This diagram in my textbook illustrates two solutions to a negative externality of consumption - here, the consumption of cigarettes. It states that MSC is shifted upwards by the specific tax. Since the deadweight/welfare loss is defined as the area demarcated by MSC, MSB and the quantity demanded, this would seem to imply that the deadweight loss is not reduced at all (as per the diagram). This seems rather strange.

Here's an alternate diagram I think makes more sense.

Since an increase in taxes will effect a change in the behaviour of individuals, I would argue that it is the MPC (and not MSC) curve that is affected by taxes (hand-drawn Diagram 1). Diagram 2 shows the same picture, but using an ad valorem tax. This will cause a reduction in the deadweight loss. One could argue that a tax will also cause an increase in MSC (effects on employment of tobacco farmers etc.), but, by my reasoning, for the policy to be effective ΔMPC>ΔMPC (otherwise the welfare loss will not be reduced). See Diagrams 3 and (w/ ad valorem) 4 for this scenario.

Does this make sense?


Your reasoning is basically correct. In fact, when I teach externalities to my students, I draw something very much like your diagram 1.

The textbook is confusing because the MSC and MSB curves are supposed to show the social benefits and costs of this particular activity. Taxes and subsidies can't possibly change these costs/benefits because they don't change the fundamental real effects of the activity (one unit of smoke is equally disgusting, regardless of whether it is taxed or not). The tax just means that in addition to this cost, some money is changing hands. But that's not really a social cost because the money will end up belonging to someone.

I don't think it's too helpful to start thinking about the idea "that a tax will also cause an increase in MSC (effects on employment of tobacco farmers etc.)"

Those workers sell their labour in a labour market with a price mechanism. Unless we think there is some market failure in that labour market, the market achieves allocative efficiency. We don't usually talk about externalities when people loose out from price increase or quantity falls in a well-functioning market because those things are efficient and there isn't a very strong case for intervention.


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