Price Elasticity Of Demand In The Cigarette Industry

INTRODUCTION

Microeconomics means the study of the behaviour of individual economic units. It studies the supply and demand in markets for particular goods and services and the resources, by examining the economic behaviour of firms and consumers.

A cigarette is a small paper-wrapped cylinder of cured and shredded or cut tobacco leaves processed with hundreds of chemicals. The cigarette is ignited at one end and allowed to smoulder for the purpose of inhalation of its smoke from filtered end, inserted in mouth. They are manufactured by a machine, and are the predominant form of tobacco used worldwide.

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In Malaysia, cigarette smoking is the extreme avoidable cause of disease and untimely death in our nation. Secondhand smoking causes frequent lung cancer deaths annually. Measures have been taken in both workplaces and public places to limit exposure to secondhand smoke. Smokers around our country are likely feeling a great deal of angst. A pack of 20s will be priced at rm10 starting today (THE STAR, 2010). The previous price at 2009 was RM9.30, and now priced 70cents higher than previous. A price increase is a good opportunity for smokers to kick the habit, adding that the ministry has set up clinics to help smokers quit free of charge (Health Minister Datuk Seri Liow Tiong Lai, 2010). Locally, there are estimated to be more than 100 types of smuggled cigarettes, priced between RM3 and RM3.50 for a 20-stick pack. He also suggested that cigarette smuggling activities might see an increase.

Malaysia government had realized that the consumption of cigarette in the country was so high and the government had decided to increase 10% tax on the tobacco. This will directly affect the price of tobacco, which will lead to the increase on price for cigarette. According to the information from the given article, an increase of 10% on tobacco will reduce 3.8% of consumers demand on cigarette. Besides that, the government had also ordered that it is a restriction for any promotion made on cigarette and there is an age limit for purchasing cigarette. The government used all these methods by hoping to further reduce the consumption of cigarette in Malaysia.

MAIN BODY

Explain price elasticity of demand. Calculate the price elasticity o demand for cigarette and use a diagram to illustrate your answer.

Price elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price. In other words, it is ration between a change in price and the resultant change in quantity demanded. There are two method used to calculate the degree of elasticity.

The first method is The Point Method. The formula for The Point Method is:

Ed = Q ÷ P

Q P

The second method is The Arc Method. In other words, The Mid-point Method. The formula for The Arc Method is:

Ed = Q ÷ P

Q1 + Q2 P1 + P2

2 2

Diagram 1

The market demand curve for cigarette will always be inelastic. This is because smoking is an addiction and the smokers need to purchase cigarette to smoke and control the addiction. Therefore, when there is an increase in the price of cigarette, there will only be a slight decrease in the quantity demanded. As shown in Diagram 1, there is an increase of 10% in the price of cigarette and this 10% increase in price had lead to a decrease of 3.8% in the quantity demanded for cigarette.

By using The Point Method to calculate the degree of elasticity:

Ed = Q ÷ P

Q P

= 3.8% ÷ 10%

= 0.38

Therefore, 1% increase in the price of cigarette will lead to a decrease of 0.38% of the quantity demanded for cigarette. According to this result, the elasticity coefficient is less than 1, which means it is an inelastic demand.

What would be the effect of setting the minimum retail price of a stick of cigarette?

By setting the minimum retail price will create a price floor in the market. Price floor is set to prevent the price from falling below a certain level. When a price floor is set, sellers are allowed to sell at prices above that price level but not below it. This may be done to protect producer’s incomes.

Diagram 2

The effect of setting the minimum retail price is surplus occurs in the market of cigarette. Quantity supplied will be at Q2 and quantity demanded will be at Q1. This means that quantity supplied of cigarette is greater than quantity demanded of cigarette.

Diagram 3

When there is surplus, government may discourage supply by imposing tax on cigarettes. This means that government influence the production of cigarettes causing the supply curve in the market of cigarette to shift to the left until the equilibrium point reached at E2 where the price of each pack of 20 cigarettes is RM10 and both quantity demanded and quantity supplied are at Q1.

Explain why government needs to increase the price for cigarettes?

Government needs to increase the price for cigarettes because of several reasons. The first reason is to protect children and teenagers from taking up the smoking habit and exposing themselves to chronic diseases or taking drugs. This is because by increasing the price for cigarettes, people without working income such as children and teenagers will not be willing to use their pocket money to buy cigarettes.

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The second reason is to decrease the death rate cause by smoking worldwide. Around 5.4 million deaths a year are caused by tobacco and World Health Organisation (WHO) estimate that tobacco use will kill 1 billion people in the 21st century if current smoking trends continue. Therefore by increasing the price for cigarettes, demand for cigarettes will eventually decrease and most smokers will try to kick the habit.

The third reason is smoking can ruin the country’s reputation and the image of the citizens. This is because when foreigners come to travel and discover that the country is full with smokers, they will eventually choose not to go to that country for travelling. It directly affect the country tourism industry and economic of that country. Therefore by increasing the price for cigarettes, demand for cigarettes will decrease and most smokers will try to kick the habit. Eventually, the country will have lesser smokers.

The last reason is to create a healthy future for the next generations. Children always treat their parents as their role model or learning model. If parents have the habit of smoking, children might follow and try to smoke when they grown up. With the increase of price for cigarettes, parents will decrease the smoking amount and eventually quit smoking. Therefore, children will slowly learn that smoking is not a good thing to learn.

Suppose that the price of a packet of 20s’ cigarette is RM Pe in the market. Now consider a decision by the federal government to impose a cigarette tax of RM t per packet. Who will bear more of the tax – sellers or buyers? Illustrate your answer with diagrams.

Government may impose direct tax or indirect taxes. Direct taxes are taxes paid by individual or organisation such as personal income tax and corporate tax. Meanwhile, indirect taxes are taxes on expenditure such as taxes on goods and services. When federal government impose tax to the cigarettes, 2 situations will occurs.

Diagram 4

The first situation is the market supply curve for cigarette is elastic. When tax is imposed into the market of cigarettes, the supply curve will shift to the left causing the equilibrium point change from A to B, the equilibrium quantity demanded change from Qe to Q1, and the equilibrium price change from Pe to P1. Therefore consumer tax is at P1BCPe and producer tax is at PeCDP2. In this situation, consumer tax is greater than producer tax. In other word, the consumer pays more taxes than the producer.

Diagram 5

The second situation is the market supply curve for cigarette is inelastic. When tax is imposed into the market of cigarettes, the supply curve will shift to the left causing the equilibrium point change from A to B, the equilibrium quantity demanded change from Qe to Q1, and the equilibrium price change from Pe to P1. Therefore consumer tax is at P1BCPe and producer tax is at PeCDP2. In this situation, producer tax is greater than consumer tax. In other word, the producer pays more tax than the consumer.

State another example of government intervention and analyse the effects of such intervention to the market.

Another intervention the government can do to the market of cigarette is setting maximum retail price of a stick of cigarette. By setting maximum retail price will create a price ceiling in the market. Price ceiling is set to prevent the price from rising above a certain level. When a price ceiling is set, sellers are allowed to charge any price up to that price level but not permitted to go above it. This is normally done for reason of fairness.

Diagram 6

The effect of setting the maximum retail price is shortage occurs in the market of cigarette. Quantity supplied will be at Q1 and quantity demanded will be at Q2. This means that quantity demanded of cigarette is greater than quantity supplied of cigarette.

Diagram 7

When there is shortage, government may encourage supply by giving subsidies or tax relief to producers. This means that government influence the production of cigarettes causing the supply curve in the market of cigarette to shift to the right until the equilibrium point reached at E2 where the price of each pack of 20 cigarettes is at Pmax and both quantity demanded and quantity supplied are at Q2.

CONCLUSION

As the conclusion, we will be talking about the questions in the Main Body. In question 1, we explained the price elasticity of demand. Then we calculate the price elasticity for cigarette and also the elasticity coefficient for cigarette. We had also included a diagram to illustrate our answers.

Meanwhile in question 2, we explained the definition of price floor. Then we explained the effect of price floor and also the way to overcome this problem. We had used 2 diagrams to illustrate our answers.

In question 3, we explained about the reason why government needs to increase the price for cigarette. We explained four reasons; two of those are about health, one about tourism and the last is about future generations.

Furthermore in question 4, we explained the effect when government impose tax into the market of cigarette. We explained the effect in two situations. The first situation is where the supply curve for cigarettes is elastic and the second situation is where the supply curve for cigarettes is inelastic. We had used 2 diagrams to illustrate both situations.

Lastly in question 5, we explained another example of government intervention. The intervention is that government set maximum price in the market of cigarette. We explained the definition of price ceiling. Then we explained the effect of price floor and also the way to overcome this problem. We had used 2 diagrams to illustrate our answers.