Price elasticity of demand

PRESENTATION 3

Workshops on Tobacco prices and taxation

World Health Organization (WHO) and International Union Against Tuberculosis and Lung Disease (The Union)

Part 1. Changes in tobacco consumption resulting from changes in tobacco prices

Part 2. Changes in government revenues resulting from changes in tobacco prices

Part 1. Questions• What are the key determinants of tobacco

consumption?• What is price elasticity?• What does a price elasticity of -0.4 mean?• Why do people continue to buy cigarettes

even in countries where the price is as high as US$ 8.00 per pack?

• What other factors can affect how strongly consumers respond to price increases?

increase? Revenue impact? Effect on deaths?Two important determinants of tobacco

consumption are the price of tobacco products and household income.

As real tobacco prices increase, there is a decrease in the consumption of tobacco...

Or if tobacco prices decline relative to the cost of other goods and services, consumption increases.

5

As real tobacco prices increased in Morocco, consumption declined…

Source: Aloui, 2003

Inflation Adjusted Cigarette Prices andCigarette Consumption, Morocco, 1965-2000

Price Elasticity of Demand

Why do smokers continue to smoke even in countries where the prices is very high – such as in Ireland where a pack of cigarettes could cost US $8.00?

The quantity of cigarettes the consumers desire is not very responsive to changes in price… or demand is ‘inelastic’…

Price Elasticity • measures the strength of the relationships between

price (P) and quantity demanded (Q)• % change in Quantity/% change in Price• is a function of the slope of the demand curve (the

steeper the slope, less elastic the good)

If the price of cigarettes increased by 20%, and quantity decreased by 2%, what is price elasticity

(PE)?

PE = .1 inelastic < 1 = inelastic (price increases have less

impact)

1 = unit elastic (1 unit to 1 unit impact)

>1 = elastic (price increases have greater

impact)

Other factors affecting demand1. Availability of substitutes: Goods with more

substitutes tend to be more elastic (consumers are very responsive to price)

2. Income: greater the income level, the less sensitive consumers are to changes in price.

For example, the poor and youth are more price-sensitive (a 10% price increase reduces smoking as much as 10% among youth and the poor).

3. Time: In the short-run, cigarettes are inelastic, but if smoker quits gradually, cigarettes are more elastic over time

Estimates of price elasticity have ranged from -0.2 (Turkey) to -0.9(Bolivia), with median value of about -0.4

Asia Bangladesh -0.27 China -0.54 Indonesia -0.34 Nepal -0.8 Sri Lanka -0.53 Thailand -0.39 Eastern Europe Bulgaria -0. 80 Estonia -0.34 Turkey -0.19 Latin America Argentina -0. 27 Bolivia -0.85 Brazil -0.25 Chile -0.22 Uruguay -0.49 Middle East Egypt -0.40 Morocco -0.31

Sources: Adioetomo, Djutaharta, and Hendratno 2005; Alcaraz 2005; Ali, Rahman, and Rahman 2003; Aloui 2003;Arunatilake and Opatha 2003; Debrott Sanchez 2005; Gonzales-Rozada 2005; Hu and Mao 2002; Iglesias and Nicolau2005; Karki, Pant, and Pande 2003; Nassar 2003; Onder 2002; Ramos and Curti 2005; Sayginsoy 2002; Taal 2004.

These reports are available on line at http://www.worldbank.org and for Latin America at http://www.paho.org.

Part 1. Review • What are the key determinants of tobacco

consumption?• What is price elasticity?• What does a price elasticity of -0.4 mean?• Why do people continue to buy cigarettes

even in countries where the price is as high as US$ 8.00 per pack?

• What other factors can affect how strongly consumers respond to price increases?

Part 2. Changes in government revenues resulting from changes in tobacco prices

Part 2. Questions• If people stop smoking in response to a

tobacco tax increase, why do government revenues tend to increase?

• What factors affect the revenue-generating potential of a tobacco tax increase?

Increases in tobacco taxes have the potential to generate increases in government revenues

• As price rises, consumption falls, but by less than the percentage rise in price (demand is price-inelastic).

• As incomes rise, so does consumption - and total revenue (the income elasticity of demand is greater than one).

The total amount of revenue that can be generated depends on several keys factors:

–Tobacco Consumption level–Tobacco tax rates–Retail price of cigarettes–Household incomes –Control of smuggling activities

Governments tend to generate revenues from tobacco tax increases because the demand for

tobacco is generally inelasticPeople do respond to changes in tobacco prices

(particularly those that are price sensitive such as children, the poor, and infrequent smokers).

However, most people continue to smoke despite increases in tax, although their consumption may decline (they smoke less cigarettes). The remaining smokers pay a higher tax – therefore government revenues tend to increase from a tobacco tax.

This suggest that tobacco taxes are good instruments to achieve both revenue and public health goals.

Example from China: an increase in tax of RMB 1/pack (approx US$ 0.15) reduces the number of smokers by

13.7 million people and saves 3.4 million lives

Teh-Weh Hu , Zhengzhong Mao, Jian Shi, Wendong Chen 2008.

 

Increase in tax by 1 RMB

Cigarette retail price RMB/pack 5.52

Total tax (RMB/pack) 2.82

Tax rate as % of retail price 51%

Reduction in number of smokers (million) 13.7

Number of lives saved (million) 3.4

However, the remaining number of smokers in China are 295.1 million people after the tax increase. Since

the remaining smokers pay a higher price after the tax, there is an increase in government tax revenues from

the tax increase.

Teh-Weh Hu , Zhengzhong Mao, Jian Shi, Wendong Chen 2008.

 

Increase in tax by 1 RMB

Remaining number of smokers after tax (million) 295.1

Additional tax revenues generated (billion RMB) 64.9

Total tobacco tax revenues (billion RMB) 235.1

Part 2. Review • If people stop smoking in response to a

tobacco tax increase, why do government revenues tend to increase?

• What factors affect the revenue-generating potential of a tobacco tax increase?

Group discussionAmong the countries represented in this

room, where are tobacco consumers -the most responsive to price? -the least responsive to price?

Why do these differences exist among countries?