the people who tend to inhale the smoke indirectly. They are just concerned about the present relaxation the cigarette gives them to cope up with their addiction. They tend to ignore the side effects of smoking.
The ban on smoking not only internalize the negative externality but also shows us that it’s the consumer’s irrational behavior which also lead to bans. If a consumer can think in a rational manner about the long term bad effects of smoking there might have been no need for the bans as the consumer himself is sensible enough to know his well being.