1. evaluate if taxation is effective to solve for negative externalities from smoking




Governments can use a variety of measures, amongst which, indirect taxation.

Indirect taxation is a form of tax that is levied on producers, who then pass on the tax to consumers in terms of higher prices. An example would be excise tax on cigarettes, alcohol, fuel.

This internalizes the external costs of production and consumption, forcing private individuals to pay for externalities generated. The allocation of such resources will then be reduced, and if all of the external costs are indeed internalized, then MEC=0. MPC=MSC, and MPB=MSB, society will now consume at MSC=MSB. As a result, allocative efficiency is achieved, there is no deadweight loss, and welfare is maximized.



For production, with a tax, supply is reduced, and costs increased for private individuals, the MPC converges to the MSC, when all external costs and internalized, then MPC=MSC since MEC = 0.

Output is reduced to Qopt, where MSC’=MSB, allocative efficiency achieved, welfare loss eliminated.



For consumption, with a tax, MPC or supply shifts leftward due to rise in costs, output drops to Qopt, where MSC’=MSB, allocative efficiency achieved, welfare loss eliminated.


Taxation has its limitations because it is not possible for governments to quantify the external costs, it is at best an approximate and markets might not actually be consuming at Qopt if calculation of external costs was inaccurate.

If demand is inelastic, taxation would be ineffective, because qty dd is unresponsive to price change. A huge amount of tax would have to be levied (which might lead to social discontent since only high income earners can consume such products), and possible growth of black markets.

Also, a tax is only truly effective if the tax revenue was used to finance education or advertising to tell people about the negative effects of smoking

– Legislation + Education


Negative advertising and education/legislation could be implemented. Providing information on external costs and negative information would reduce the demand over time, and lead to a reduction in consumption.

Legislation such as restriction of underage consumption of alcohol, cigarettes, would completely eliminate external costs such as health problems to bystanders, or reduced crime rates from alcoholism. Over the long run, MPB shifts down to Qopt in negative consumption diagram.


The limitation of such policies are that they are long run in nature, especially for education.

It also requires governments spending intensively, which incurs opportunity costs, since such spending could be better used in other areas such as subsidizing healthcare, education, etc.


In short, each policies have their limitations. Demand side policies like tax should be used in short run to control the consumption of items such as cigarettes, alcohol, fuel. Quota might be better in controlling the production, in cases such as carbon trading, where firms have ability to pass on the tax to consumers. In the long run, a good mix of short run demand policies and education could be used to control consumption and force markets to internalize external costs to achieve allocative efficiency.