Question

Smokers are gasping at higher cigarette and cigar prices as the largest federal tobacco tax increase in history takes effect. The increases, which raise the federal cigarette tax from $0.39 a pack to $1.01, applies to all tobacco products. It comes as more than two dozen states, desperate for revenue in a sunken economy, considering boosting their own tobacco taxes this year. "This is very historic," said Mathew McKenna, director of the Office of Smoking and Health at the Centers for Disease Control and Prevention. Before the tax hike, cigarette prices averaged about $5 a pack. Now tobacco companies are raising prices by different amounts. Some are absorbing part of the increase; others are raising prices more. In the past, a 10% price increase reduced cigarette consumption about 4%, McKenna said. He expects the federal tax hike to prompt at least 1 million of the 45 million adult smokers to kick the habit. Suppose the average cigarette price rose by 18%.
Required:
a. According to the article, by what percentage might smoking be expected to decline?
b. If the price elasticity of demand for teen smoking is 0.7, by how much would teen smoking decline if the price of cigarettes increased by 18%?

Answer 1

Answer:

a. Smoking might decline by 7.2%

b. Teen smoking would decline by 12.6%

Explanation:

1. The elasticity of demand is able to check the amount that demand will reduce by if prices rose.

The formula is;

= % change in quantity demanded / % change in price

Given that a 10% price increase reduced cigarette consumption about 4% in the past, the elasticity is;

= -4%/10%

= - 0.4

Given that prices rise by 18%, the resultant decrease in consumption should be;

= - 0.4 * 18%

= -7.2%

b. Given and elasticity of demand of 0.7, the teen smoking rate would decline by;

= elasticity * price increase

= 0.7 * 0.18

= 12.6%