Cost of Tobacco Industry

Costs

Because smoking is a habit so hard to kick, demand for cigarettes is highly inelastisic - meaning that large price changes induce only small changes in the quantity demanded. Equivalently, only large price increases (decreases) will shrink (stretch) demand because the demand is inelastic to price changes. Social factors and education are often significant determinants of which people start smoking, but for those who do smoke the number of cigarettes smoked is not highly sensitive to price.

When a tax is imposed or increased, its burden falls on those consumers or producers who cannot move to a substitute product to avoid the tax. For consumers that means that there is no substitute product that becomes more attractive relative to the newly taxed product that can be consumed instead. For producers it means that the resources used in producing the product cannot easily be deployed in the production of something else. 

Cigarette demand is inelastic because nothing else is a close substitute for cigarettes.

The point is that inelasticity and the burden of tax go hand in hand. If the demand is inelastic and the supply is elastic (the cigarette industry) the burden of a new tax falls very largely on the consumers, with most of the tax revenue coming out of consumer surplus.

The diagrams illustrate the idea.

1. Diagram 1 shows the demand curve for tobacco companies before the imposition of the tax. The numbers are given as an example. The price that consumers pay, $2 per packet, is the price that the producers receive (ignoring distribution costs) for the 15 billion packs consumed. There is a single price - the price per pack that consumers pay is the revenue per pack that producers receive.

2. Diagram 2 illustrates supply and demand after the tax has been imposed. The payments from tobacco companies to the States, required by new law, amount to the difference between the price paid by consumers and the price received by tobacco companies, times...