According to studies undertaken by the U.S. Department of Agriculture, the price

Question

According to studies undertaken by the U.S. Department of Agriculture, the price elasticity of demand for cigarettes is between ?0.3 and ?0.4 and the income elasticity is about 10.5. Suppose Congress, influenced by studies linking cigarette smoking to cancer, plans to raise the excise tax on cigarettes so the price rises by 10 percent. 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 percent as expected over the next decade, cigarette sales would double. What is your reaction to this investment advice?

Explanation / Answer

Solution-

1. Increase in Price = 10%

Ed = % change in Qd / % change in Price

Let assume that Ed = 0.45 approximately

0.45 = % change in Qd / 10

% change in Qd = 0.45 x 10

= 4.5%

Hence, Demand falls by approximately 4.5%

2. Increase in Income = 50%

Ed = % change in Qd / % change in Income

Let assume that Ed = 0.6

0.6 = % change in Qd / 50

% change in Qd = 0.6 x 50

= 30%

Hence, demand increases by 30%

Hence, This statement is not correct, Demand will not increase by half  

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.