The True Cost of Smoking

Photo by Anastasia Vityukova on Unsplash

In economics, an “externality” refers to the cost (negative externality) or benefit (positive externality) incurred or received by a third party, who has no control over the creation of that cost or benefit.

The “go to” example used to explain negative externalities is pollution. A company that pollutes receives the economic benefits of their polluting activity, while the rest of society bears the cost of the environmental damage caused by the polluter.

If an industrial factory discharges their chemical waste into a nearby river, the residents near the river will be made worse off as a result. The people who live near the river had no control over the factories decision to pollute the river, but they bear 100% of the cost of that action.

That’s a negative externality. Specifically, that is a negative “production externality” as it is caused by economic production. However, there are also consumption externalities caused by consumption of products that have a cost to society.

The most obvious example is smoking (consuming) cigarettes. Choosing to regularly smoke cigarettes greatly increases an individual's chance of developing chronic medical issues. Which puts a serious financial strain on public budgets which are paid for by taxpayers AKA, the rest of society.

In the U.S, the economic cost of smoking is tremendous. According to a recent study;

  • The direct economic costs of smoking account for 1% of U.S GDP or about $190 billion. The major driver of which is smoking-related healthcare expenditures.
  • The indirect cost (lost productivity) caused by smoking is more than $150 billion. (think of your co-worker who takes a “smoke break” every 40 minutes).
  • Note, while the production of cigarettes provides economic activity, we are focusing on the consumption of cigarettes.

In the absence of heavy taxes placed on the consumption of cigarettes, the negative externality (the cost to society) of smoking would be hundreds of billions of dollars every year.

To reduce or eliminate the externality caused by the consumption of cigarettes, we need to make smokers pay. That is why the U.S government applies a $1.0066 tax for a 20-pack of cigarettes. States also impose a tax on the consumption of cigarettes, the magnitude of which varies from state to state.

For every dollar spent on buying cigarettes, the federal and state governments collect $0.443.

If we were to assume that the tax collected on the consumption of cigarettes was enough to offset the costs to society associated with smoking (they are not), there would be no negative externality. In this case, the Marginal Social Benefit of smoking would be equal to the Marginal Social Cost, at which point we are indifferent to whether people smoke. That is, in an economic sense. We would still not want people to smoke if we care about there personal well-being.

For more details on the economics of consumption externalities, check out the “Nerd Appendix” below.

Nerd Appendix: Breaking Down a Negative Consumption Externality

  • When looking at the externalities of consumption we assume Marginal Private Cost (MPC) is equal to Marginal Social Cost (MSC), depicted by the blue line below.
  • The red lines below indicate that there is a difference in the Marginal Private Benefit (MPB) and the Marginal Social Benefit for engaging in an activity like smoking.
  • From the smoker's perspective, point “A” is the optimal outcome as this is where the benefit of smoking is equal to the cost to the smoker.
  • However, as discussed above smoking has a cost for the non-smokers which is referred to as a negative externality.
  • Smoking costs society hundreds of billions each year. At point “A”, the smokers do not pay any of this cost, society bears this cost.
  • From a societal point of view, point “C” is optimal. This is where the Marginal Social Cost of smoking is equal to the Marginal Social Benefit. At point C the consumption of cigarettes would drop from Q1 to Q2.
  • We could reach point “C” by applying an appropriate tax on the consumption of cigarettes that would fully offset the costs associated with smoking.
  • The triangle between points “A”, “B”, & C” is the deadweight loss to society as a result of smokers smoking as much as they please without paying for the costs they inflict on the rest of us.