Taxing Cigarette Consumption. Smoking is detrimental to the health of both smokers and non-smokers. Recent trends have shown a growing intolerance of “secondhand” smoke in public areas. Due to this...

Taxing Cigarette Consumption. Smoking is detrimental to the health of both smokers and non-smokers. Recent trends have shown a growing intolerance of “secondhand” smoke in public areas. Due to this negative externality, smokers are being forced to compensate their behavior through legislative measures, such as the imposition of a tax on cigarettes. Suppose the price of a pack of cigarettes is $6.00 and the average social cost of smoking is $10.00 in a country.

a. Determine the optimal retail price of a pack of cigarettes and compare it to the current price. Is the current level of cigarette consumption too high or too low? Why?

b. If excise taxes are imposed on cigarettes, are these taxes set at the optimal level? Briefly explain.

c. Assuming that the social cost per cigarette pack does not change with a fall in demand, what should be the correct amount of an additional tax on cigarettes?

d. Suppose demand is relatively inelastic while supply is relatively elastic in this market. Who will bear more tax incidence, producers or consumers?