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Tobacco demands becoming price elastic?

I always told my economics students that while retailers often did not know the elasticity of demand for their products –  how sensitive demands are to prices – they could easily infer this information by experimenting with price variations. If prices are increased a bit and firm revenues from a product fall then demands are elastic (they depend sensitively on price in the sense that, for example, a 10% increase in price causes more than a 10% reduction in quantities demanded); if revenues increase then demands are inelastic (a 10% increase in price causes less than a 10% reduction in quantity demanded).

Cigarette products have conventionally been assumed to have inelastic demands – the price elasticity is around -0.4 so a 10% increase in price causes about a 4% reduction in the number of cigarettes smoked.  They are assumed to be inelastic because smoking involves an addiction to nicotine, a habit that is notoriously difficult to kick. But elasticities are not fixed numbers – they vary with the level of prices as a consumer operates at different points on their demand curve.  At high enough prices all demands will become elastic as consumers substantially reassess the desirability of goods.  So if cigarettes are costing $40 per pack, as proposed recently by the Labor Party, this might make people think twice about smoking – a packet per day then costs $280 weekly. Have prices for cigarettes reached levels where demand is elastic? Have cigarette prices become so high that further price increases will produce more than proportionate reductions in cigarette consumption and hence less revenue?

There is now some evidence that this might be the case.  Cigarette prices have increased strongly in Australia in recent years because of excise tax increases.  These taxes are “specific taxes” that are levied per stick or per cigarette.  The ABS’s latest volume measure of tobacco consumption published in early December showed that, since mid-2014, cigarette consumption has declined at double digit pace. This is higher than at any time since 1983 and 4 times the average decline over the past 10 years. Excise revenue is expected to fall by 2.3% from 2015 to 2016 and by a further 4.7% from 2016-2017.  Spending on cigarettes fell to a record low of $3.4b in the September quarter of 2015.

The qualifications to the claim that price sensitivities have increased are that, in recent years various non-price disincentives (plain packaging, anti-smoking propaganda) will likely have also had an effect on consumption.

The importance of the view that elasticities have increased is that, if this is so, the labor Party’s plans to fund further expansion of schools by charging higher excises on tobacco, will fail with certainty.  They will fail because there will be a reduction in cigarette consumption that is proportionately greater than the excise increase.  It might still be a good idea to increase the excise to force more cigarette quitting – with high prices such excise increases will be particularly effective at doing that – but relying on increased excises to fund increased education spending will fail.

6 comments to Tobacco demands becoming price elastic?

  • I am and will always be Not Trampis

    Seems one RMIT academic would have trouble with this but then again he doesn’t believe you can say consumption has fallen!

  • Tom Davies

    Substitution into vaping may be significant. Anecdotally several friends of mine have converted from cigarettes to vaping.

    Unfortunately we still have to sit in smoking areas in pubs, so while I’m saved from their second hand smoke, I’m still subjected to everyone elses!

  • John

    If the price did go to $40 or more, that’s gett to wards a prohibition, surely the incentive for blackmarket contraband would become big? Creating yet another war on drugs is not a good idea, surely?

  • […] driving illicit tobacco growth,” while Emeritus Professor Harry Clarke of La Trobe University takes the view that ever increasing prices are resulting in smokers becoming more sensitive to price than they have […]

  • […] unlawful tobacco growth,” while Emeritus Professor Harry Clarke of La Trobe University takes a perspective that ever augmenting prices are ensuing in smokers apropos some-more supportive to cost than they have […]

  • derrida derider

    Surely you tell your students to distinguish between short run elasticities and long run ones. The usual argument with an addictive good is that the short run elasticity is to a first approximation zero but the long run one may not be – high prices don’t make people give it up but might deter people from taking it up.

    That’s actually the only decent argument, in my view, for making drugs illegal – you might be able to force up their price too high for people to even sample them (cocaine anyone?). Of course the problem there, though, is that there are often cheaper and even nastier substitutes (chrystal meth anyone?).

    So what we may be seeing with tobacco is not prices entering a region where the elasticity is much higher, but the lagged effect of past price rises. There’s an intertemporal identification problem here.