Question

7. The price elasticities for cigarettes by habitual smokers (addicts) and potential smokers (young people) are -0.2 and -3 in equilibrium. The government is considering levying a new 10% tax on cigarettes.

   1. (a) For each type of consumer, calculate the expected reduction in consumption from the new tax. Explain why the responses of these two groups will differ, focusing on the determinants of elasticities.

   2. (b) From which group will the government raise more tax revenue. For each group, will tax revenue fall or rise relative to the original tax?

Answer 1

Elasticity = % change in Q / % change in P

A)

Given % change in P = 10%

For habitual smokers (addicts)

% change in Q = -0.2 x 10 = -2%

For potential smokers (young)

% change in Q = -3 x 10 = -30%

Thus, as one can see, consumption reduction is greater in case of young potential smokers who have elastic demand. This is because in case of elastic demand, quantity changes more than the change in price.

B)

For the habitual smokers (addicts) the government must raise more tax revenue as they have Inelastic demand and increase in price due to tax would not reduce sales much and thus increase government tax revenue.

Habitual smokers: Revenue will rise

Potential smokers: Revenue will fall