## Saturday, February 27, 2010

### The Demand for Cigarettes is MORE elastic than we thought! (Yes, it is IMPORTANT!!)

D.C. Cigarette Tax Hike Fail:  In AP Microeconomics, we learn that if a community wants to eliminate a "Negative Externality" it should levy a per unit tax on a good or service to discourage the purchase and use of the offending good/service through higher prices.  The most prominent example teachers use is cigarettes.  Cigarettes create third party injury with secondhand smoke and other direct and indirect health  related problems.  Another reason the example is appropos is demand for cigarettes is generally relatively INELASTIC. When a good has inelastic demand it means that a change in price of the good will bring about a relatively small change in quantity demanded of the good, whether the price is increased or decreased.  If the price, with tax, increase by, say, 25% and it results in only a 10% reduction in quantity demanded then demand is said to be "inelastice". (The elasticity formula is %change in Quantity Demanded divided by the %change in Price--if result is less than one, demand is inelastic)...There is also a Total Revenue Test for Elasticity too.  If demand is inelastic, like cigarettes, then if %change in price increases MORE than the %change in quantity demanded than Total Revenues will INCREASE! However, it did not work out this way in D.C.
The projections are now that this year's estimated cigarette tax revenues will fall below the pre-hike FY2009 levels (\$37.6 million)---in other words, the tax hike got the city less revenue, not more...instead of \$45.4 million in revenue, Gandhi says the District will only bank \$30 million.
Some predictable variables show up in this instance:
Because the increase, to \$2.50, catapulted the District's rate over Maryland's \$2-per-pack rate, Gandhi explains, many Maryland smokers who'd bought their tobacco in the District switched back to buying in Maryland. Add that to all the D.C. smokers who started buying cheap-as-dirt Virginia smokes, and you get the picture---
It appears that close proximity of a "substitute" LOCATION to buy cigarettes has made the demand curve for cigarettes in the Maryland/DC area MORE elastic! (The demand for a good becomes  MORE elastic with the increase in available substitutes)....If politicians and policy makers took an economics class now and again, they may become more aware of the consequences of their actions...
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