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Economics - Market Equilibrium - Public Goods - Assessment Answer

March 01, 2018
Author : Ashley Simons

Solution Code: 1ADEJ


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Economics Assignment

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In this paper, we are going to discuss the tax on cigarettes which has increased over time in Australian Economy. The main impact of raising the cigarette tax is to control the consumption or habit of smoking by youngsters (both genders) which have serious health effects on the citizens of Australia. The main idea of imposing the tax on cigarettes is to reduce smoking and its externalities in the economy. The article selected for this purpose is the article about increasing taxes on cigarettes which would make the consumers or cigarette smokers pay more for a pack of cigars (probably the highest price in the world) (Metherell, 2016). As the economic concept of law of demand says that when the price of a commodity increases, the quantity demanded of it decreases and hence people would reduce their smoking habits.

Market for Cigarettes and its prices:

The demand and supply of tobacco cigarettes is shown in the diagram below. We can see that the demand for cigarettes and the supply of cigarettes is intersecting at point E in the figure where the price is Pe and the quantity demanded and sold is at Qe. There has been an increasing concern in the Australian economy that increase in smoking among all age groups have led to higher deaths per week and other health issues like cancer and heart diseases. Thus it is very important for the government to intervene and levy taxes (either producer tax or consumption tax) that will make the cigarette packs costly such that cigarette consumption might get reduced in the economy.


In the above diagram we can see that the demand curve for cigarettes is negatively sloped which means that when the prices are lower, the quantity demanded will be higher and when the prices are higher the quantity demanded would be lower. The supply curve of cigarettes shows the postive relationship between the price of cigarettes and quantity supplied which means, higher the price higher quantities would be supplied and when the price is lower, the quantity supplied would be lower. The intersection of the two curves at point E gives us the equillibrium price Pe and equillibrium quantity Qe.

The adverse health effects of cigarette smoking has resulted in government regulation, where the Australian Government has planned for an excise tax on cigarettes of 12.5% each year till 2020. This will increase the costs of supplying the cigarettes which will shift the supply curve to the left as shown in the figure below.

Price Elasticity of demand:

One another economic concept to be discussed in this context is the price elasticity of demand. Price elasticity of demand is explained as the responsiveness of quantity demanded of a commodity to a change in its price. There are three types of price elasticities – income elasticity, cross elasticity and also price elasticity. The concepts of income elasticity would not work in case of cigarettes as cigarette smoking is considered as a bad habit which would be more whether income is higher or lower. Similarly the concept of cross elasticity also does not hold in case of cigarettes as cigarettes don’t have close substitutes the price of which might have its effect on the demanf for cigarettes. However one important concept that would be of help in taxing cigarettes is the price elasticity of demand. Since cigarette smoking is a habit among many youngsters and almost all people in Australia, it can be seen as an addiction which means the price elasticity of demand is very inelastic. The responsiveness of quantity demanded to a change in price is lower than 1. Any percentage change in price of cigarettes say 5% will have less than 5% change in the quantity demanded of cigarettes. Such a demand for cigarettes is shown in the following figure.


In the diagram above let us assume that the price of cigarette packs has increased from $10 to $14 and this has resulted in the reduction in quantity demanded from 8 packs to 6 packs, we can derive the price elasticity of demand using the formula

PED = ? Q /?P * P/Q

= (2/4) * (10 / 8) = 0.625

We can see that the price elasticity of demand for cigarettes is lower than 1 which means that any percentage change in price will not trigger the equal amount of change in quantity demanded but it will be less. This indicates that any tax imposed on the cigarettes will have a larger burden on the consumers than on the producers as shown in the figure below.

Negative externality of consumption:

Economic concept of externality means that the effects of producing or consumption of a good falls on the third parties who are not part of the transaction. These externalities can be positive or negative and can also occur due to the production or consumption activity. One classic example of positive externality of production is the growing of apple trees by a farmer which benefits the bee keeper as the nectar provided by the apple trees is beneficial to the bee keeper. Similarly negative externality of production is the polluting industries which let out toxic chemicals into the river nearby, which affects the habitats of nearby villages (Frijters, Dulleck and Torgler, 2010).

There can also be positive or negative externalities of consumption. For example, when people get vaccination against a particular disease he benefits the others nearby by not being the agent of spreading the disease. This is a positive externality of consumption. Similarly, the negative externality of consumption is our case of tobacco smoking of cigarettes which have negative influences on the society he lives in.

Cigarette smoking is one of the negative externality of consumption that has its adverse effects on the health of passive smokers in the society (people who do not smoke but are staying together with the smokers). As the effects of smoking is felt on the third parties who are not part of the transaction, this is called as negative externality of smoking that had an impact on the society and non-smokers. As the producers and consumers of cigarettes do not take into account the social costs involved in the negative externality of smoking, it is considered as a market failure and this suggests that some governmental regulation must be taken to internalize this external costs on the society (Hubbard et al., 2013).


In the figure above, we can see that the marginal private benefit is higher than the marginal social benefit, which means that in a free market, cigarette smokers will maximise their utility at a point where marginal social cost curve intersects marginal private benefit curve at price Pp and quantity Qp. However this is higher than the socially optimum level of output which is at price Ps and quantity Qs which happens with the intersection of MSB and MSC in the above figure. Thus we can see that without market intervention by the government, it is possible for the consumers to smoke more at Qp (Miller, 2012).

Government intervention:

The taxes on cigarettes have made Australia the most costly places among other countries to buy a cigarette pack according to data sources. With the hike in tax rates, it is going to become still more costly for the people (Piotrowski, 2016).


In the above figure, the imposition of a tax on cigarettes or increase in tax (as the article suggests) would shift the supply curve to the left from SS to SS + tax. This means that an imposition of 12.5% increase in excise will shift the supply curve leftward as the imposition of tax will increase the costs of production for the producers of cigarettes which will shift the supply curve to the left as shown above.

The imposition of tax has decreased the supply of cigarettes in the market and this has resulted in the equillirbrium quantity decreasing from Qa to Qb and resulting in the increase of prices paid by the consumers for a pack of cigarettes. This is clearly above the initial equillibrium price at Pa and the price consumers pay now has increased to Pc and what the producers receive for a pack of cigarettes is at Pp (Miller, 2012). This imposition of taxes on cigarettes has increased the price for consumers from Pa to Pc and has decreased the price received by producers to Pp. The tax revenue collected by the governemtn by the excise imposed on cigarettes is PcPp per unit where the pink shaded area is the consumer burden after the imposition of the tax and blue shaded area is the producer burden after tax. The total of pink shaded area and blue shaded area is the tax revenue collected by the government by imposing the tax on cigarettes. (Hubbard et al., 2013) Since the pink shaded area is larger than the blue shaded area, we can conclude that the burden on the consumers is higher than the tax burden on the producers and this will have its impacts on cigarette smoking by reducing it proactively.

However it is very difficult for the government to determine the tax rates to be imposed on cigarettes such that the external costs are internalised. In some cases, like cigarettes, tax revenue collected by the government is used to conduct health campaigns and to educate the people at large about the ill effects of smoking and the adverse health effects of the same (Baumol and Blinder, 2012).


The article suggests the fact Australia has the highest tax rates imposed on cigarettes around the world. This is mainly due to the fact that it has the largest number of smokers among its population. The main reason for imposing a tax is to reduce the consumption of cigarette smoking and to make people healthier and capable of more productivity in their working age. The market failure of negative externality of smoking cigarettes and producing them on the society creates many health problems amongst the people which has to be corrected by such tax impositions by the government.

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