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When there is a negative consumption externality: SMB = PMB – M; where MD is the marginal damage done to others by an individual’s consumption of an additional packet of cigarettes. In the private market for cigarettes the supply and demand curves represent the PMC and PMB.  In this example the SMC equals the PMC because there are no externalities associated with the production of cigarettes in. The SMB in this case is less than the PMB. The graphical illustration is as below

Price

S = PMC = SMC

 

     P2

P1

 

A

C                                 D=PMB

B         MD

SMB =PMB – MD

 

0                                    Q2             Q1                       Quantity

Here the private equilibrium where PMB = PMC (which is equal to SMC in this case) is not socially efficient. The social welfare maximizing level of consumption is given at the intersection of MSB and MSC (point C in the graph).  With the negative consumption externality, the private market leads to overproduction and overconsumption of cigarettes by Q1- Q2.  The social costs exceed social benefits for all units between Q1 and Q2. As a result, there is a deadweight loss (area ACB) in the market for cigarettes.

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