Question

The surgeon general has determined that smoking causes cancer and heart disease for both smokers and passive smokers (nonsmokers who breathe smoke filled air). If cigarette prices are determined in a free market, which of the following will be true?

1. The price of cigarettes will be too low and the quantity sold will be too high
2. The price of cigarettes will be efficient but the quantity sold will be too high
3. The market will be efficient because markets always equate marginal benefits and marginal costs
4. The price of cigarettes will overstate the true social cost imposed on nonsmokers

Answer 1

The price of cigarettes in a free market will be too low and the quantity sold too high because the true social costs, such as health impacts on smokers and passive smokers, are not reflected in the market price. Taxes on cigarettes serve to correct this by reducing consumption and generating government revenue, but the impact depends on demand elasticity.

Step-by-step explanation:

If cigarette prices are determined in a free market without considering the negative externalities like cancer and heart disease caused by smoking and second-hand smoke, the resulting market equilibrium will not reflect the true social cost of smoking.

Given this scenario, option 1 is correct: The price of cigarettes will be too low and the quantity sold will be too high. This is because the private market price and quantity (Pm and Qm) do not take into account the external costs to passive smokers, so the socially optimal output and price (Pe and Qe) are different - typically at a higher price and lower quantity. When these externalities are taken into account, a deadweight loss to society is realized, which can be illustrated in a graph showing the divergence between the private equilibrium and the socially optimal equilibrium.

Taxes on cigarettes are a practical tool used by governments to correct this market failure by internalizing the external costs. They aim to both reduce cigarette consumption and raise tax revenue. Still, the effectiveness of taxes on altering consumption and raising revenue depends on the price elasticity of demand for cigarettes.

Answer 2

1) The price of cigarettes will be too low and quantity sold will be too high

Step-by-step explanation:

The fact that so many people suffer from lung cancer directly associated with smoking, either first hand or second hand smoking, means that too many cigarettes are being consumed. Since too may cigarettes are being consumed, that means the price of cigarettes is too low. The only way to reduce the negative side effects and costs of smoking would be to levy a heavy tax on cigarettes. That should increase their price so much that eventually the quantity demanded should significantly lower.