Question

Assume the government would like to create a more healthy society as a way to lower insurance premiums. In order to do this they have decided to tax cigarettes.   Show using indifference mapping the change in consumer optimization. You may assume the “other goods” as an axis on each graph.

Answer 1

The choices that a consumer make between cigarettes and other goods can be depicted using indifference curve theory. A tax on the consumption of cigarettes will reduce the consumption of cigarettes by the consumer. This can be depicted by the following indifference curve approach:

Let AB denote the initial budget line of the consumer and IC₁ denotes the intial indifference curve and optimum occurs at point E₁ where C₁ units of cigarettes are being consumed. A tax on the consumption of cigarettes will pivot the budget line inwards to AB' and IC₂ represents the new indifference curve of the consumer with E₂ as the point of optimum consumption where consumption of cigarettes is decreased to C₂ and consumption of other goods has increased to G₂.

Thus, imposition of tax on cigarettes will reduce the consumption of cigarettes and it will improve health of the consumers which is a way to lower insurance premiums.