Discuss the possible consequences of the imposition of an indirect tax on cigarettes for the different stakeholders in the market.

An indirect tax (when a government places a tax on goods or services) on cigarettes is an example of the correction of a negative externality of consumption (a market failure). This is when the consumption of the good creates negative effects on a third party not involved in the consumption of that good. The consumption of cigarettes creates many spill overs on third parties, such as second hand smoke inhalation and public health issues. This negative externality therefore, causes the marginal social benefit (the benefits derived from the use of that good, for the consumer and society) to be lower than the marginal private benefit (the benefit experienced by the consumer of the good), which is the demand curve. The marginal private cost (cost per unit of output for the firm) and the marginal social cost (all costs faced by the firm) equal each other and represent supply in the market. This results in a quantity equilibrium (where MPB = MSC/MPC) higher than the the Pareto efficient quantity (where MSB = MSC). This difference captures the negative effects caused by cigarettes, i.e. the welfare loss to all stakeholders in the market. Therefore, the government imposes an indirect tax, which raises the price of cigarettes and therefore decreases the quantity demanded, as consumers don’t value the good at this higher price. This leads to a shift of the supply curve to the left (where MSC equals MSB), which corrects the market to the Pareto quantity.(DIAGRAM)This, however, presents various consequences for the different stakeholders in the market. Firstly, for consumers, the rise in price from the imposition of the tax, reduces their quantity demanded, as some consumers do not value cigarettes at this higher price. Secondly, for producers, the tax leads to a decrease in quantity sold, and an increase in costs, as the producers internalise the cost of the tax, which raises their overall production costs. Finally, the government benefits, as it captures the indirect tax, i.e. receive the revenue of the tax.