Answer to Question #239574 in Microeconomics for Tenn

Question

Suppose there is a bill to increase the tax on cigarettes by $1 per pack coupled with an income tax cut of $500. Suppose a person smokes an average of 500 packs of cigarettes per year—and would thus face a tax increase of about $500 per year from the cigarette tax at the person’s current level of consumption. The income tax measure would increase the person’s after-tax income by $500.

Would the combined measures be likely to have any effect on the person’s consumption of cigarettes? Why or why not?

Answer 1

Solution:

The combined measures would likely not have any effect on the person’s consumption of cigarettes.

This is because of the substitution and income effect that will result from the introduction of both policies. Initially, an increase in tax on cigarettes would result in an increase in its price which will lead to a fall in the quantity demanded of the said commodity. Due to the substitution effect, the person would seek other cheaper alternatives. Therefore, as the cost of cigarettes increases by $1 per pack, people buy fewer cigarettes. The consumer will seek a substitute good, for instance, another cigarette brand or a product that contains nicotine due to reduced budget.

The income factor will income in whereby a tax cut of $500 will increase a person’s after-tax income by $500. Since cigarette is a normal good, the income increase will make the individual purchase more cigarettes by nullifying the substitution effect. Therefore, the combined effect will be considered as zero and the person’s consumption of cigarettes will not exhibit any kind of effect. This is because the person’s disposable income will almost remain the same since the tax cut can compensate for the cigarette’s tax increase.