Question

Given the inelasticity of cigarette demand, discuss an excise tax on cigarettes in terms of deadweight loss and tax incidence.

Answer 1

Cigarette has inelastic demand. This is because smokers are addicted ot cigarettes and will abosorb any price hike. Casual smokerrs only will decease/ quit consumption of cigarettes. Hence with price rise, the decrease in quantity demanded is only marginal.

Tax burden:
When taxes are imposed (either on consumers or on sellers -- effect is the same), the burden of tax is higher on consumers of cigarette because the demand curve is inelastic and the supply curve is elastic. This is according to the property of elasticity. evident in the graph below.

  

Supply curve shifts to the left due to tax. Pb is the price paid by the consumers after tax, and Ps is the price received by the sellers after tax. The difference bertween Pb and Ps is the tax amount. We see that Pb - P is greater than P - Ps. That is, tax burden on consumers is greater than that on sellers.

Deadweight loss:

As the quantity demanded falls only marginally, deadweight loss is minimal. In the graph above, we see that the quantity falls from Q to Q1 when tax is imposed. The deadweight loss is seen in the small red triangle between the equilibrium quantity and the new quantity. Deadweight loss increases as the elasticity of demand (or supply) curve increases. This is because the more the elasticity of both the curves, the lower the quantity at the new equilibrium. As the new quantity decreases deadweight loss increases.

Conclusion:

Hence it is the inelasticity of demand of cigarettes that attracts high taxes on cigarettes. due to inelastic demand, consumers are willing to bear higher prices. Again, due ot inelastic demand, deadweight loss is minimal.