Smoke and Nicotine in New York – Social Surplus, Taxation, and Consumer Migration to Substitutes

George Orlov, Cornell University-Endowed Colleges, Douglas McKee, Cornell University
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Summary

Students will examine the effect of a tax increase in a market with negative externalities in the context of the New York City tobacco and e-cigarette market. The exercise offers a more challenging setting than traditional single-market-focused examples by having the students consider a related market for a substitute (e-cigarettes) and two groups of consumers (adult and adolescent smokers).

Context for Use

● The activity is appropriate for both Principles and Intermediate Microeconomics, as well as some of the Public Policy courses.

● Students should be familiar with consumer surplus, externalities, and how taxation changes the surplus depending on elasticity of demand.

● This activity should be suitable for discussion in any class size.

● The activity will likely take around 20 minutes.

Overview

In this activity, which uses a stylized version of the New York City tobacco and e-cigarette markets, students will examine how the introduction of a tax in a market with negative externalities can affect consumers in this market in short-term (the cigarette market). They will also consider the indirect effects on markets for substitutes (e-cigarettes) and the social surplus for those who are affected by the negative externalities produced by these markets.

This activity is designed to challenge students by making them think not only about a single market affected by an increase in a tax, but of a related market which offers a substitute. Furthermore, the exercise covers two types of consumers (adult and adolescent smokers), each with different price elasticity. This difference implies proportionally different responses to a tax increase. The effect of the tax on non-smokers in this case is non-trivial since while there will be a positive surplus gain from the reduction in second hand smoke, this gain will be attenuated due to some smokers switching to e-cigarettes from regular cigarettes.

Expected Student Learning Outcomes

In this exercise students will employ and expand their understanding of taxes in markets with externalities and their effect on social surplus.

Information Given to Students

Even though New York City had the highest per pack price for cigarettes in the US in 2017, the city still had approximately 900,000 smokers, 15,000 of whom were adolescents. Furthermore, there were 174,000 adults and 42,000 adolescents using e-cigarettes. In an effort to reduce the numbers of smokers and e-cigarette users, Mayor Bill de Blasio announced a series of legislative proposals, which included a significant increase in the per pack cigarette tax:


"We're going to raise the floor on the cost of a pack of cigarettes from $10.50 to $13 — the highest price in the country.
— Bill de Blasio (@NYCMayor) April 19, 2017"


Focusing on the effects of these taxes, rank the following groups by the percentage changes in the consumer surplus (from largest reduction to the greatest increase, if such is present). Consider only short-term effects of the changes in the markets. For this activity, assume that only the cigarette (but not the e-cigarette) market is affected by the tax. Back up your arguments with graphical representation of relevant market segments.

A. Adult smokers.

B. Adult e-cigarette users.

C. Adolescent smokers.

D. Adolescent e-cigarette users.

E. Non-smokers.


Student Handout for "Smoke and Nicotine in New York – Social Surplus, Taxation, and Consumer Migration to Substitutes" (Microsoft Word 2007 (.docx) 17kB Sep16 19)
Instructor Solutions for "Smoke and Nicotine in New York – Social Surplus, Taxation, and Consumer Migration to Substitutes" (Acrobat (PDF) 346kB Aug26 19)

Teaching Notes and Tips

● What prefatory remarks should set up the application exercise? – It is important to note that the supply side is best represented by a horizontal line in this case, and taxation would shift this line up.

● Does facilitating the teamwork require any special action? – No, beyond the usual circulation and making sure that the groups are actively discussing the problem at hand.

● What kinds of follow-up questions are recommended for facilitating the debriefing conversation among team reporters? In particular, how might the instructor get teams to evaluate which answer is the best, provide the analytical support for the team answers, identify what information would enable an economist to decide between alternative answers? - One of the more challenging aspects of this activity is the fact that cigarettes and e-cigarettes are (imperfect) substitutes and a portion of the smokers would shift towards the latter after the introduction of the tax. Therefore, consumer surplus in the cigarette market will decrease (and more so for adolescents, since they are more price sensitive due to lower incomes), but the overall consumer surplus in the e-cigarette market would increase (due to an outward shift in demand).

One further option that potentially might not get enough of discussion initially is the effect on the non-smokers. Here students need to think about the gains that non-smokers might experience from the reduction in the number of cigarettes consumed, based on what the students believe would be the reduction based on their assumptions about the elasticity of demand across different age groups.

● What points should be emphasized in the instructor's summary remarks to conclude the exercise? - One of the things which should be emphasized is that while the effect in percentage terms is comparable, the sizes of the surpluses in absolute value are, however, a different matter. These could be discussed in terms of market sizes. For example, the adult market for cigarettes is 60 times larger than the adolescent market (and, potentially, has a less elastic demand).

Assessment

Have the students think of two linked markets with a positive externality and have a subsidy applied to one of them. Have the students discuss and report on the implications of a subsidy introduction for the surplus of involved parties. Alternatively, talk about a more complicated (closer to reality) version of the cigarette and e-cigarette market in NYC, by adding a tax onto e-cigarettes (devices and refills).

References and Resources

The activity is based on the following announcement of the NYC government:

https://www1.nyc.gov/office-of-the-mayor/news/239-17/de-blasio-administration-city-council-members-elected-officials-sweeping-legislation#/0

I would suggest assigning the announcement as reading after the discussion, as there are extra details that might throw students off, since they have been excluded from the stylized version of the problem at hand.