Question

On a graph, show the effect of a per unit tax on SELLERS of cigarettes. (This requires you to think about the shape of the demand curve for cigarettes. You can assume a sort of neutral supply curve. Indicate the change in price and quantity from the tax. The consumer and producer surplus after the tax, the tax incidence on buyers and sellers and the deadweight losss. Who pays more of this tax?

Answer 1

Cigarettes are the type of goods for which consumer is habitual which means that if price of the cigarettes increases then the demand by the consumer does not change significantly. It implies demand for cigarettes is inelastic.

Initially supply curve is SS and demand curve is DD. E is the point of intial equilibrium where equilibrium price is P* and quantity is Q*.

Consumer surplus	Producer surplus	Total surplus
a+b+c+d	e+f+g+h+i	a+b+c+d+e+f+g+h+i

Now due to per unit tax supply curve shifts to the left from SS to SS'. Thie will cause new equilibrium to arise at E' where new increased equilibrium price is P** and decreased equilibrium quantity is Q**. In this situation, consumer has to pay P** and seller will receive Ps. Tax amounts to (P**-Ps).

Consumer surplus(after tax)	Producer surplus(after tax)	Government revenue(after tax)	Total surplus(after tax)
a	h+i	b+c+e+f	a+b+c+e+f+h+i

A consumer need to pay (P**-P*) as a tax

A producer will pay tax share amount= (P*-Ps)

From the graph below it can be oberved that (P**-P*)>(P*-Ps) which means consumer need to pay more of this tax.

Deadweight loss= Change in total surplus= (a+b+c+e+f+h+i)-(a+b+c+d+e+f+g+h+i)= -(d+g)