Question

Cigarettes in Australia have long been subject to excise tax – a per cigarette tax levied on the suppliers of cigarettes. (The tax applies to all tobacco products, however for the purposes of this exam assume cigarette and tobacco consumption are the same thing). In 2016 the federal government announced that the excise tax rate for cigarettes would rise by 12.5% a year for the next 4 years. Over this period tax revenue collected from the sale of cigarettes has increased considerably. Legal cigarette consumption has fallen to an all-time low in Australia due to a combination of the tax on cigarettes, and public health initiatives such as plain packaging, health warnings and banning advertisements.

Part (a) Consider the following two policies aimed at reducing cigarette smoking:

(i) A tax on the suppliers of cigarettes, and

(ii) The public health campaign initiatives.

Illustrate both of these policies separately using a fully labelled and explained demand and supply diagram for each of parts (i) and (ii). Do not use actual numbers; this is intended as a theoretical exercise. Compare and contrast the impact on equilibrium price and quantity of cigarettes of each of these policies, explaining your answer with reference to the diagrams. Consider the impact of each policy on government revenue. Explain your answer. Can the impact on government revenue be illustrated on either of your diagrams? If so, indicate and explain the area on the diagram/s that represents government revenue.

Answer 1

Part a:

i. A tax on the suppliers of cigarettes:

When a tax is imposed on the suppliers of cigarettes, then this will increase the cost of production of cigarettes in the market. As the cost of production increases, profits of the producers will decrease and this decrease in the profits of the producers will reduce production and thus quantity supplied decreases at each price level and this leads to leftward shift of the supply curve of cigarettes.This leads to fall in equilibrium price and fall in equilibrium quantity of cigarettes. This can be depicted in the diagram as:

Tax on the cigarettes will also generate revenue for the government and total revenue of the government is denoted by green shaded area. It is equal to tax amount * equilibrium quantity after tax.

Thus, tax represents a supply side policy of the government.

ii.The public health campaign initiatives.

This is the demand side initiative of the government and is depicted in panel ii. These campaigns will increase the awareness among the people regarding harmful effects of smoking. This will change their tastes and preferences and thus demand for cigarettes will reduce and this will lead to leftward shift of the demand curve to D'D' and thus lead to decrease in equilibrium price and quantity. Since this does not involve any imposition of tax, thus it will not generate any government revenue.