Question

Consider the cigarette market. The market demand for cigarettes is given by P=50-Q_D. The market supply of cigarettes is given by P=10+4Q_S. Suppose that the government designs a tax program to reduce the number of smokers; it imposes an excise tax of $5 per pack on cigarette producers.

1. What is the tax incidence on producers?
   1. $7
   2. $8
   3. $28
   4. $32
   5. $35

Answer 1

Answer :

P=50-Q_D (Demand Function)

P=10+4Q_S (Supply Function)

Equilibrium points are :

Quantity demanded = Quantity supplied

50 - Qd = 10 + 4Qs

50 - Q = 10 + 4Q

40 = 5Q

Q = 8 (Equilibrium quantity)

P = 50 - 8 = 42

P = 10 + 4*8 = 42 (Equilibrium Price)

IF an excise tax of $5 per pack is imposed on cigarette producers:

New supply function will be : P - T = 10 + 4Qs

Therefore, new equilibrium condition will be :

50 - Qd = 10 + 4Qs + T

50 - Q = 10 + 4Q + 5

35 = 5Q

Q = 7 (New equilibrium quantity)

P = 50 - 7 = 43

P - T = 10 + 4*7

P - 5 = 38

P = 43 (New Equilibrium Price) (with tax)

This implies that new market price will be $43 and producers/supplier will get $38 in his pocket and will pay $5 as tax to the government.

Earlier producers were receiving $42 in their pocket.

Incidence of tax on producers = $42 - $38 = $4

Means out of $5 excise tax per unit, $4 will be borne by producers and therefore $1 by consumers.

Tax Incidence on producer = quantity*tax per unit borne by producer 7*4 = 28