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Economics "Ask the Instructor" Clip 38 Transcript
Why are taxes on cigarettes so high?
Taxes levied on cigarettes have increased tremendously in recent years. As of year 2000, the combined
state and federal taxes per pack ranged from about 37 cents in KY to $1.45 in NY.
The primary reason why cigarette taxes are high is because the tobacco industry is out of favor
with the public and it is “politically correct” for legislators to tax the industry. However, one could argue
that taxes are appropriate to correct for negative externalities and to discourage consumption for public
health reasons. But what we want to focus on is the connection between price elasticity of demand and
taxation.
You know that price elasticity of demand measures how responsive quantity demanded is to a
change in price. Specifically, it’s the percent change in quantity demanded divided by the percent change
in price.
You also know that any tax levied on either producers or wholesalers of cigarettes will shift
market supply to the left. This will result in an increase in price to the consumer. How much price rises
depends on price elasticity of demand. The more inelastic the demand, the more price will rise.
Suppose that taxes are increased on all brands of cigarettes equally. The price elasticity of
demand for cigarettes is a relatively small number. The higher taxes levied on the cigarette industry will
cause the industry supply curve to shift to the left. Because demand is inelastic, much more of the tax can
now be shifted forward to consumers via higher prices.
Negative publicity associated with smoking is an important reason why the tobacco industry is
heavily taxed. However, part of the reason is that legislators recognize that consumers of tobacco products,
particularly cigarettes, do not alter their consumption very much even when prices increase. That is, the
demand for cigarettes is inelastic with respect to price.
This means that taxation of cigarettes is a great
way to raise tax dollars. And of course legislators can justify this tax on the grounds that part of the
revenue is being used to cover the health costs of smokers.
In summary, the concept of price elasticity of demand is very important. Legislators need to know
about it before proposing a tax. Retailers need to have some idea of the price elasticity of demand for their
product before deciding whether to raise or lower their prices. Finally, one reason why cigarette taxes are
so high has to do with the low price elasticity of demand.