Cigarettes is a type of demerit good as it exhibits negative externalities from consumption. They are deemed to be socially undesirable. Negative externalities refer to incidental costs to third parties that are not taken into account by those who are involved in the activity.
A smoker will only take into account his private costs (price of the packet of cigarettes and own smoking-related health problems) and private benefits (satisfaction derived from smoking).
However, he does not consider the negative externalities that would be generated by his smoking (smoking-related health problems on passive smokers, costs incurred to society for having to provide healthcare for smoking-related health problems as well as clearing and maintenance costs for the litter).
The social cost from undertaking the activity is the private cost faced by the smoker as well as external costs accruing to third parties. Negative externalities will lead to divergence of private cost and social cost. With the presence of negative externalities, social cost will be greater than private cost.
Market failure is likely to exist because the negative externality is underpriced by the price mechanism. If cigarettes were provided through the free market, social costs of smoking exceed the private costs. Private optimum occurs at Qe where PMB (the benefit to the individuals of smoking the last unit of cigarette) equals PMC (the cost to the individual of smoking the last unit of cigarette).
The socially efficient level is where SMC=SMB i.e. at output Qs. Therefore, there are too many scare resources devoted to the consumption of cigarettes. There will be over-consumption of cigarettes because society values an extra unit of cigarette less than what it would cost society to produce it. Shaded area represents the welfare loss to society as a result of this over-allocation of resources. Society as a whole could be made better off if the current level of cigarettes were reduced to socially efficient level. (Qs)
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