Question

1. Suppose officials in the U.S. want to reduce the national cigarettes consumption from the current 400 billion to 300 billion cigarette packs per year. They propose two workable solutions that would each bring about such a reduction of 100 billion cigarette packs sold and purchased.

   Option 1 is to place a tax on every cigarette pack sold.

   Option 2 is to impose a price floor on what consumers have to pay for a pack of cigarettes.

   (a) Provide a separate diagram for each option above, and for each, show the CHANGE in consumer surplus, the CHANGE in producer surplus, and the DWL that would result if that option were imposed. Please do that by putting letters in your diagrams and referring to those letters in your answer.

   (Do NOT consider any market failures in this question; just assume that cigarettes are like any other good traded in a perfectly competitive market)

   (b) Based on the information in this question, agree or disagree with the following statement, and briefly explain your answer: “The deadweight loss will be less in Option 1 (the per unit tax) than in Option 2 (price floor) because the government will get some tax revenue as a result of the tax.”

   (c) A government official has made a statement that a tax on cigarettes will allow the government to raise a lot of revenue at a low economic cost (the economic cost of raising tax revenue is the DWL). Do you agree with this statement? Explain.

   (d) If a tax on cigarettes is imposed, how will the burden of this tax be shared between consumers and producers of cigarettes? Briefly explain.

Answer 1

A price floor is the lowest price that can be paid in a market for cigarette and taxes will increase the price of cigarettes proportianally.

Consumer surplus is the extra benefit that consumer is getting above cost after consumption and Producer surplus is the extra benefit that producer is getting on producing the product.