Problem Set 3 Part II on Externalities & with some Implications of Elasticity

1.Briefly summarize the Coase Theorem (include the 3 key conditions).

2.List the major types of approaches government typically takes to deal with negative externalities.

3.Suppose the demand for cigarettes is represented by the equation P = 20 - .04Q and the supply is represented by P = 5 + .01Q where P is in dollars and Q is in billions.

a.Using math and graphs determine and depict the equilibrium price and quantity.

b.Illustrate on a graph and estimate mathematically the producer surplus and the consumer surplus.

4.Cigarettes can cause negative externalities such as lung damage from second hand smoke and increased risks to non-smokers from fires.Suppose this negative externality works out to about $2 per package of cigarettes.

a.Using math and graphs determine and depict how much over consumption of cigarettes is there?

b.Illustrate on a graph and estimate mathematically what is the deadweight loss (DWL) from over consumption of cigarettes?

c.If negative externalities were the only reason to tax cigarettes in this example what is the optimal level for an excise tax on cigarettes? Why is this optimal?

d.With that tax what would be the new market price paid by consumers?

e.With that tax what would be the new price received by sellers?

f.With that tax what would be the estimated tax revenue?

5.Cigarettes are also a leading cause of cancer. So many people want to tax cigarettes to discourage smoking. Thanks to this argument and the need for tax revenues suppose you raise the tax to $5 per package.

a.What will be the new quantity?

b.How much tax revenue will you get?

c.What will be the new price to the consumers?

d.What will be the new price to the sellers?

e.Compare the producer surplus and consumer surplus to when there were no taxes.

6.To get more tax revenues suppose you raise the tax from $5 to $10 per package, how much tax revenue would you get?Did this strategy to get more tax revenue work?

7.If you raise the tax to $15 how much tax revenue will you get?

Part of the idea in these problems is that we believe the elasticity of demand for cigarettes is low relative to supply and so most of the burden of cigarette taxes falls on consumers.The elasticity of demand also varies with price so as taxes increase tax revenues would eventually fall.However, for simplification the numbers for these problems are madeup. In real like elasticity of demand estimates vary from about .37 at a price of $2 to about 1.80 at a price of $10, with an average of about .77 (Tauras, John A.,Michael F. Pesko, Jidong Huang, Frank J. Chaloupka, and Matthew C. Farrelly, (2016) "The Effect of Cigarette Prices on Cigarette Sales: Exploring Heterogeneity in Price Elasticities at High and Low Prices" NBER Working Paper No. 22251, https://tobacconomics.org/wp-content/uploads/2016/06/Tauras_CigPrice_NBER_2016.pdf).

If you are interested in this topic area you might also look at: The Cancer Council (2019) "Tobacco in Australia: Facts and Issues", https://www.tobaccoinaustralia.org.au/chapter-13-taxation/13-1-price-elasticity-of-demand-for-tobacco-produc,

Federal Tade Commission (2019) "Federal Trade Commission Cigarette Report for 2018" https://www.ftc.gov/system/files/documents/reports/federal-trade-commission-cigarette-report-2018-smokeless-tobacco-report-2018/p114508cigarettereport2018.pdf, Tobacco Free Kids, (2020) "State Excise and Sales Taxes Per Pack of Cigarettes Total Amounts & State Rankings" https://www.tobaccofreekids.org/assets/factsheets/0202.pdf