Negative externalities are the undesirable effects of the consumption or production of a good on ‘outsiders’ (individuals or firms) that are not accounted for in the private market (market for private firms and individuals) and are therefore called ‘spillover’ effects. For example in the case of tobacco, the negative externalities are health and are risks to the users and the people around them, pollution of the surrounding areas, addiction etc. It is a type of market failure. Market failure is when a market works badly or is absent completely. In this case, the market is overproducing tobacco therefore it is a market failure.
This indicates that the social benefit is less than private benefit i.e. benefit to individuals. This can be shown in the market diagram for tobacco.
Market for tobacco showing negative externalities
Quantity of tobacco (hundreds of tonnes)
MSB is the marginal social benefit (social demand). It is the demand curve showing social demand for tobacco. MPB is the marginal private benefit (individual demand). The vertical distance between the two demand curves is the negative externality, i.e. P3-P2. When MSB = MPB, there is no market failure as the good is not being overproduced anymore. Therefore to decrease the negative externality, it must be incorporated into the price, thus decreasing the quantity demanded to equal the MSB equilibrium quantity (Q1).
Tobacco is thus a demerit good1. It is not only supplied in the form of cigarettes but also in the form of tobacco pouches that can be used in roll-up cigarettes. Consumers are switching from cigarettes to roll-ups because the tax on tobacco pouches is less than that on cigarettes.
The UK government has levied an average tax of 75 – 90% on a packet of cigarettes whereas the tax on roll-up tobacco is ‘just below 70 percent’. One solution to reduce the consumption of tobacco is to increase the tax on tobacco as a whole instead of on cigarettes or tobacco pouches. The supply will therefore shift to the left. This is shown in the diagram below.