Question

New York City has the highest cigarette taxes in the country. During the four months following the recent tax hike, sales of taxed cigarettes in the city fell by more than 50 percent as consumers turned to the city's bustling black market. The thriving illegal market for cigarettes has diverted billions of dollars from legitimate businesses and governments to criminals. Source: Cato Institute, February 6,2003 a. How has the market for cigarettes in New York City responded to the high cigarette taxes? b. How does the emergence of a black market impact the elasticity of demand in a legal market? c. Why might an increase in the tax rate actually cause a decrease in the tax revenue?

Short answer

a. Sales of taxed cigarettes fell by more than 50%. b. Increased black market activity suggests high elasticity. c. High elasticity can lead to tax revenue decreases.

Step-by-step solution

Analyze the response to high cigarette taxes

The problem states that sales of taxed cigarettes in New York City fell by more than 50 percent following a recent tax hike. This indicates that consumers responded to the higher taxes by significantly reducing their purchases of taxed cigarettes. Instead, they turned to the black market to satisfy their demand.

Understand the impact on elasticity of demand

The emergence of a black market suggests that the demand for legally taxed cigarettes is highly elastic. Elasticity of demand measures how sensitive the quantity demanded is to a change in price. In this case, a significant drop in legal sales due to higher prices implies that consumers have many substitutes available (in this case, the black market), and they are willing to shift to these alternatives when the legal price increases.

Explain the potential tax revenue decrease

An increase in the cigarette tax rate can cause a decrease in tax revenue if the demand for taxed cigarettes is highly elastic. When taxes are increased, consumers may turn to black market alternatives, reducing the taxable volume of cigarettes sold. Consequently, despite the higher tax rate, the overall tax revenue may decrease because fewer legal transactions occur.

Key concepts

elasticity of demand

Elasticity of demand measures how much the quantity demanded of a good changes when its price changes. When demand is elastic, a small change in price leads to a significant change in quantity demanded. In New York City, the sharp decline in sales of taxed cigarettes by over 50% following a tax hike indicates that the demand for these cigarettes is highly elastic.

Consumers have a variety of substitutes available, including illegally sold cigarettes from the black market. When the price of legally taxed cigarettes went up, many consumers switched to these untaxed options. This is a classic example of high elasticity, where a price increase results in a substantial decrease in the quantity of the product that consumers buy legally.

The high elasticity in this context means people are quite responsive to changes in price. If there are cheaper or alternative sources like a black market, they will quickly switch their purchasing habits to avoid higher costs.

black market

The emergence of a black market for cigarettes in New York City is largely a consequence of high cigarette taxes. When taxes make the legal price of cigarettes too expensive, consumers look for cheaper alternatives. This illegally operated market attracts buyers because it offers lower prices by avoiding the high taxes imposed by the government.

The black market diverts significant revenue from legitimate businesses and the government to illegal operators. This not only leads to a loss of lawful tax revenue but also fuels criminal activities. The presence of a black market demonstrates how sensitive consumers are to price changes in the legal market.

As consumers find the black market to be a viable and cheaper substitute, the elasticity of demand for legally sold cigarettes increases. This newly developed black market compounds the elasticity issue by offering consumers an easy alternative to avoid high prices.

tax revenue

Tax revenue refers to the money collected by the government through taxation. Ideally, higher taxes should lead to higher revenue. However, this isn't always the case, especially when dealing with products that have highly elastic demand, such as cigarettes in New York City.

When the tax on cigarettes was increased, it did not lead to an increase in tax revenue. Instead, consumers reduced their purchases of taxed cigarettes and turned to the black market. As a result, the volume of sales on which taxes could be collected decreased significantly.

High elasticity means that consumers are very responsive to price changes; thus, higher taxes can drive them to seek untaxed alternatives. Consequently, the government's total tax revenue from cigarette sales can decrease even if the tax rate is higher because the taxable sales volume drops.

This example from New York City showcases that raising taxes on goods with highly elastic demand can sometimes backfire and result in lower overall tax revenue.