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.