Question

“When a tax is levied on a good, a share of it is paid by both the consumer and producer. In the case of cigarettes however much more of the burden of the tax is paid by consumers, even though the tax is levied on the suppliers of cigarettes.”

Why might this be the case? In your answer explain both parts (sentences) of this statement.

If the price of a packet of cigarettes increased by 10%, and in light of your explanation of the quotation, would you expect the quantity of cigarettes consumed to increase or decrease, and by more or less than 10%? Explain your answer.

Part (c) Taxation of cigarettes is often justified on the grounds that cigarette smoking creates externalities. What is meant by the term “externalities” in this context? Give two examples of externalities created by cigarette smoking and explain how a tax on cigarettes could potentially address both of these. Using a fully labelled and explained diagram explain how a tax can increase efficiency in the cigarette market. What size tax should be levied to maximise efficiency in this market? (Indicate the efficient tax size on your diagram – no actual number required).

Answer 1

b. Even when the tax is levied on the producers of cigarettes, the consumers have to bear the maximum incidence of the tax because demand for cigarettes is relatively inelastic. This is because people whi consume cigarettes are generally addicted to its consumption and will not reduce consumption by a greater amount even when price of cigarettes is increased. This is because they cannot change their habits, tastes and preferences in short run. They will bear a higher portion of the tax but will not reduce consumption to a large extent.Thus, it can be stated that even when tax is levied on the producer, the consumers have to bear the maximum burden of the tax.

Since price elasticity of demand is less than 1, thus when price of cigarettes increases by 10 per cent, the quantity consumed of cigarettes will decrease by less than 10 per cent. This is because Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price of the good.

c. In the context of smoking, externality refers to the harm caused to the third party who is not direclty smoking but has to consume the smoked air because of smoking action of the smokers. The two examples of externalities caused by smoking in this context are as follows:

1. passive smoking where another person has to breathe the polluted air which can cause damage to the lungs of passive smoker.

2. pollution in the atmoshpere.

This increases marginal cost of smoking and marginal social cost of smoking is more than marginal private cost of smoking. Thus, pigouvian taxes needs to be imposed so that socially efficient quantity is equal to the market efficient quantity. This can be depicted in the diagram as: