Economic Analysis of Excise Duty on Cigarettes, Production Costs and Market Structures

Contents
Question 1...................................................................................................................................................1
Question 2...................................................................................................................................................2
a) Fixed and Variable Costs..................................................................................................................2
b) Differences between Monopolistic and Oligopolistic Market Structures........................................3
Price and Output determination in a Monopolistic Competition..............................................................5
Short Run Equilibrium.........................................................................................................................5
Long Run Equilibrium.........................................................................................................................7
Question 3.................................................................................................................................................11

Question 1
a) There is an excise duty (tax rate) is as follows Australian Taxation Office, (2018)
Tax Rate Retail Price Base Price
Upto Jan 2018 0.6898 30 17.7535
Since March 2018 0.71046 30 21.3138
Price Elasticity refers to the degree to which the demand a good is price sensitive. i.e. if a small
increase in the price, reduces the demand disproportionately (greater than 1), then the demand for
the god is highly price elastic. Similarly, if the demand for the good is relatively unaffected, then
the price elasticity is low. (Less than 1) (Mankiw, 2008)
It is measured as:
EDP = Proportionate change in demand/ proportionate change in per unit price.
Figure 1 Price Elasticity of Demand
Source: (Samuelson & Nordhaus, 2006)
In the diagram above, as the price drops from P1 to P2, the demand (and consequently output)
moves from Q1 to Q3. The ratio of (P2-P1)/(Q2-Q1) is the elasticity of demand. The reverse effect

is seen as price increases from P1 to P3. Output falls fromQ1 and Q2 and hence the (P3- P1/ Q1- Q3)
elasticity will be negative.
Figure 2 Various kinds Price Elasticity of Demand
Source: (Chauhan 2009)
According to international research, generally, the elasticity of demand for cigarettes in Western
Countries is less approximately -0.4. (Tobacco in Australia, 2018)Thus, the Price Elasticity of
demand for cigarettes is low (Panel 2 of Figure2). Hence, an increase in the tax would not reduce
the demand in the same proportion. (Mankiw, 2008) Tobacco consumption has decreased
significantly in Australia and taxation has played a role in this transformation. (Australian
Bureau of Statistics, 2013)

Figure 3 The Effect of Taxes on Tobacco Based Products (Example: Cigarettes)
Since, the demand is not expected to reduce to a great extent, if the price changes considerably,
the seller can afford to pass it on to the consumer, Thus, the consumer will have to pay a higher
price of the cigarette. The implication of this is that the consumer will either be forced to pay
more or decrease consumption. The benefit of this is received in the form of greater public
health. Additionally, given that the demand for cigarettes is highly inelastic and the demand is
not expected to shrink much, there is the possibility of additional revenue to the government.
(Mankiw, 2008)
Question 2
a) Fixed and Variable Costs
b) Marginal Costs is calculated as the cost of the “last unit produced i.e Current Total Costs
– Previous Total Costs for every level of output. (Chauhan, 2009)