Question

Upper Slobbovians smoke 10 million cigarettes per year; so do Lower Slobbovians. To discourage smoking, each country imposes an excise tax of 50 cents per pack. As a result, the price of cigarettes rises by 35 cents per pack in Upper Slob … but by only 15 cents per pack in Lower Slob. Assuming the slope of the supply curves are identical in both countries but that the slope of the demand curves vary, in which country does the tax discourage smoking more effectively (i.e. lead to a bigger decrease in smoking)? Demonstrate your answer graphically using supply and demand in the two markets. (2 pts)

Answer 1

An excise tax raises price to be paid by consumers and lowers the price to be received by producers. In a market where demand is more elastic (more inelastic), the rise in price as a result of excise tax will be lower (higher), because the market is more (less) sensitive to a given rise in price. Therefore, demand in Upper Slob is more elastic compared to demand in Lower Slob.

In following graph, Panel A & Panel B depict the market for cigarette in Upper Slob & Lower Slob respectively, where S0 is the identical initial supply curve in both markets. D1 & D2 are demand curves in Upper Slob & Lower Slob (D1 is more elastic, therefore D1 is flatter than D2), intersecting S0 at point A & B, with initial price P0, and initial quantity Q1 and Q2 respectively. The excise tax equal to T per unit (= 50 cent) shifts the supply curve to left, from S0 to S1. The new supply curve intersects demand curve D1 at point C and demand curve D2 at point D. After the excise tax, in Upper Slob, price paid by consumers is P1 and price received by producers is P2 (Therefore, T = P1 - P2) and in Lower Slob, price paid by consumers is P3 and price received by producers is P4 (Therefore, T = P3 - P4). When T = P1 - P2 = P3 - P4, it is observed that (P1 - P0) < (P3 - P0), therefore consumer price has increased by a lesser amount in Upper Slob and by a larger amount in Lower Slob. After-tx equilibrium quantity are Q3 and Q4 in Upper Slob and Lower Slob respectively, and quantity has decreased by a larger magnitude in Upper Slob.