Describe the factors that economic theory would suggest are likely to determine the demand for cigarettes in the UK.

Gideon Krotosky Microeconomics Coursework Nancy Devlin/PeterWilks

The Economics of Smoking December ‘03

Describe the factors that economic theory would suggest are likely to determine the demand for cigarettes in the UK

The demand for a good is the quantity consumers are willing and able to buy at a given price over a period of time. Its determinants include:

Price of the good
Consumers’ income
Expectations
Consumer preferences
Advertising
Government legislation
Price and availability of substitute and complement goods

Those affecting demand for cigarettes in the UK though, only include the following out of the above:

Price of cigarettes,
Consumers’ income,
Expectations
Availability and price of substitute and complement goods.

Overleaf is a demand curve for cigarettes showing the relationship between the price of cigarettes and their quantity demanded over a given period of time.

It is evident that at price P, Q cigarettes are demanded but when prices rise to P1, the quantity demanded of cigarettes falls to Q1 and there is a movement upwards along the demand curve. This is consistent with the law of demand, which tells us that when the price of a good rises, its quantity demanded will fall. This happens because people will feel worse off and as a result, their purchasing power has fallen because their real income as fallen. This is known as the income effect. The substitution effect of a price rise results in people substituting their goods for an alternative, because they now cost more compared to the alternative. As cigarettes do not have a direct substitute, the substitution effect is minimal.

If consumers’ disposable income rises, depending on how big one’s opportunity cost for cigarettes is, the demand for cigarettes will rise. The opportunity cost of buying cigarettes can be defined as the next best alternative sacrificed. If this is large, then the extra income is unlikely to go towards more cigarettes, but if it is small then the consumer’s demand for cigarettes is likely to rise.

Demand could rise temporarily if smokers stock up in anticipation of a price rise associated with the budget demand rises. The demand curve as illustrated below will then shift to the right because more cigarettes are being demanded at the same given price P1.

There are no real direct substitutes for cigarettes. Cigars and pipes are not really direct substitutes in my opinion so I have disregarded them because they taste different and are not as addictive as they are a less potent source of nicotine. Marijuana, in my opinion, it is more of a complement good than a substitute good and therefore, if its price was to rise, then the price of cigarettes would resultantly rise.

b) In many countries, including the UK, governments impose sales (‘excise’) taxes on cigarettes. Explain in words and using appropriate diagrams, the ...

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b) In many countries, including the UK, governments impose sales (‘excise’) taxes on cigarettes. Explain in words and using appropriate diagrams, the effect of these taxes on the market for cigarettes.

Price elasticity of demand (PED) measures the responsiveness of demand to a change in price and with a value of less than 1, cigarettes can be defined as an inelastic good. This is mainly due to the fact that cigarettes have very few substitutes if any, and because they are addictive, a change in prices of cigarettes will have very little long-term effect on their quantity demanded. The main determinants of price elasticity of demand for cigarettes include: the number and closeness of substitute goods and the proportion of income spent on the cigarettes.

An indirect tax can be defined as a tax on the expenditure on goods. They are not paid directly by the consumer, but indirectly via the vendors of the good. When the government impose excise duties on cigarettes, they do it with the aim of raising revenue and lowering the consumption of cigarettes. It results in the supply curve shifting upwards by the amount of the tax as shown below.

As the tax is a per unit tax i.e. a specific tax, there is a parallel shift upwards, because the amount of the tax is the same at all prices. The supply curve shifts upwards when a tax is imposed because in order for firms to be persuaded to produce the same quantity of cigarettes as before the levying of the tax, they need to receive a price, which allows them fully to recover the tax they have to pay i.e. P1+tax. Before the imposition of the tax, the equilibrium point is at P1 Q1, but after the tax it is now at P2 Q2.

Since cigarettes are an addictive good, they have a very inelastic (i.e. steep) demand curve. However, evidence shows (Patrick C. Gallagher) that among those under the age of 25, it is likely that if prices of cigarettes were to rise through taxes, individuals would not have the money to afford such a habit unless through crime, and the opportunity cost for a packet of cigarettes would now be a lot greater for this age group. This is because they are relinquishing longer life expectancy and thus, potential earnings in the future. All in all, it means that cigarettes are a lot more inelastic for age groups over 25 than under 25. The incidence of taxation for the over 25’s is illustrated below:

Equilibrium is initially at a price of £P1 and cigarette sales of Q1. However, due to the tax, the supply curve has shifted to the left and the new equilibrium point is now at P2Q2. Prices have risen from P1-P2, but the price increase is less than the full amount of the tax, showing that producers pass on only part of the burden of the tax( Longman Guide: ’98: page315). Quantity demanded has not changed very much because demand for cigarettes in this age group is so inelastic, and this results in the consumers paying the majority of the tax burden while the producers pay just a minority. This is illustrated in the diagram. The area A represents the gain in tax revenue after the imposition of the tax. The consumer surplus is the excess of what a person would have been prepared to pay for a good (i.e. the utility) over what the person actually pays. Before the imposition of the tax, this is area ABH. The producer surplus can be defined as the difference between what a supplier is paid for a good and what it costs to supply. Before the tax, this is area CDE. Total surplus is maximised at this output level. After the levying of the tax, consumer surplus falls to area A and producer surplus falls to area D. The areas CB give the revenue from the tax, otherwise known as government surplus. The deadweight welfare loss is the loss of consumer surplus plus producer surplus after the imposition of the tax and areas EH represent this in the diagram.

As the demand curve for those under the age of 25 is slightly more elastic than the over 25’s, its slope is not so steep, and this results in the burden of the tax being distributed slightly more evenly between the producer and consumer even though the consumer still ends up paying more. This is illustrated below.

The elasticity of supply also affects the burden of tax between producers and consumers. The elasticity of supply measures the responsiveness of quantity supplied to a change in price. The more elastic the supply curve is, the smaller the burden on producers and the larger the burden on consumers.

Another effect of taxes on the market for cigarettes is the possibility of it making tobacco smuggling more lucrative, tempting individuals and crime rackets. Smuggled cigarettes account for up to 10% of the UK market and they are losing the government over £3billion each year in tax revenue (Sloman: ‘03:page 69).

(c) In what other ways do Governments intervene in the market for cigarettes? If consumers are well informed and rational, as consumer choice theory assumes, why are such interventions deemed necessary?

Government methods of intervention apart from taxes include:

1) Provision of educational campaigns in schools to dissuade children from starting smoking.

2) Restricting where smoking takes place. Smoking is now banned in many public places in the UK including: cinemas, trains, buses and aeroplanes. This is mainly to help prevent passive smoking, which according to statistics is responsible for approximately 3000 lung cancer deaths each year in non-smoking adults and harms the health of hundreds of thousands of children (Economics of Smoking Bans 7/03: page1).

3) The selected banning of billboard advertising. This has proved invaluable in the past in helping to reduce the consumption of cigarettes (Basic Facts No.3: 10/03: page1).

4) The restriction of duty free quantities of cigarettes at portals of entry to the country as well as vigorous campaigns by customs officers to seek out those suspected of smuggling tobacco.

A rational consumer is one who weighs up the costs and benefits of consuming an additional unit of a good and attempts to maximise his/her total consumer surplus. However, as cigarettes are an addictive substance they result in irrational consumer behaviour because consumer preferences are so strong and withdrawal symptoms override logic. Combining this with incomplete information, it results in government interventions being deemed necessary. Smokers realise the heavy costs in smoking which include the current monetary price as well as the cost in terms of future harm and addiction but, in their mind, they are in denial and think it won’t happen to them. They have made a utility maximising decision and in essence have done a cost-benefit analysis i.e. they have weighed up the costs and benefits of smoking but still decide to start/continue smoking.

Smokers impose enormous costs on others, which have resulted in a mandate for government action. These mainly include health costs which according to statistics, costs the National Health Service (NHS) approximately £1.5billion a year for treating diseases caused by smoking (Basic Facts No.3: 10/03: page1). With regards to the case of pregnant women, smoking leads to an increased incidence of low birth weight babies, which imposes both short-run costs of medical care and long run costs of special education.

Smokers dispute this and say that as they have a shorter life span, they actually reduce NHS costs and care costs in the long term and so are assets to the government and the population.

Surveys show that the majority of smokers want to quit (NBER working paper series part1 smoking behaviour and policy: page7), so even if consumer choice theory was correct, the government still need to carry on intervening through the methods mentioned above and hope their persistence will actually pay off.

Word Count- 1645

Bibliography

1) Economics John Sloman fifth edition pages: 31-33, 67-68, 301, 88, 91,