Negative Consumption Externalities

• • Producers maximise private benefit by producing an output of Q1 tobacco, which is directly below point A, where MPC = MPB.
• • However, Q1 is less than the socially optimal level of consumption of Q2, which is directly below point B where MSC = MSB.
• • Consumers are therefore over-consuming tobacco, shown by Q1 - Q2.
• • In order to bring about the socially optimal level of consumption of Q2, an indirect tax equal to the distance between points B and C could be imposed which would increase the price of tobacco to P2.
• • The tax needs to be set equal to the marginal external cost (MEC) of consumption at the socially optimal level of consumption Q2, to limit the production of tobacco and therefore reduce over-consumption, which completely removes the DWL.