According to studies undertaken by the US Department of Agriculture, the price e

Question

According to studies undertaken by the US Department of Agriculture, the price elasticity of demand for cigarettes is between – 0.3 and – 0.4 and the income elasticity is about + 0.5. Suppose Congress, influenced by studies linking cigarette smoking to cancer, plans to raise the excise tax on cigarettes so the price rises by 10%. Estimate the effect the price increase will have on cigarette consumption and consumer spending on cigarettes (in percentage terms). Suppose a major brokerage firm advised its clients to buy cigarette stocks under the assumption that, if consumer incomes rise by 50% as expected over the next decade, cigarette sales will double. What is your reaction to this investment advice?

Explanation / Answer

The effect the price increase will have on cigarette consumption

ed = % in Quantity demanded/% change in Price

ed = between 0.3 and 0.4 and % change in Price = 10%

% in Quantity demanded = ed*% change in Price

= 03*10 = 30%

= 0.4*10 = 40%

So change in cigratte consumption will be between 30% to 40%.

Spending on cigratte for ed=30% = P*Q = (P + 0.10P)*(Q - .30Q) = 0.77P.Q

So Change in spending 077PQ - PQ = 23%

Spending on cigratte for ed=40% = P*Q = (P + 0.10P)*(Q - .40Q) = 0.66P.Q

So Spending will be less by between 23% to 34%.

The investment is not worthy to accept because it is just taking into consideration the one variable while ignoring the other variables which also impacts the sales of cigrattes like price which will also increase over the next decade and will change the quantity of cigratte demanded and hence sales . So, cetris peribus assumption used while giving the advice should also be considered while making investment decision.

If you don't understand anything , comment , I will revert back with the required information. :)

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