Assume that the daily demand for packs of cigarettes is Q = 100 P. Further assum

Question

Assume that the daily demand for packs of cigarettes is Q = 100 P.

Further assume that the marginal cost of producing a pack of cigarette is $6, and that the market for cigarette is prefectly competitive. Assume that each pack of cigarettes smoked does $6 worth of health damage to the smoker in the form of increased cancer risk and and a total of $5 worth of health damage to the smoker’s neighbors via secondhand smoke. Finally, assume that all cigarette smokers are aware of these costs.

(a) Assume that a smoker states that he is willing to buy a pack of cigarettes for $8, but not a penny more. In this market, where the price is $6 per pack, what are the private benefits and private costs incurred whenever he buys a pack of cigarettes? Is it privately efficient for him to buy a pack of cigarettes at this price?

What about the public benefits and public costs? Is it socially efficient for him to buy a pack of cigarettes at this price?

Explanation / Answer

(a) Price = $6

Private benefit (demand): Q = 100 - P = 100 - 6 = 94

Private cost = Marginal cost (PMC) = $6

Since price equals marginal cost, this is privately efficient.

(b) Marginal external cost (MEC) = $6 + $5 = $11

Public cost = Social marginal cost (SMC) = PMC + MEC = $(6 + 11) = $17

Public benefit = Private benefit = 94 (as computed in part a)

Since Price is less than public cost, it is not socially efficient.

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