In a free market for cigarettes, which of the following is true relative to the social optimum given known health risks?

In a free market for cigarettes, which of the following is true relative to the social optimum given known health risks?

• A. The price of cigarettes will be too high and the quantity sold will be too low
• B. The price of cigarettes will be too low and the quantity sold will be too high
• C. Price equals social optimum and quantity equals social optimum
• D. Price too low and quantity too low

Answer: (B)

When a good creates costs for others that aren’t paid by the buyers or sellers, the market outcome doesn’t reflect those external costs. Cigarettes impose health risks that affect more than just the smoker, so the social cost of smoking is higher than the private cost that the market uses to determine price and quantity. In a free market, prices and quantities are set by private marginal cost and private marginal benefit, not by the full social cost. Because the external costs aren’t internalized, the price ends up too low and the quantity too high relative to the social optimum. The socially efficient outcome would require a higher price and a smaller quantity, so the market over-allocates cigarettes compared to what society would choose if all costs were considered. That’s why the correct statement is that the price is too low and the quantity is too high. If the externalities were internalized (for example, via a tax or regulation), the price would rise and consumption would fall toward the socially optimal levels. The other possibilities describe scenarios where the price might be too high or the quantity too low, which would happen if there were positive externalities or if policy more aggressively restricted consumption, not in a free market with a harmful externality.

When a good creates costs for others that aren’t paid by the buyers or sellers, the market outcome doesn’t reflect those external costs. Cigarettes impose health risks that affect more than just the smoker, so the social cost of smoking is higher than the private cost that the market uses to determine price and quantity. In a free market, prices and quantities are set by private marginal cost and private marginal benefit, not by the full social cost. Because the external costs aren’t internalized, the price ends up too low and the quantity too high relative to the social optimum. The socially efficient outcome would require a higher price and a smaller quantity, so the market over-allocates cigarettes compared to what society would choose if all costs were considered.

That’s why the correct statement is that the price is too low and the quantity is too high. If the externalities were internalized (for example, via a tax or regulation), the price would rise and consumption would fall toward the socially optimal levels. The other possibilities describe scenarios where the price might be too high or the quantity too low, which would happen if there were positive externalities or if policy more aggressively restricted consumption, not in a free market with a harmful externality.