Question

On a graph, show the effect of a per unit tax on SELLERS of cigarettes. (This requires you to think about the shape of the demand curve for cigarettes. You can assume a sort of neutral supply curve. Indicate the change in price and quantity from the tax. The consumer and producer surplus after the tax, the tax incidence on buyers and sellers and the deadweight losss. Who pays more of this tax?

Answer 1

The demand for cigarates will be inelastic. The reason is that cigarates are addictive in nature and there aren't any close substitutes available to it.

A per unit tax causes the supply curve to shift to the left (S to ST) indicating the rise in per unit costs due to the tax. The initial equilibrium is at e1 where D and S intersect. When tax is imposed the new equilibrium occurs at eT point. At this point the price is PTb which is higher than the inital price-P1. The PTb is the price buyers are paying for cigaretes. Since taxes exist on suppliers, sellers receive a lower price PTs. The gap between PTb and PTs is the amount of tax levied.

The tax burden falls more on the consumers. This is understood by viewing the graph. Observe that the gap between PTb and P1 is larger than P1 and PTs. This means that consumers pay more of the tax burden. The reason is their inelastic demand. As demand is inelastic even when prices rise due to taxes the consumers do not have much alternatives and so they must buy the cigarete at even higher prices. Hence quantity response is small as indicated by small decrease from Q1 to QT.

The producer surplus after tax is the area below price received by buyers and above supply curve. This is area of triangle Oe0PSt (P.S). While consumer surplus is area above PTb line and below the demand curve. The area is marked CS and is a traingle PTbeT1 There is a third area marked TR which is government's tax revenue equal to area of rectangle PTbeTe0PTs. Finally the loss in welfare due to tax i.e. dwl is the triangle eTe1e0.