1. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 18 Tobacco and Alcohol

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline AN ECONOMIC MODEL OF TOBACCO AND ALCOHOL WHY IS REGULATION WARRANTED TAXES ON TOBACCO AND ALCOHOL

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Impact of Beer and Cigarettes Beer Industry –Sales $17 billion –Employees 33,000 Cigarette Industry –Sales $27 billion –Employees 20,000

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Simple Model Supply Demand Q* P* P Tobacco/Alcohol A B C 0 Value to the Consumer: 0ACQ* Consumers Pay Producers: OP*CQ* The Variable Cost to Producers: OBCQ* Consumer Surplus: P*AC Producer Surplus: BP*C

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Regulation is Warranted To provide information or to correct for the inability of consumers to make good decisions –Examples: restrictions on advertising of tobacco, warning labels, age restrictions To deal with externalities (effects of a transaction that hurts or helps people who are not a part of that transaction) –Examples: drunk driving and second-hand smoke Immorality of a good (not a justification economists often use) –Example: prohibition

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Ads and the Information Problem Whaaazzuupp (how ya doin) Joe Camel NASCAR Winston Cup, Busch Series (Car sponsors Miller, Budweiser, Kodiak) Virginia Slims Tennis These ads appeal to children (whether or not they are intended as such).

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Externalities Tobacco accounts for approximately $1 per pack in costs incurred by taxpayers and nonsmokers. –Medicare, Medicaid, Asthma, Drunk Driving accounts for one-third of the 37,000 traffic accidents that cause 40,000 deaths

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Modeling Externalities S Marginal Cost D (Marginal Benefit) Q* P* P Tobacco/Alcohol 0 Social Cost External Cost Q’ P’

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Twist on the Externalities Argument for Tobacco Cigarette smokers are more likely to die – at an earlier age than they would have otherwise died. –in a less costly manner than they would have otherwise died. (e.g. heart attack rather than Alzheimer’s.) Some economists estimate that this effect saves Social Security, Medicare and Medicaid (because they are not in nursing homes) more money than the $1 per pack in estimated external costs.

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Using Taxes to Correct for Externalities S Marginal Cost D (Marginal Benefit) Q* P* P Tobacco/Alcohol 0 Social Cost=S+tax External Cost=tax Q’ P’

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Tobacco Settlement and Why Elasticity Matters 1998 settlement between several states and several tobacco companies $250 billion spread over 20 years Demand for tobacco products is fairly inelastic. This means that the percentage change in prices will be more than the percentage reduction in smoking.

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Tax on Tobacco with Inelastic Demand S Marginal Cost D (Marginal Benefit) Q* P* P Tobacco/Alcohol 0 S+tax tax Q’ P’

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Estimates Elasticity of Demand –for Tobacco -.2 for adults -.5 for children –For Beer -.53 Implications –A dollar increase in the tax on cigarettes would reduce consumption by adults by 10% and reduce consumption by children by 25%.