Reference no: EM132471441

Problem: As an analyst for the FDA, your boss requests that you determine the factors likely to influence the demand for cigarettes. Accordingly, you estimate the following demand equation:

QD = 484136 - 3638.37AP + 288.844AI + 160.171AA

QD = total cigarette consumption demanded (in millions of packs)

P = price per pack of cigarettes (in cents per pack)

I = personal disposable income (in billions of dollars)

A = cigarette industry advertising (in millions of dollars)

A. Based on this equation, discuss whether (i) cigarettes adhere to the law of demand and (ii) cigarettes are a normal or inferior good. Why is it reasonable for the number in front of A to be positive, as it is?

B. Suppose personal disposable income is currently 3000 and advertising is currently 500. If the supply of cigarettes is: QS = 500000 + 1361.63AP, where QS is the quantity supplied of cigarettes (in millions of packs), determine the equilibrium price and quantity of cigarettes. Graph the demand and supply curves, illustrating the equilibrium. Be careful to indicate the horizontal-axis and vertical-axis intercepts. At the equilibrium, determine the values of the price, income, and advertising elasticities of demand. With respect to price, is cigarette demand elastic or inelastic?

C. Due to the health risks associated with smoking, suppose the government decides it would like to reduce smoking incidence. One approach the government might consider is a complete ban on cigarette advertising. Based on the demand and supply model, compared to your answer in part B, how much of a reduction in equilibrium consumption would likely occur as a result of an advertising ban?

D. An alternative means of reducing consumption is to tax cigarettes. With I = 3000 and A = 500, which would reduce consumption the most, a $1 per pack tax on cigarettes (i.e., a 100-cent per pack tax levied on consumers) or a complete ban on cigarette advertising?