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

Price elasticity = percentage change in demand/percentage change in price

If price increases by 10%, percentage change in price=+0.1

Percentage change in demand=Price elasticity*0.1=-0.3*0.1 to -0.4*0.1=-0.03 to -0.04

Thus percentage decline in demand=3% to 4%

Percentage change in Demand= Income elasticity *Percentage change in income            

Since income elasticity=0.5

Percentage change in Demand=0.5*Percentage change in income         

If percentage change in income =50%=0.5

Percentage change in Demand=0.5*0.=0.25=25%

Thus sale will rise by 25% and will not double

Thus the fact of brokerage firm is incorrect and I will invest on the assumption that stock will rise by approx. 25% not 100%

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