Question

Suppose the average monthly demand for cigarettes can be described by the equation QD = 30−p, and supply can be described by the equation QS = 18+2p, where p is the price of a pack of cigarettes. When there is no tax on cigarettes, the equilibrium price is p₀ =$4 per pack and Q₀ =26.

(a) Suppose the government sets a specific tax on tobacco producers of τ = $1.50 per pack to reduce tobacco consumption. How much do consumers pay for a pack of cigarettes after the tax? How much do producers receive per pack? How much does average monthly cigarette consumption (Q) decline? (4 points).

(b) What share of the tax burden falls on consumers? (i.e., what is the “tax incidence” on consumers, ∆p/∆t ?) (2 points).

(c) Suppose the tax τ is imposed on consumers rather than producers. How will this

impact the tax incidence on producers compared to the case above where the tax is imposed on producers? (i.e., will the incidence to producers increase, decrease, or remain the same?) (1 point)

(d) Intuitively, do you expect the demand for cigarettes to be very elastic or inelastic? Why? How will that impact the incidence of tax born by consumers? (2 points)

(e) The equilibrium with no tax is shown in the graph below. On the graph, illustrate the effect of the tax on equilibrium prices and quantity using a shift in one of the functions. Label the vertical or horizontal distance equal to the amount of the tax. Shade in the area equal to the amount of revenue collected by the government from taxes. Your illustration does not have to be exactly to scale. (3 points)

Answer 1

Answer:

A) B) Tax incidence depends upon the price elasticity of demand. If the elasticitiy of demand is inelastic the maximum burden of tax is to be beared by consumer.

Price elasticity = Change in quantity demanded/ Change in Price = (0.5/26)*(4/-0.5) = -0.15

Hence the price elasticity is in inelastic. The tax burdern borne by consumer is = $(0.5*25.5) = $12.75

C) As the demand curve is inelastic, with the imposition of tax on consumer the tax incidence on producer will reduce.

D) The demand for cigrarettes must be inelastic. As there is no subsitiute of this good, whatever increase in the price will be it is to borne by consumers.