The lefthand diagram below illustrates a market with adverse third-party effects (external costs), and the righthand diagram illustrates a market with beneficial third-party effects (external benefits). The flu shots market is completed as an illustration. Complete the analysis for the cigarette market.

Notation: PR = private; EX = external; SO = social (private and external combined)

 
 
 
 
 
 
 
 
 
 
 
 
 

Step 1: Add the following labels to your diagram:
    Q_PR: the private market's equilibrium quantity (hint: where does MB_PR = MC_PR?)
    P_PR: the private market's equilibrium price
    Q_SO: the socially optimal quantity (hint: where does MB_SO = MC_SO?)
    A: the welfare loss at Q_PR
 
Step 2: Indicate what policy you would recommend to move consumption to Q_SO
    For cigarettes: _________
    For flu shots: subsidy
 
Step 3: Add the following labels to your diagram:
    P_SO: the price paid by buyers at your new equilibrium
    B: the government's revenue or expenditure at the new equilibrium
    For cigarettes: ____________
    For flu shots: B=expenditure