MAE101: Microeconomic Applications Report - Trimester 3, 2019

This report provides a comprehensive microeconomic analysis of the Australian cigarette market. It begins by examining the legal market, illustrating the equilibrium price and quantity, and discussing the inelastic demand and elastic supply characteristics of cigarettes. The report then explores th...Read More

Running head: Microeconomic Applications
Microeconomic Applications
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1Microeconomic Applications
Table of Contents
Answer 1: The legal Australian Cigarette Market...........................................................................2
Answer 2: The market structure of the legal Australian cigarette market.......................................5
Answer 3: The illegal Australian cigarette market..........................................................................7
Reference.......................................................................................................................................11

2Microeconomic Applications
309
D
31
Price per pack of
Cigarettes ($)
S
Packet of Cigarettes (in millions)
Answer 1: The legal Australian Cigarette Market
(a)
Figure 1: Cigarette market equilibrium in Australia in
2017
Source: (Created by the Author)
In figure 1, it can be seen that the market equilibrium of the cigarette market in Australia
occurs where demand meets supply and at that point equilibrium quantity and price is given by
309 million packets and $31 per packet.
(b) Cigarette is a demerit good and thus consumers do not give up much of consumption
compared to the rise in price. Therefore, in case of cigarette price elasticity is significantly less
than 1 (Tucker, Laugesen and Grace 2017). Hence, for cigarette demand is assumed inelastic. On
the other hand, as the demand is inelastic rise in price increases the profitability of the cigarette

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Q1
P1
D1
Q
D
P
Price per pack of
Cigarettes
S
Packet of Cigarettes
manufacturers’ rise. Thus, supply increases as price increases and hence the supply of the
cigarette assumed elastic.
(c)
Figure 2: Effect of education programme on cigarette market
Source: (Created by the Author)
The government of Australia has launched an education programme to discourage
consumption of cigarettes. Under the education programme, the government will aware the both
smokers and non-smokers the adverse health effects of cigarette smoking such that smokers
reduce consumption and non-smokers do not take up smoking in future (Stead, Carroll and
Lancaster 2017). Owing to this policy, the significant number of smokers who are not of health
adversities of cigarette smoking will reduce their consumption. Consequently, the demand for
cigarette will fall and demand curve shifts to D1 from D in figure 2. Therefore, both the price

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P1
Producers’ tax burden
Consumers’ tax burden
P*
Q
P
D
Price of cigarettes
S
Unit of cigarettes consumed
Q*
and quantity of the cigarette in the market will fall. After, launch and effective implementation of
the education programme the new equilibrium quantity and price is given by Q1 and P1
respectively, which are lower than the values of the respective parameters in the market before
the launch of the programme.
(d)
Figure 3: Effect of excise tax on cigarette market
Source: (Created by the Author)
The government of Australia has imposed an excise tax on cigarette as a result the price
per unit of cigarette increased to P* from P and the quantity reduced from Q to Q* in figure 3
(Ho et al. 2018). Thus, after tax P* and Q* are the new equilibrium price and quantity. However,
the producer receive the price P1 as both the consumer and producer share the burden of tax
imposed (Rozema 2018). The amount of tax imposed is given by difference between P* and P2
shown in the figure.

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The demand for cigarette is inelastic whereas the supply is relatively elastic and thus
according to the theory of demand and supply, the majority of the tax burden is shared by the
consumers and a least amount is on the producers (Chelwa and van Walbeek 2019). The green
rectangle in figure 3 shows the amount of tax burden of the cigarette producers and the yellow
rectangle is amount of tax burden of the consumers.
Answer 2: The market structure of the legal Australian cigarette market
(a) The firms in oligopoly market structure face kinked demand curve. It means that the 1/3rd
demand curve is flatter on the upward portion and the 2/3rd of the curve is steeper on the
downward portion. Thus, a firm in the oligopoly market has less incentive in increasing price as
they would market share to the other competitors (Suprihanti et al. 2018). Alternatively, if a firm
try to reduce the price in order to in order to capture more market share then other firms will
reduce price as well and thereby profit of all firms will fall. Due to this reason, firms in oligopoly
market are reluctant to compete on price.
(b) As given in the question the market of the cigarette industry is shared between British
American Tobacco Australia, Philips Morris Ltd., Imperial Brands and others (Kvålseth 2018).
The market share of the respective companies are given as 38.2%, 28.1%, 30.4% and 3.3%. To
find the market concentration calculating Herfindahl-Hirschman Index (HHI).
HHI =(38.2)2 +(28.1)2 +( 30.4)2+(3.3)2
HHI =1459.24+ 789.61+ 924.16+10.89
HHI =3183.9
The value of HHI is found to be 3183.9, which means that the market of cigarette
industry is highly concentrated. Therefore, it can inferred that the industry is oligopoly in nature.

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The competition in the market is low and is dominated by few firms maximum 3 or 4 that have
the maximum market share. These firms have significant power over the market. New firms face
huge difficulty in entering the market as there exists high barriers to entry and exit.
(c)
Figure 4: Oligopoly market
after collusion
Source: (Created by the Author)
The oligopoly firms when acts like monopoly firms when collude with each other as they
cooperate and set prices (Zeuthen 2018). As a result, the firms charge price higher than oligopoly
market shown as P* in figure 4. At this price, the quantity trade in the market is Q*. Both the P*
and Q* are equilibrium price and quantity which are equivalent to the equilibrium price and
quantity in monopoly market.

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Q#
DP#
Price per pack of
Cigarettes
S
Packet of Cigarettes
(d) The outcome of the market after collusion is not socially efficient because output is Q*,
which is much lower than the output Q in perfectly competitive market. In addition to that, the
price P* charged is higher than the socially efficient price PC (Colombo 2016). Under this
monopoly market, as shown in figure 3 the consumers losses their surplus due to rise in price.
The amount of lost consumer surplus is given by yellow rectangle and blue triangle shown in the
above figure. However, there is a social welfare loss given by blue and green triangle (Liu 2019).
This loss in social welfare is known as deadweight loss. Thus, it is evident that after collusion the
market become less competitive than it was in oligopoly structure. The firms earn highest
possible supernormal profit at the cost of consumers (Fitchet 2018). The production is lower too
than in the case of perfect competition which is considered the most socially efficient market
structure. The output is produced using the same amount of factors used in the perfectly
competitive market and hence it can be inferred that productivity decreases in monopoly market
structure. Therefore, the society receives less than it invests and a part of its investment that is
resources is lost. Hence, there exists inefficient resource allocation in the monopoly market
(Jackson and Jabbie 2019). The market hence is socially inefficient.
Answer 3: The illegal Australian cigarette market
(a)

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Q1
P1
D1
Q
D
P
Price per pack of
Cigarettes
S
Packet of Cigarettes
Figure 5: Illegal cigarette market
Source: (Created by the Author)
Figure 5 depicts the illegal cigarette market where the equilibrium price and quantity is
given by P# and Q# (Von Lampe 2019). The price is however lower than the price existing in
legal market and quantity traded in the market is given by the amount of supply in the market.
In illegal cigarette market, the consumers are willing to buy cigarettes at any given price
until it is lower than the price in the legal market. However, the supply in the market is perfectly
inelastic as it does not depend on the price since the suppliers are price setters in this market
(Hidayat and Surjono 2016). Thus, in the illegal market supply is demand of the market. It
should be noted that supply in the market is completely price inelastic because the smugglers do
not have any cost of production they make profit at any positive price. On the other hand, the
consumers who buys cigarette from the illegal market would continue to buy from it until price is
below the legal market price. Thus, the demand curve in the illegal market is horizontal which
means the demand curve is perfectly elastic.
(b)

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S*
Q*
D*P*
Q#
DP#
Price per pack of
Cigarettes
S
Packet of Cigarettes
Figure 6: Fall in demand in legal cigarette market due to rise in supply in illegal market
Source: (Created by the Author)
Figure 7: Effect of increase in supply in the illegal market
Source: (Created by the Author)
The supply in the illegal cigarette market increases from Q# to Q* as shown in figure 7.
Consequently, the supply curve of the market shifted to S* from S. Owing to this increase in
supply in the illegal market more number of consumers from the legal market give up purchasing
from the legal market. As a result, demand in the legal market would fall by the amount of
increase in supply in the illegal market. Therefore, the equilibrium quantity in the legal market
fell to Q1 from Q. Thus, it can be inferred that difference between Q* and Q# in illegal market is
equal to difference between Q and Q1 in the legal market. Due to fall in demand, the price in the
legal market fell to P1. This fall in price exerted pressure on the price of illegal market because
consumers will keep on purchasing from the market as long as its price remains below the price
of legal market. Subsequently the equilibrium price in the illegal market fell to P*. Therefore, it

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is evident from the above discussion that rise in supply in the illegal market reduces price in both
the markets and quantity traded only in legal market.
(c) The government of Australia imposed tax on cigarettes to discourage consumption. The
concept of the tax was to increase the price of the cigarettes such that, per unit consumption of
gets more expensive and thereby the consumer gets discouraged and lower consumption such
that the people of the country can be saved from the harmful effects of the cigarette (Geis 2019).
However, the consumers getting affected by the rise in price are eager to buy cigarettes at lower
prices since it is an addictive good. These leads to emergence of cigarette smuggling sector. This
sector further gives rise to burglary of cigarettes from stores. The cigarettes stocked from
burglary is then sold in the illegal market of cigarettes. Thus, the government policy of tax
imposition give rise to crimes like smuggling and burglary.
(d) Imposition of tax on cigarettes has increases its price and as a result, the consumers are
getting less utility by spending more money. This leads to the lower benefit of the consumers. It
is the nature of people to make the most of its available resources. This rationality of the people
encouraged the smugglers to import cigarette illegally. For the illegal importers the trade is
beneficial as they do not need to share the burden of tax if they sell it in the illegal market. In
addition to that, they would be able to evade every possible tax. This would increase the profit of
the importers and thus they are gaining more benefit by investing less amount of resources. The
rational theory of maximizing benefit given the amount of resources has helped the illegal
market to flourish. This is has caused under the structure of free market as in the underground
economy there is no intervention by the government (Childs 2017). Trade occurs where benefit
of both buyers and sellers is maximized. This decision rule is called the rule of invisible hand. It

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means that let the market work on its own. Therefore, this decision rule is the basis of occurrence
of financial crime.
Reference
Chelwa, G. and van Walbeek, C., 2019. Does cigarette demand respond to price increases in
Uganda? Price elasticity estimates using the Uganda National Panel Survey and Deaton’s
method. BMJ open, 9(3), p.e026150.
Childs, R.A., 2017. The invisible hand strikes back. In Anarchy and the Law (pp. 218-231).
Routledge.
Colombo, S., 2016. Mixed oligopolies and collusion. Journal of Economics, 118(2), pp.167-184.
Fitchet, M., 2018. Key Drivers In Stock Growth Of" Big Tobacco" (Doctoral dissertation,
University of Cape Town).
Geis, G., 2019. Chop-Chop: The illegal cigarette market in Australia. Centre for Tax System
Integrity (CTSI), Research School of Social Sciences, The Australian National University.
Hidayat, A. and Surjono, N.D., 2016. Impact of specific excise rate simplification on cigarette
consumption and government revenue in Indonesia. World Customs Journal, p.73.
Ho, L.M., Schafferer, C., Lee, J.M., Yeh, C.Y. and Hsieh, C.J., 2018. Raising cigarette excise tax
to reduce consumption in low-and middle-income countries of the Asia-Pacific region: a
simulation of the anticipated health and taxation revenues impacts. BMC public health, 18(1),
p.1187.

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Jackson, E.A. and Jabbie, M., 2019. Understanding market failure in the developing country
context. In Decent Work and Economic Growth: Encyclopedia of Sustainable Development
Goals (pp. 1-10). Cham: Springer Nature Switzerland.
Kvålseth, T.O., 2018. Relationship between concentration ratio and Herfindahl-Hirschman
index: A re-examination based on majorization theory. Heliyon, 4(10), p.e00846.
Liu, R., 2019. Upstream Monopoly, Asymmetric Competition and Social Welfare: Mechanisms
IV. In How State-owned Enterprises Drag on Economic Growth (pp. 97-113). Springer, Berlin,
Heidelberg.
Rozema, K., 2018. Tax Incidence in a Vertical Supply Chain: Evidence from Cigarette
Wholesale Prices.
Stead, L.F., Carroll, A.J. and Lancaster, T., 2017. Group behaviour therapy programmes for
smoking cessation. Cochrane database of systematic reviews, (3).
Suprihanti, A., Harianto, H., Sinaga, B.M. and Kustiari, R., 2018. The Impact of Cigarette Excise
Tax Policy on Tobacco Market and Clove Market in Indonesia. International Journal of
Economics and Financial Issues, 8(6), p.54.
Tucker, M.R., Laugesen, M. and Grace, R.C., 2017. Estimating demand and cross-price elasticity
for Very Low Nicotine Content (VLNC) cigarettes using a simulated demand task. Nicotine and
Tobacco Research, 20(7), pp.843-850.
Von Lampe, K., 2019. The illegal cigarette trade. International and Transnational Crime and
Justice, p.49.
Zeuthen, F., 2018. Problems of monopoly and economic warfare. Routledge.

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