Question

3. Consider the market for cigarettes. Let’s think about how this market works and how it would be affected by government excise taxes. Below are the demand and supply conditions. Assume a competitive market. P represents the cost of a pack of cigarettes in dollars, and Q represents thousands of packs sold (i.e. Q = 1 means 1,000 packs).

The market’s supply curve can be expressed: Ps = 4 + 0.2Qs

The market’s demand curve can be expressed: Pd = 10 - 0.1Qd

a.) Draw the supply and demand graph for this market, labeling the lines, axes, and intercepts. How many packs will be sold in this market, and at what price, in equilibrium?

b.) Suppose the City of Orlando takes a cue from New York City and places a $1.50 tax on each pack of cigarettes sold. Suppliers are required to pay this tax out of their revenues. Draw a new graph with the original supply and demand curves, and then show the change caused by this tax. What are the new equilibrium total quantity and price levels? Note that there are two relevant prices: the price actually paid by the smokers (call it PSmoke) and the price received by the cigarette company (call it PCig). Label these on your graph.

c.) Based on comparing the new price to the previous equilibrium price, what fraction of the total tax burden is being paid by smokers? What change or changes in the initial supply or demand curves would cause smokers to pay a smaller portion of the tax?

Answer 1

3. (a) The graph is as below.

As can be seen, the equilibrium quantity is 20 thousand packs while the price is $8 per pack.

The algebraic solution would be as follows. The equilibrium quantity would be where or or or , and the equilibrium price would be or or .

(b) The relevant after-tax supply curve would be as or or . The graph is as below.

The new equilibrium quantity would be where or or or . The price paid by consumers (equilibrium price at which the exchange takes place) would be or or . The price received by suppliers would be as .

(c) The total burden of tax is $1.5 per unit. Out of this, consumer's burden would be while the producer's burden would be . The total burden of consumers would be and total burden of tax is (tax revenue collected by government). The fraction of total tax burden paid by smokers would be , ie 33.33%.

If wither the demand curve was more flatter (have less slope) or the supply curve was more flatter; or the demand curve was more flatter than the supply curve, that would cause smokers to pay a smaller portion of tax.