Question

Cigarettes 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.

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

(i) Externalities occur when positive effects of an individual or a firm’s actions outweigh the negative effects.

In the present scenario the efforts by the Australian government to curtail the consumption of cigarettes is a move to promote welfare among its people. The effect of receiving tax revenue to the government from such a move is a ‘positive effect’ of cigarette consumption an production.

In the above diagram, price of cigarettes (Y axis) and quantity per pack (X-axis) have been taken. D is the demand curve for cigarettes and S is the supply curve. A tax on cigarettes will shift the supply curve to the left from S to S₁. The total revenue is P₁QTS, the proportion of tax borne by consumers ( who are addicts and will pay any amount for a cigarette, including willing to bear the extra burden of tax !) is P₁PQR, the proportion borne by producers is PRTS, the producers or sellers bear a lesser burden.

On the other hand in case of buyers who have an elastic demand, who smoke on a casual basis, will reduce their consumption , either altogether or demand very little quantity of cigarettes. In such cases the seller bears a greater the burden of tax . As stated , the legal consumption has fallen in Australia due to a tax and hence , the burden of a tax now falls more on the seller than the buyer. In the diagram -the buyers bear a lesser burden because of their elastic demand—an effect of a tax --P₁PQR, while the seller bears—PRST amount of tax.

In case of the campaign to reduce the cigarette consumption the marginal social benefit derived from a fall in smoking is more – better health , less stress , increased productivity and so on. The society enjoys more than the loss to the individual producer.

It can be depicted in the diagram below: The society ‘s demand curve or marginal benefit curve is MSB is higher than the MPB or the marginal private benefit derived by smokers—the area ABC shows the welfare loss or the amount of social benefit sacrificed if the quantity were Q₁ instead of Q. With lesser quantity consumed and greater benefits of such a reduction in consumption, the society at large benefits than the individuals.