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 number of cigarettes consumed to increase or decrease, and by more or less than 10%? Explain your answer

Answer 1

Even when a tax is levied on the supplier of the good, the major incidence of the tax falls on the consumers of the good because demand for cigarettes is relatively inelastic as compared to supply of cigarettes. And the side of the market with a relatively inelastic price elasticity will have to bear the maximum burden of the tax. In this case since demand is relatively inelastic, thus consumers have to bear the major incidence of the tax. This can be represented in the diagram below:

The above diagram shows that tax will shift the supply curve leftwards and the price paid by the consumer increases by a greater amount as compared to the fall in the prices that sellers have to receive. Thus,major incidence of the tax falls on the buyers.

Since demand for cigarettes is relatively inelastic, with an increase in the price level by 10 per cent, the number of cigarettes consumed will decrease by less than 10 per cent.