Analyzing the Cigarette Market: Demand, Supply, and Excise Tax Effects

This economics essay analyzes the cigarette market, focusing on demand, supply, and the impact of excise taxes in Australia. It defines demand and supply, explaining the factors that influence them, such as price, income, substitutes, and advertising. The essay explores price elasticity of demand, noting the inelastic nature of cigarette demand. It examines Australian government policies, particularly excise taxes, and their effects on price, quantity sold, and government revenue. The analysis includes graphical representations to illustrate these concepts. Furthermore, the essay discusses the consequences of tax imposition, including tax burden distribution and the cost-benefit analysis, considering both private and external costs associated with cigarette consumption. The conclusion highlights the role of taxation in correcting externalities and reducing healthcare costs.

Running head: ECONOMICS FOR BUSINESS
Economics for Business
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Realizing the adverse consequences of consuming cigarette government in different
countries introduce a tax on cigarette. The current essay researches demand and supply concepts
related to cigarette market of Australia and consequences of an excise tax imposition on
cigarette.
Demand
The economic definition of demand states that demand is the desire of the consumers’
group to purchase certain goods and services backed by their purchasing power reflected in their
willingness of pay.
Demand curve explains how price is related to quantity demanded of the good. It is
drawn following the principle of demand which asserts that given all the factors than can
influence demand, surge in own price of the good lowers quantity demanded of the good while a
decrease in price general increases demand for the good (Mankiw 2020). Therefore, when
cigarette’s price hikes, quantity demanded of decreases. This is reflected by a movement towards
upward direction of the demand curve. When price of Cigarette falls demand for cigarette
increases and accordingly a downward movement occurs along the demand curve.

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Figure 1: Effect of price change of cigarette
In figure 1, as price upsurges from P* to P1 demand falls from Q* to Q1. Consequently
point on the demand curve moves from A to B. Following a decrease in price in cigarette from
P* to P2, demand increases from Q* to Q2 causing point on the demand curve to move downward.
Apart from prices there are other factors that influence demand for cigarette. These
factors include income of consumers, price of substitutes, advertising and social awareness
campaign. Changes in these factors shift the demand curve of cigarette to a new curve.
Income
For smokers’ cigarette seems to be a normal good. Therefore when income increases
there is greater tendency to consume more cigarette as this increases willingness and ability to
but cigarette even at a high price. This increases demand for cigarette. Demand for cigarette falls
when there is a fall in income.
Price of substitutes

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If the price of substitutes such as electronic cigarette, cigar and other tobacco product
increases demand for cigarette increases. On the other hand, when price of these substitute falls
demand for cigarette falls (Ajjandaleh et al. 2017).
Advertising
Effective advertisement may influence people to forgo other substitutes of cigarette and
consume more cigarette. This increases demand for cigarette.
Figure 2: Increase in demand of cigarette

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Figure 3: Decrease in demand of cigarette
Supply
Followed by economic definition supply of a good represents willingness of suppliers to
supply various amount of the good corresponding to different prices.
The law of supply indicates a positive association between quantity supplied and price of
the good. This states given different factors influencing supply, surge in price corresponds to a
surge in quantity supplied and vice-versa. Therefore with the positively sloped curve as price of
cigarette increase suppliers are more willing to supply cigarette. The increased supply causes
point on the supply curve to move upward (Baumol and Blinder 2015). Conversely, when price
of cigarette falls, sellers reduce supply of cigarette causing thee given point on the supply curve
to move downward along the curve.

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Figure 4: Effect of a change in price
The upward movement of point along the supply curve from A to B is caused due to an
increase in supply. The downward movement of point along the supply curve from A to C
indicates a movement because of decline in price.
Like demand, supply of cigarettes are influenced by number of factors other than prices.
These factors are price of inputs, government policies, productivity and number of seller.
Changes in these factors lead to change in the supply curve shifting the supply curve either
inward or outward.
Price of input
One primary input needed for producing cigarette is tobacco. If price of tobacco
increases, there is a hike in cost of production of cigarette leading ta fall in supply and the supply
curve shifts inward. When tobacco price falls, production cost falls as well (Cowen and Tabarrok
2015). This increases supply of cigarette and shifts the supply curve outward.
Government policy

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In Australia, government policies such as tax on tobacco produce influence supply of
cigarette. When government imposes an excise tax on cigarette, this discourages production of
cigarette shifting the supply curve of cigarette to the left.
Number of sellers
When number of sellers in the industry increases supply of cigarette increases and vice
versa. The tobacco industry in Australia forms a subset of tobacco industry operating globally.
Three international tobacco companies operating in Australia are Imperial Tobacco Australia,
Phillips Morris International and British American Tobacco Australia
(Tobaccoinaustralia.org.au. 2020). Attracted by high profitability of the industry, new brands
enter the market which increase the supply of cigarettes.
Figure 5: Increase in supply

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Figure 6: Decrease in supply
Price elasticity of demand
“Price elasticity of demand” for a commodity is defined as a measure that captures
change in demand computed in percentage term of the commodity given the percentage variation
in price of the commodity.
Depending on responsiveness of demand to changes in price, demand sis categorized as
either elastic or inelastic. When demand varies at a larger proportion relative to variation in price
demand is considered as relatively elastic (Kolmar 2017). In contrast when demand changes at a
relatively smaller magnitude than price change, then demand is considered as relatively inelastic.
When change in demand proportion is same as the price change then demand is unitary elastic.
“Price elasticity of demand” varies at different point on a demand curve. Elasticity tend
to be higher at a higher price while elasticity is relatively lower at the lower price along the
demand curve.

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Figure 7: Price elasticity of demand along the demand curve
Cigarette is an addictive item. Because of the addictive nature people are unwilling to
lower demand for cigarette when price increases indicating a price inelastic demand. Hence,
“price elasticity of demand” for cigarette is less than 1(Tuchman 2019).
Cigarette being a normal good for smokers has a positive “income elasticity of demand”.
The cross price elasticity of demand between cigarette and other tobacco products is positive.
Other factors affecting elasticity of elasticity of demand of cigarette are age group,
income group and other related factors.
Exercise tax on Cigarettes in Australia
Federal government in Australia impose excise tax on cigarettes made in Australia.
Federal government designs the tax following Excise Act passed in 1901. With the objective of

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lowering consumption of cigarettes government makes time to time revision in the excise tax.
The tax rate remains unchanged in between 1999 and 2010. Between 2013 and 2017 excise duty
was increased at an annual rate of 12.5% (Tobaccoinaustralia.org.au. 2020). There were four
annual increase in the tax between the four years. It is likely to further increase at the same rate
to 2020.
Figure 8: Value of excise tax on tobacco in Australia
(Source: Tobaccoinaustralia.org.au. 2020)
Effect of tax on price and quantity sold

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Figure 9: Impact of excise tax on cigarette
The consequences of imposition of an excise tax on cigarette is described in the above
figure. When government levies a tax on cigarette, the supply curve of cigarette shifts to the left
by the tax amount. The difference between the two supply curve shows size of the tax. Now
because of the tax buyers face a larger price shown as P1 and sellers receive a lower price shown
as P2. The quantity of cigarette sold in the market falls to Q1.
Other consequences of tax
Tax is one main source of government revenue. The excise tax imposed of cigarette
yields revenue to the government for per unit of cigarette sold. In figure 9, revenue earned by
government from the excise tax on cigarette is shown as P1P2FE1. In case of indirect tax like
excise duty buyers and sellers share the tax burden. The relative share of tax burden depends on
“price elasticity of demand”. Smaller the price elasticity of demand larger is the tax burden. In
case of cigarette, demand is found to be relatively inelastic. Since demand is less sensitive to
price, consumers are unable to make much adjustment when price increases due to tax (Selvaraj,
Srivastava and Karan 2015). As a consequence, a greater share of tax burden is borne by
consumers group as shown by the shaded region.
The discussion on cigarette tax needs a cost benefit analysis. The consumption of
cigarette yields imposes an external cost to those who does not smoke. This is known as the
negative externality associated with cigarette consumption. Private parties do not consider the
external cost involved in smoking (Purwanti and Lutfi 2018). Tax is one instrument that helps to
correct the externality yielding an economically efficient outcome.

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Tax on cigarette also benefits people in the society in terms of a reduce cost of health
care in their later life. Consumption of cigarette and other tobacco products make people
vulnerable to lung cancer and increases mortality rate. Government then needs to incur a higher
cost for health care spending. This limits government ability to spend on productive activity
(Browning and Zupan 2020). Tax on cigarette helps to reduce consumption of cigarette and
therefore lower health care risk associated with consumption of cigarette.

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List of References
Ajjandaleh, H., Bolze, C., Khoury, F., Melchior, M. and Mary-Krause, M., 2017. What are the
factors for electronic cigarette use in French young adults? Fabienne Khoury. European Journal
of Public Health, 27(suppl_3).
Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Nelson
Education.
Browning, E.K. and Zupan, M.A., 2020. Microeconomics: Theory and Applications. John Wiley
& Sons.
Cowen, T. and Tabarrok, A., 2015. Modern principles of microeconomics. Macmillan
International Higher Education.
Kolmar, M., 2017. Principles of Microeconomics. Springer International Publishing.
Mankiw, N.G., 2020. Principles of microeconomics. Cengage Learning.
Purwanti, N.D.A. and Lutfi, A., 2018. Evaluation of Revenue Allocation Policy for Cigarette
Tax. ICASPGS, p.228.
Selvaraj, S., Srivastava, S. and Karan, A., 2015. Price elasticity of tobacco products among
economic classes in India, 2011–2012. BMJ open, 5(12), p.e008180.
Tobaccoinaustralia.org.au. 2020. 10.3 The manufacturing and wholesaling industry in Australia -
major international companies - Tobacco in Australia. [online] Available at:
https://www.tobaccoinaustralia.org.au/chapter-10-tobacco-industry/10-3-the-manufacturing-and-
wholesaling-industry-in-australia [Accessed 27 Jan. 2020].

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Tobaccoinaustralia.org.au. 2020. 13.1 Price elasticity of demand for tobacco products - Tobacco
in Australia. [online] Available at: https://www.tobaccoinaustralia.org.au/chapter-13-taxation/13-
1-price-elasticity-of-demand-for-tobacco-produc [Accessed 27 Jan. 2020].
Tobaccoinaustralia.org.au. 2020. 13.2 Tobacco taxes in Australia - Tobacco in Australia. [online]
Available at: https://www.tobaccoinaustralia.org.au/chapter-13-taxation/13-2-tobacco-taxes-in-
australia [Accessed 27 Jan. 2020].
Tuchman, A.E., 2019. Advertising and demand for addictive goods: The effects of e-cigarette
advertising. Marketing Science, 38(6), pp.994-1022.