What is the reason behind
Australia’s proposed levies and its potential consequences?
Introduction to theory
The cigarette market is an
example of a market failure. This occurs whenever the market equilibrium of a
product is not pareto efficient. The free market allocation of resources in
this instance is inefficient since cigarettes are a demerit good. Its
consumption is considered unhealthy, causing a negative externality. These are
costs incurred by other members of society that are not taken into account by
the parties in the transaction such as passive smoke exposure (i.e. third party
Connection to article
The Australian government devised
a plan to tackle this by increasing ad valorem tax (levies) by 12.5% annually,
for four years.
Figure 1.1 illustrates how the
marginal private benefit (MPB) is greater than the marginal social benefit
(MSB), as society benefits less than the user. The smoker will not consider the
effects of passive smoke but only thinks about personal benefits. Consequently,
free market allocation of resources achieves an equilibrium e1, which is
greater than the socially optimum equilibrium e2. The output of firms that
create harmful externalities typically exceeds socially optimum levels since they
ignore elements of social costs in their decision making process as they aim to
maximize profit. The market for cigarettes is over-allocating resources,
allowing overconsumption at Q1, when the socially ideal amount is Q*. This is
demonstrated by the grey triangle, representing welfare loss
This figures depicts the effects from
levies being imposed. It causes the marginal social costs (MSC) to vertically
shift by the amount of the levies, achieving a new equilibrium e3, ceteris
paribus. If the increase in levies is equivalent to the negative externality,
production would be at the ideal amount Q*, therefore removing the welfare loss,
as price increases from P1 to P2, becoming unaffordable for some individuals.
In Figure 1.3, a free market
equilibrium e1 is achieved with Qe being supplied and demanded at the price Pe.
After levies of 12.5% are imposed, the supply curve contracts from S1 to S1+
tax, achieving a disequilibrium e2 as there is a surplus. This causes downward
pressure on prices, until it reaches equilibrium at e3, with price P1, where Q1
is demanded and supplied.
Given the nature of the product,
the tax incidence falls mainly on consumers as they are less responsive to
price changes. Consequently, prices rise from Pe to P1. The producer receives C
per unit, after paying tax to the government thereby producer revenue decreases
from being the product of Qe, Pe to C, Q1.
There are many pros and cons to the
taxation of cigarettes. Firstly, higher government revenue could be used to
fund production of merit goods, while combating the effects of the negative
externality. Accordingly, healthcare costs associated with treating the effects
of long term smoking, such as lung cancer will decrease. Furthermore, as figure 1.3 illustrated, the
quantity of cigarettes supplied decreases to Q1, therefore shrinking the
cigarette market. Subsequently, smoking will decrease in the long run, as
people would have time to suppress their addiction through nicotine patches and
other means. On the other hand, people would have less disposable income,
decreasing living standards and increasing social deviance. More importantly, the
price increase could result in people buying cigarettes from parallel markets
(PMs), thus decreasing government revenue.
There are various effects on
different members in society. The tax is beneficial to nonsmokers as exposure
to passive smoke decreases. Conversely, it damages tobacco corporations as
their sales and existing market will decline, compounded by a reduction in
potential market growth from new smokers. The policy will particularly hurt
poorer socioeconomic groups because of the regressive nature of the tax.
A significant increase in the
price of cigarettes should result in decreased consumption, ceteris paribus.
There are many assumptions made in such a theory. Firstly, it assumes that
consumers are price elastic. However, the price elasticity of demand in the
cigarette market is relatively inelastic. This means that the percentage change
in price is greater than the percentage change in demand since cigarettes is an
addictive product. It also assumes that all cigarettes are bought through legal
channels, but many people may and probably would turn to PMs as they are
Overall, the Australian
government recognizes that smoking is a serious problem and that the proposed levies
could be the solution. For an effective outcome, Australia needs to strengthen
law enforcement on contraband and increase fines to combat the possible growth
of sales in PMs.