Price Elasticity of Demand (PED) measures the percentage change in the price of a product, to the percentage change of demand for that same product. It is measured through varying degrees of elasticity. An inelastic good means that a change in price will have a very little effect on the demand. Due to PED=%?Q / %?P, inelastic ­goods have a PED<1, explaining the gradient of the graph in Figure 1. If a product is completely inelastic (PED=0),it implys that however much a tax increases, it does not affect demand, as consumers are still going to buy it. If the price doubles and people buy more than half of what they were originally going to buy, it’s inelastic. If it’s less than half, it’s elastic. Because smoking is addictive, and buyers are always willing to pay, it is inelastic.

Taxation is the process in which the government influences the economy, and is the basis of the Fiscal Policy. The main motivation for this policy is revenue, as tax raises money to spend on improving society for the public, for example improving the NHS, schools and roads. It also helps redistribute wealth more equally among the public, and reduce negative externalities. There are two types of indirect taxation. Ad Valorem Tax is implemented most frequently, where the tax attached to a good is correlated to the price it is being sold at, so is a percentage of the total price, currently levied at the standard rate of 15%. However, Specific Tax is a form of indirect taxation that is not based on the value of the goods, only the quantity. For example, if two packets of cigarettes both contained 20 cigarettes, one was priced at £5.99 and the other at £2.99, because they both contain the same quantity, the tax added would be a constant value, regardless of the original selling price. There are many factors that need to be taken into consideration when looking at price elasticity of demands and taxation. The availabilty of substitutes will make demand more elastic, as customers have more alternatives to buy. However, when there are no appropriate substitutes, and the customer does not have the ability to postpone consumtion, they are seen as a necessity, and therefore the price elasticity of demand will be very inelastic.

When considering specific tax being mandatory for buyers of cigarettes, and the changes this would bring about regarding elasticity, the addictive element of niccotine must be taken into account as to what effects this would have on demand. It is shown that “taxes on cigarettes can be raised nearly 2.5 times the current level without any fall in revenue” (Rigo, 2005). Therefore, the demand for cigarettes will be inelastic. As shown in Figure 1, the demand for an inelastic goods such as cigarettes, is very unresponsive to a change in price.

The creation of a larger specific tax for cigarettes is not only a burden on the consumer however. The producer may have to lower their original price to make sure their customers still purchase their product. This means the company has to absorb most of the tax if the PED is elastic. However, the alternative is that the business can pass the tax on to the consumer by increasing the price of a good, and this is called shifting the burden of tax. Seeing as cigarettes have a very inelastic demand, this gives the company the ability and confidence to increase prices without worrying about loss of sales. This is shown in Figure 2.

Figure 2 shows the effect that a specific tax has on consumers when demand is inelastic. It will cause demand to fall from D to Dt, which causes the quantity demanded to fall from q* to qt. The equilibrium price after the tax is Ps, which is what the producers will charge, and adding the tax on top of that price will give Pc, with the tax revenue being AC.

Similarly, when demand is elastic and a specific tax is imposed, it will cause demand to shift left from F to Ft. this will cause the quan