Question

Assume that, according to empirical research

1. the price elasticity of demand for cigarettes is 0.6;
2. low income families spend too much on cigarettes and don’t buy enough milk for their children.

To remedy this situation, a legislator recommends to increase substantially the tax on cigarettes. This would discourage poor people from smoking, as a consequence, they will spend less on cigarettes and more on milk. Is the legislator right or wrong, and why?

(instead of drawing the actual graph, briefly explain the graph instead. Explain all the curves, shifts, points and axis, intersections and labels etc).

Answer 1

Increasing taxes on cigarettes would not discourage poor people from smoking and increasing their spending on milk for children. This is because the demand for cigarettes in inelastic. An inelastic demand implies that quantity demanded for cigarettes is less responsive to change in the price of cigarettes. So an increase in price of cigarettes due to an increase in taxes would lead to a shift in demand towards left but since the demand is inelastic (steeper demand curve), the change in equilibrium quantity would fall but the change would be small. So the legislator is wrong if they think that they can discourage spending on cigarettes by increasing taxes on it