Explain how consumption of cigarettes lead to market failure (10)


Q1. Define Market Failure

Market failure occurs when the allocation by price mechanism is inefficient. Free market is not consuming or producing at the optimal level of output, ie welfare not maximized (DWL exists) and there is requirement of government intervention. Welfare is maximized or market is efficient only if Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).


Define Negative Externalities

Costs incurred by third parties who are not directly involved in production and consumption of goods and services. It negatively influences third bystander who is not involved in transaction. WIthout government regulation, the price mechanism does not make the people pay for external cost they generate.


– Consumption- smoking, alcohol, traffic congestion



Individuals smoke, create second hand smoke that pollutes the environment and cause health problems. this is an example of external cost generated.

Private individual benefits more than society, so MPB>MSB

Give examples of private benefits or private costs and social benefits, social costs

MPB of smoking= personal satisfaction. EC of smoking= air pollution, health problems for others. MSB=MPB + EC, so MSB<MPB




From diagram, social welfare is maximized when MSC=MSB, at Qs. But in the absence of government regulation, external costs are not internalized by price mechanism, society consumes at MPB=MPC, or output Qm.

This results in over-consumption and welfare loss (or dwl), which it the shaded region in the diagram.


If production- factory producing and causing carbon emission

  • in the case of production, when factories produce items, they give off air and water pollution which lead to negative externalities for the society.
  • so the MSC is greater than MPC
  • MPC is the cost to operate the factories, and MSC is the cost to society, which is higher than factories