Question

Suppose that the U.S. government determines that cigarette smoking creates social costs not reflected in the current market price and equilibrium quantity of cigarettes. A study has recommended that the government can correct the externality effect of cigarette consumption by paying farmers not to plant tobacco used to manufacture cigarettes. It also recommends raising the funds to make these payments by increasing taxes on cigarettes. Assuming that the government is correct that cigarette smoking creates external costs, evaluate whether the study’s recommended policies might help correct this negative externality.

Short answer

The policy of levying taxes and giving revenue to farmers will reduce the consumption of cigarettes due to higher prices which also reduces the negative externality.

Step-by-step solution

Step 1. Definition of Externality.

An externality is a consequence of an economic activity that affects the third party. For example, pollution is an externality.

Step 2. When taxes are levied on cigarettes.

When the government levies taxes on cigarettes the consumption quantity decreases due to a rise in prices which leads to a decrease in negative externality. The diagram below shows the change in quantity and price due to taxes levied on cigarettes.

Step 3. Farmers reduce production.

The revenue generated from the taxes levied on cigarettes is being given to the farmers to stop planting tobacco. This will further increase the price of cigarettes because the quantity available will be further reduced. The diagram shows that this policy of the government has shifted the supply curve further left.