Tax cigarettes

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1. A country which does not tax cigarettes is considering the introduction of a $0.40 per pack tax. The economic advisors to the country estimate the supply and demand curves for cigarettes as: Q D = 140,000 – 25,000P Q S = 20,000 + 75,000P, where Q = daily sales in packs of cigarettes, and P = price per pack. The country has hired you to provide the following information regarding the cigarette market and the proposed tax.

a. What are the equilibrium values in the current environment with no tax?

b. What price and quantity would prevail after the imposition of the tax? Illustrate your answers in a graph.

c. What portion of the tax would be borne by buyers and sellers respectively?

d. Calculate the deadweight loss from the tax. What tax revenue will be generated? 

2. Answer the following questions.

a. Originally, Lizzy consumes 10 icecream cones each week at a price of $1. The government levies an ad valerom tax of t on the consumption of icecream cones. Now, Lizzy decides to consume 0 icecream cones. Lizzy pays zero in taxes so she is unaffected by the tax and there is no excess burden at all. Do you agree? Explain using a graph.

b. The government has hired you to advise them on the merits of a project that is being proposed. The project is expected to generate benefits of 14 million dollars today, 5 million dollars in one year from today, and 1 million dollars in two years from today. (These are the only years of concern.) The project costs nothing today, but will cost 20 million dollars in two years. Assume the interest rate is 10%. If the benefit – cost ratio is greater than 1, the project should be allowed. What is your policy suggestion?

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