Explain the effect of indirect taxation on the consumption of cigarettes

AQA AS-Level Paper 1 June 2016 Insert

Extract F (line 10) states ‘Taxation is one way governments attempt to control cigarette consumption.’ Explain the effect of indirect taxation on the consumption of cigarettes. (10 marks)

An indirect tax is an additional cost of production imposed by the government on firms, and this causes the supply of cigarettes to decrease.

The overall effect of an indirect tax is an increase in the market price and a decrease in the equilibrium quantity of cigarettes in the market. Indirect taxes lead to an increase in costs of production, which means that firms become willing and able to produce fewer cigarettes at each given price. Therefore, there is a decrease in supply. This causes a contraction along the demand curve due to the rationing function, which causes the price to increase from p1 to p2 and the quantity to fall from q1 to q2, as shown in the diagram below.

Another impact of these indirect taxes is an increase in government revenue. This is shown by the shaded yellow rectangle and it is calculated by multiplying the tax per unit by the new equilibrium quantity. The diagram also shows that some of this is paid by the producer and some of it is passed onto the consumer (due to the change in price from p1 to p2). The more price inelastic the demand for cigarettes, the greater the tax revenue will be.

Finally, an indirect tax causes a deadweight loss; a fall in consumer surplus and producer surplus. This is shown by the pink triangle. Consumer surplus is the difference between the price consumers actually pay compared to the highest price they are willing to pay. And, producer surplus is the difference between the lowest price producers are willing to sell cigarettes for and the price they actually sell cigarettes for.

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