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Impact of Tax

Discuss about the Tobacco Perfectly Competitive Market.

The question states that the tobacco market can be assumed as a perfectly competitive market. As a result, the market would host a huge number of sellers and the size of each of these sellers would not be large enough so as to affect the market price. Additionally, the product sold by each of these sellers would be exactly the same, hence there would be no difference in the quality of the product sold. In such a market, the price of tobacco would be determined based on the consideration of the demand and supply of tobacco at the industry level and not at the firm level.  The above aspect with regards to the tobacco market has been captured and represented below (Krugman & Wells, 2013).

Economic Profit

On the left hand is the price, cost and revenue for a single firm while on the right is the industry demand and supply. It is evident that the individual firm is a price taker and not a price maker and the equilibrium price is essentially determined by the respective demand and supply at the industry level. It is noteworthy that the long run equilibrium is driven by the underlying price which plays the role of a equilibrating force. This is because if in the short run the firms would make economic profit, then new firms would enter the market due to absence of entry barriers. Over a period of time, this would lead to increased supply which would bring down price to a level where the economic profit for the individual firms become zero and hence an equilibrium position is reached where the new firms enter only to the extent an existing firm leaves the market (Mankiw, 2014).

Based on the article given, the following two factors are responsible for the decrease in the tobacco production.
  • Increase of tax burden on cigarettes to the tune of 12.5% during the previous two years
  • Introduction of the plain packaging norms

The following graph aptly captures the effect of levying tax on cigarettes as indicated in the article.

Impact of tax

Assuming that a taxation burden of $ 0.60 is levied on cigarettes and this whole tax burden is borne by the consumers, then the unit price of cigarette increases to $ 2.60. This leads to a shift equilibrium point from A to B. As a result of the increased price, the cigarette demand would plummet but the supply curve would be altered from its original position S0 to the new position S1. The net effect of the change in demand and supply would lead to a decrease in the cigarette consumption. The extent of decrease in consumption would be driven by underlying elasticity of cigarettes in the particular market where tax is imposed (Nicholson & Snyder, 2011).

Impact of Plain Packaging

In Australia, the enforcement of plain packaging norms has limited the opportunity of marketing their brand to the cigarette manufacturers. This in all likelihood would lower the cigarette demand especially amongst the youth who tend to find the plain packaging non-attractive and may not be currently addicted to smoking (WHO, 2013). The following diagram accurately reflects the effect of plain packaging on the corresponding price and quantity of cigarettes.

Decrease in Demand

It is apparent that the plain packaging norms would lead to a shift in the demand which causes a leftward shift in the demand curve while the supply of cigarette remains unaltered. As a result of the above alteration in the demand curve, there has been a decrease in both the equilibrium quantity and price which is clearly indicated in the above graph. Therefore, it is evident from the above graph that the plain packaging norms would lead to lower consumption of cigarettes and hence would be beneficial to the society (Pindyck, & Rubinfeld, 2001).

It is noteworthy that plain packaging is rarely implemented in isolation and often involving levying of high taxes so as to enhance price coupled with decrease in demand so as to limit the incidence of chain smoking and encourage the users to search for cheaper alternatives.

The price elasticity of a given product is driven by a host of factors whose cumulative effect needs to be taken into consideration. These factors include the nature of good (basic, luxury, giffin), underlying income of the consumer, cheap substitute availability and other factors (Krugman & Wells, 2013).

The tobacco demand is likely to be relatively inelastic (i.e. elasticity would be lesser than 1). This is primarily because the availability of cheaper alternative is highly limited particularly considering the addictive nature of consumption of tobacco in various forms. As a result, even when the price increases by some amount, most users tend to continue with the consumption although there is some decline.  However, the formula for PED (Price elasticity of demand) is shown below (Mankiw, 2014).

PED = - (Percentage quantity change/Percentage price change)

For the habitual tobacco users in various forms, it is extremely difficult to decrease the consumption that too suddenly and only in the long run would there be seen tangible results in this context. Therefore, the price increases for tobacco would cause a proportionately lesser decrease in the tobacco consumption thus, the PED magnitude is lower than 1. Even though, through technology interventions products like e-cigarettes are being hailed as viable alternative for reducing tobacco consumption but there are issues with regards to their usage due to which these are not very popular. However, it is likely that in the future viable and safer alternatives of tobacco are available which would lead to increased PED for tobacco.

The impact of sales tax on the consumers and producers can be explained through the assistance of the following diagram.

Diagram

It is evident from the above demand curve that the nature of demand for the given product is inelastic. This is apparent from the fact that even when the price increase has occurred from P to P1, the corresponding quantity decrease is comparatively marginal only as denoted through a shift from Q to Q1. Due to the inelastic nature of demand, the consumption of cigarettes would not decline even though the price may increase as consumers are addicted. This allows the sellers to act a pass through mechanism with a major portion of the incremental tax burden being borne by the final consumer (Krugman & Wells, 2013). This situation is reflected in the diagram shown above where the green area indicates the extra burden for the producers while the pink area indicates the extra burden for the consumers.  The diagram clearly highlights the fact that area in pink covers more area than the area in green.

In case, the elasticity of cigarettes increases owing to availability of comparable and cheaper alternatives, then the pink area would shrink and would be substituted by the green area. This would be indicative of the diminishing clout on the part of the seller with regards to pass the incremental tax burden to the consumers as this may lead to a decrease in the demand of cigarettes. Thus, it may be generalised that the incremental burden of tax borne by the producer is directly proportional to the product PED (Pindyck, & Rubinfeld, 2001).

References

Krugman, P & Wells, G 2013, Microeconomics,  3rd edn Worth Publishers, London

Mankiw, G 2014, Microeconomics, 6th edn, Worth Publishers, London

Nicholson, W & Snyder, C 2011. Fundamentals of Microeconomics, 11th edn, Cengage Learning, New York

Pindyck, R & Rubinfeld, D 2001. Microeconomics, 5th edn. Prentice-Hall Publications, London

WHO 2013. Reducing the appeal of smoking – first experiences with Australia’s plain tobacco packaging law, World Health Organisation, Available online from https://www.who.int/features/2013/australia_tobacco_packaging/en/ (Accessed on July 15, 2016)

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[Accessed 02 March 2024].

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