Question

The accompanying diagram shows the market for cigarettes. The current equilibrium price per pack is \(\$ 4,\) and every day 40 million packs of cigarettes are sold. In order to recover some of the health care costs associated with smoking, the government imposes a tax of \(\$ 2\) per pack. This will raise the equilibrium price to \(\$ 5\) per pack and reduce the equilibrium quantity to 30 million packs. The economist working for the tobacco lobby claims that this tax will reduce consumer surplus for smokers by \(\$ 40\) million per day, since 40 million packs now cost \(\$ 1\) more per pack. The economist working for the lobby for sufferers of second-hand smoke argues that this is an enormous overestimate and that the reduction in consumer surplus will be only \(\$ 30\) million per day, since after the imposition of the tax only 30 million packs of cigarettes will be bought and each of these packs will now cost \(\$ 1\) more. They are both wrong. Why?

Short answer

Answer: The actual reduction in consumer surplus per day is \$10 million.

Step-by-step solution

Understanding consumer surplus

Consumer surplus is the difference between what consumers are willing to pay and what they actually pay for a good. In this case, we are looking at the change in consumer surplus before and after the government imposed the tax on cigarette packs.

Calculate consumer surplus before the tax

Before the tax, the equilibrium price per pack was \(\$ 4\) and there were 40 million packs sold per day. The total expenditure by the consumers on cigarettes can be calculated as \(4 \times 40 \, million = \$ 160\, million\) per day.

Calculate consumer surplus after the tax

After the tax, the equilibrium price per pack is \(\$ 5\) and there are 30 million packs sold per day. The total expenditure after the tax can be calculated as \(5 \times 30 \, million = \$ 150\, million\) per day.

Calculate the change in consumer surplus

The change in consumer surplus can be calculated by subtracting the consumer surplus after the tax from the consumer surplus before the tax: \(160\, million - 150\, million = \$ 10\, million\) per day.

Compare the change in consumer surplus with the economists' claims

Both economists are wrong because they both overestimated the reduction in consumer surplus. The economist working for the tobacco lobby claimed a reduction of \(\$ 40\, million\) per day, and the economist working for the lobby for sufferers of second-hand smoke claimed a reduction of \(\$ 30\, million\) per day. However, the actual reduction in consumer surplus is only \(\$ 10\, million\) per day.

Key concepts

Equilibrium Price

The concept of equilibrium price is crucial in understanding how the market operates. It is the price point at which the quantity of a good demanded by consumers equals the quantity supplied by producers. In a perfectly competitive market, the forces of supply and demand find a natural balance, and this is the equilibrium price. It is like a seesaw balancing act, where the preferences of buyers and the production abilities of sellers are equal.

In the case of the cigarette market discussed in the exercise, the equilibrium price was initially \(\\(4\) per pack, with 40 million packs sold. This means that at a price of \(\\)4\), the quantity of cigarettes smokers were willing to buy was exactly what was available in the market.

Changes in equilibrium price occur when external factors affect either supply or demand, such as taxation, changes in consumer preferences, or variations in production costs.

Taxation Impact

When the government imposes a tax on a good, it directly affects the market dynamics by altering the price consumers pay and the price producers receive. This taxation, represented in the exercise as a \(\\(2\) per pack tax on cigarettes, raises the cost for consumers and can change their buying behavior.

A tax influences the supply curve, shifting it upwards by the amount of the tax. This shift means that for every pack sold, an additional \(\\)2\) must be paid to the government. Consequently, the price consumers see is higher, altering their demand for the product. In simple terms, taxes make a product more expensive from the consumer's perspective, usually decreasing the quantity demanded.

• Consumers tend to buy less because the price goes up.
• Producers may earn less per item sold because the government's cut reduces their profit margins.
• The resulting price increase and drop in sales volume lead to market adjustments to a new equilibrium.

Market Equilibrium

Market equilibrium is the point where supply meets demand. After the imposition of a tax, market equilibrium is re-established at a new price and quantity where the quantities demanded and supplied are once more equal.

In the cigarette example, the tax changed the equilibrium conditions. Initially, the equilibrium was at \(\\(4\) and 40 million packs. Post-tax, the equilibrium price adjusted to \(\\)5\) per pack, with only 30 million packs being sold.

This new equilibrium conditions arise because the higher price leads consumers to demand fewer cigarettes, and producers adjust the quantity supplied to match the new lower demand. It's a flexible system where prices and quantities continue to adjust until a new balance is achieved.

Cigarette Market

The cigarette market provides a unique context to study economic principles due to its regular interaction with taxation and health policies. Cigarettes, being products with significant social and health implications, are often subject to government regulations and taxes.

In this market, demand can be relatively inelastic, meaning consumers may not significantly change their quantity purchased even when prices increase. However, significant tax rates, as in our scenario, eventually push some consumers away from buying as many cigarettes as before, reducing the quantity demanded.

• Health policies use taxes to discourage smoking.
• Even with inelasticity, a high enough price will see demand decreases.
• The market must balance consumer needs with health regulations, a constant economic consideration.

Economic Surplus

Economic surplus is the sum of consumer and producer surplus in the market. It is a measure of the market's efficiency and overall welfare, representing the total benefits available to society from the production and consumption of goods and services.

Consumer surplus represents the difference between what consumers are willing to pay and what they actually pay. Producer surplus is the difference between what producers are willing to accept for a good versus what they actually receive.

In the context of this exercise, the introduction of a tax reduces consumer surplus because consumers are now paying more for fewer goods. Taxes create a deadweight loss, a loss of economic efficiency. This deadweight loss represents the total welfare lost to society due to the tax imposition, reducing both consumer and producer surplus.