Examine the Importance of the Elasticity of Demand in a Government Decision to Impose a Specific Tax on the Buyers of Cigarettes.

881 WordsNov 1, 20124 Pages
Examine the importance of the elasticity of demand in a government decision to impose a specific tax on the buyers of cigarettes Price Elasticity of Demand is the responsiveness of a change in the quantity demanded of a certain good to a change in its price. The formula for Price Elasticity of Demand is the percentage change in the quantity demanded of a certain good divided by the percentage change in the price of that certain good (Alain Anderton, p.55). A specific tax is a tax that’s amount levied does not change with the value of a good but with the amount or volume of a good purchased (Alain Anderton, p74). Cigarettes are demerit goods which yield negative externalities. Demerit goods are goods that are overprovided by the price…show more content…
If a specific tax is imposed on the buyers of cigarettes and they have an inelastic demand for them and the supply of cigarettes is fairly elastic then the incidence of the tax will fall largely on the consumer. This is illustrated below: Figure 2 shows that in a free market the equilibrium price for cigarettes is 0P1 and quantity OQ1. However, the social optimum price is 0P2 and quantity 0Q2 where marginal social costs equal marginal social benefits of the last unit produced. The vertical distance CA represents the external cost for each cigarette consumed. By placing a tax equal to the external cost CA per cigarette, the government successfully internalises the externality. The total tax area is P2ACP3. The area P1P3CB represent the amount the producer pays towards the tax and the area P2P1BA represents the amount the consumer pays towards the tax. As illustrated, the incidence of the tax largely falls on the consumer because the demand for cigarettes is fairly inelastic and supply of cigarettes is fairly elastic. Hypothetically, if the demand for cigarettes was perfectly inelastic and the supply of cigarettes was perfectly elastic then the incidence of the tax would fall fully on the consumer. Therefore, The importance of the Price Elasticity of Demand in a government decision to impose a specific tax on the buyers of cigarettes lies in the fact that the elasticity of

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