Problem 2 An empirical study by Callison a... [FREE SOLUTION]

Chapter 3: Problem 2

An empirical study by Callison and Kaestner (2012) suggests that a \(100 \%\) cigarette tax would be required to decrease adult smoking by as much as \(5 \% .\) What does this result imply about the shapes of the supply and demand curves (assuming that the cigarette market is competitive)?

Short Answer

Expert verified

The result implies the demand curve for cigarettes is steep, indicating inelastic demand.

Step by step solution

Understand the relationship

The question is about how cigarette consumption responds to a 100% tax increase leading to only a 5% decrease in smoking. This implies that even with a significant price increase, the quantity demanded reduces only slightly.

Analyze the demand curve

A 5% decrease in demand with a 100% price increase indicates that demand is inelastic. Inelastic demand means consumers are not very responsive to price changes, suggesting the demand curve is steep.

Analyze the supply curve

Since the exercise doesn't specifically discuss supply, we assume it's a typical upward-sloping curve seen in competitive markets. The problem focuses primarily on demand elasticity.

Implications of steep demand curve

Inelastic demand means that even large price changes result in small changes in the quantity demanded. This shape is typical for necessity goods like cigarettes, where consumers are less sensitive to price changes due to addiction or habit.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Inelastic Demand

The concept of inelastic demand plays an important role in understanding how consumers react to price changes. When we talk about inelastic demand, we mean that the quantity demanded by consumers doesn't change much even when the price changes significantly. This is often visualized by a steep demand curve. In general, there are a few key characteristics:

Necessity: Goods that are considered necessities often have inelastic demand. Cigarettes may fall under this category because of addiction.
Lack of substitutes: Items without close substitutes tend to have inelastic demand. Smokers might find it hard to find alternatives to cigarettes.
Small change in quantity demanded: In our example, a 100% price increase leads to only a 5% decrease in cigarette consumption, highlighting the inelastic nature.

In economics, necessity and addiction can strongly influence demand elasticity. That's why some products respond very little to price fluctuations.

Competitive Market

A competitive market is one where numerous buyers and sellers exist, and no single entity can influence the market prices. This is important for understanding the general expectations for the supply and demand behaviors:

Price takers: In these markets, individuals and firms accept the market price established by supply and demand interactions.
Standardized products: Products are generally uniform, so different buyers perceive them as identical.
Free entry and exit: In a truly competitive market, new firms can enter freely if profits appear attractive, and they can also leave easily if they're not making enough money.

For cigarettes in a competitive market, the supply side can be assumed to follow typical behavior where producers respond to price. However, in our example, the demand side is more critical due to its inelastic nature.

Supply and Demand Curves

Supply and demand curves are visual tools used to represent the relationship between the price of a good and the quantity supplied or demanded. They help illustrate core economic principles:

Demand curve: A graphical representation showing how the quantity demanded varies with price. In our cigarette example, the steep demand curve conveys inelastic demand.
Supply curve: Typically an upward-sloping line indicating that as the price increases, the quantity supplied also rises. In competitive markets, the supply curve follows standard predictions.
Equilibrium: The point where the supply and demand curves intersect, determining the market price and quantity.

These curves are instrumental in predicting how changes in the market, such as taxes in our issue, influence the behavior of buyers and sellers.

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