E-cigarettes are battery-powered devices that heat a liquid containing nicotine, producing a vapour that is inhaled and leaves no smell. More firms are drawn to the market for e-cigarettes due to the surge in sales. Meanwhile, the sales of conventional cigarettes are still suffering from tax hikes imposed by governments around the world.

Discuss the possible effects of the changes on the revenue earned in the cigarette industry, using elasticity concepts whenever possible. [25]

Introduction

“Cigarette industry” here can refer to both conventional cigarettes and e-cigarettes.

“More firms are drawn to the market” – could have implied an increase in the supply of e-cigarettes.

“Tax hikes” – for conventional cigarettes.

“the sales of conventional cigarettes are still suffering” – suggests that the outcome on revenue; would want to explain there will be a fall in revenue. 

Revenue is given by P x Q (price times quantity) 

Explain briefly concepts of PED, YED and XED

PED

1.     Measure of responsiveness in the quantity demanded for a commodity because of a change in the price of the same commodity, ceteris paribus

2.     Always Negative

3.     Price elastic: change in price of good èmore than proportionate change in quantity demanded for the good 

4.     Price inelastic: change in price of good èless than proportionate change in quantity demanded for the good

5.     Factors affecting PED: availability and closeness of substitutes, proportion of income, degree of necessity, scope of definition

YED

1.      Measure of responsiveness in the quantity demanded of a good to the change in the income of the people demanding the good, ceteris paribus                                                             

2.      Negative for inferior goods                                    

3.      Positive for normal goods

4.      Normal goods: e.g. rise in income èrise in Demand

5.      Inferior goods: e.g. rise in income èfall in Demand

6.      Factors affecting YED: nature of the good                                                        

XED                                                                                                                                                                      

1.     Measure of responsiveness of the quantity demanded of a good to a change in the price of another good, ceteris paribus

2.     Positive for substitutes

3.     Negative for complements

4.     Substitutes: e.g. Fall in price of good A èfall in Demand for good B

5.     Complements: e.g. Fall in price of good A èrise in Demand for good B

6.     Factors affecting XED: closeness of the 2 goods                        

 Figure 12a: Market for Conventional Cigarettes

Increase in supply of e-cigarettes

An increase in supply of e-cigarettes will lead to a fall in prices of e-cigarettes. Assuming that demand for e-cigarettes are price elastic (not seen as a necessity or close substitute for cigarettes), quantity demanded will increase more than proportionately àIncrease in total revenue for e-cigarettes

XED: Positive relationship between e-cigarettes and conventional        

The lower price of e-cigarettes, which is a weak substitute for conventional cigarettes -> some consumers of conventional cigarettes would switch to using e-cigarettes -> moderated decrease in demand for conventional cigarettes. With reference to figure 12a, which shows the market for conventional cigarettes,

• Demand curve shifts from DD0 to DD1

• Price falls from P0 to P1

• Quantity falls from Q0 to Q1

• Both price and quantity falls ètotal revenue falls, from area P0E0Q00 to P1E1Q10

Impacts of developments on the market for conventional cigarettes

Rise in incomes

Income inelastic – cigarettes seen as necessity for smokers rather than a luxury good -> increase in incomes over the years in major economies like China, U.S -> less than proportionate increase in demand for cigarettes -> Higher Total Revenue for conventional cigarette firms

Figure 12b: Market for Conventional Cigarettes

Tax hikes

Increases cost of production of conventional cigarettes èLess profitable to produceconventional cigarettes at every price level èLower Supply. With reference to figure 12b, which shows the market for conventional cigarettes

·      Demand curve is likely to be relatively price inelastic as cigarettes are a habit-forming and addictive good, given by DDi

·      Supply curve shifts from SS0 to SS1

·      Price increases from P0 to P1

·      Quantity decreases less than proportionately from Q0 to Q1

·      Price increases while quantity demanded falls less than proportionately ètotal revenue increases, from area P0E0Q00 to P1E1Q10

Conclusion

We would expect an unusual increase in total revenues for both e-cigarettes and regular cigarettes consequentially from the events stated, even though they are substitutes for one another.

Comments

While it was not mentioned in the preamble there was a rise in income, we brought in a likely income change so that we can make use of YED concept in our discussion. An alternative answer could completely omit the discussion of YED, citing that in the absence of any mention of income changes – YED concept is irrelevant.