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Managerial Economics

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Introduction :

Supply and demand is an economic model of price determination in

a market. It concludes that in a competitive market, price will function to
equalize the quantity demanded by consumers, and the quantity supplied
by producers, resulting in an economic equilibrium of price and quantity.

The diagram shows a positive shift in demand from D1 to D2, resulting in an

increase in price (P) and quantity sold (Q) of the product.


Elasticity is a central concept in the theory of supply and demand. In this

context, elasticity refers to how strongly the quantities supplied and
demanded respond to various factors, including price and other

Elasticity is calculated as the percentage change in quantity divided by the

associated percentage change in price. For example, if the price moves from
$1.00 to $1.05, and as a result the quantity supplied goes from 100 pens to
102 pens, the quantity of pens increased by 2%, and the price increased by
5%, so the price elasticity of supply is 2%/5% or 0.4.

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Since the changes are in percentages, changing the unit of measurement or

the currency will not affect the elasticity. If the quantity demanded or
supplied changes by a greater percentage than the price did, then demand
or supply is said to be elastic. If the quantity changes by a lesser
percentage than the price did, demand or supply is said to be inelastic. If
supply is perfectly inelastic;that is, has zero elasticity..

Elasticity in relation to variables other than price can also be considered.

One of the most common to consider is income. How strongly would the
demand for a good change if income increased or decreased? The relative
percentage change is known as the income elasticity of demand.

Another elasticity sometimes considered is the cross elasticity of demand,

which measures the responsiveness of the quantity demanded of a good to
a change in the price of another good. This is often considered when looking
at the relative changes in demand when
studying complements and substitute goods…

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1. Based on the empirical results of the paper ,are advertising bans

(both limited and comprehensive ) effective in controlling
consumptions of cigarettes in developing countries ? Discuss.

Price of

Due to
a decrease
in adrevertising

Quantity of
cigarettes (X)

Tobacco control advocates and practitioners argue that tobacco

advertising has a positive impact on aggregate consumption and that
restricting and even banning tobacco advertising has a positive
impact on aggregate consumption and that restricting and even
banning tobacco advertising altogether can reduce aggregate

comprehensive advertising bans have played a role in reducing

consumption in developed countries but that limited policies have not
.A study on 30 developing counties has found that both

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comprehensive as well as limited policies are effective in reducing

consumption although comprehensive bans are more powerful than
limited ones .In addition, it finds that advertising bans may be even
more effective in the developing world than they are in developed
world . Limited bans reduce per capita consumption by 13.6%while
comprehensive bans result in a larger 23.5%reduction in per capita
consumption(relative to the base case of a weak policy regime). It is
important to notice how countries that changed to limited and
comprehensive strategies were more than likely high income
countries and those that kept weak policies in place developing
countries .Further more ,countries that implemented limited and
comprehensive bans found consistently declining consumption over
the period while countries that kept weak bans in place found that
consumption consistently rose .As a result ,countries which
implemented more restrictive advertising regimes were more likely to
have another policies in place which discouraged smoking such has
higher taxation(and price)…

2.What you conclude about the price elasticity of demand and income
Explain the effect of price and income
changes as demand determinants on
cigarette consumption

Income elasticity of demand is used to see

how sensitive the demand for a good is to an
income change. The higher the income
elasticity, the more sensitive demand for a
= α0 +αX PX +αY PY +αM M +αH H
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good is to income changes. For the case of a linear demand relation ,

one might specify the demand function as

Where ‘s are the parameters to be estimated ,py , M,and H are

demand shifters, and e is the dandom error term that has a zero

Alternatively, a log-linear specification might be appropriate if the

quantity demanded is not linearly related to the explanatory variable
ln Q X d = β0 + βX ln PX + β Y ln PY + β M ln M + β H ln H

In the recent question ,the static model is estimated in natural

logarithms to allow for interpretation of the coefficients and is
formalized by the following equation :

Ln Cit = 0+ 1 ln Pit + 2 ln Yit + 3 D(Comp) it + µit

Where C represented per capita consumption ,P real price ,Y per

capita real income , D(Comp) represent the dummy variables for
limited and comprehensive bans ,respectively and the subscript (it)
refers to country i and time period t .
The price elasticity is negative and statistically significant and
consistent with our expectations that tobacco is price inelastic and a
normal good . The absolute magnitude of price elasticity is relatively
low indicating that 10% increase in the real price result in only a
1.2%reduction in per capita consumption .This result is somewhat
unexpected and not consistent with what is found in the literature .It
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suggests that the impact on consumption of an increase in price is far

smaller than expected .There are a number of reasons why this is the
case although the high level of aggregation of the data might be to
blame . The high level of aggregat6i9on8 redu9ces our ability to
control for many important effects including the interaction between
demand and supply ,illicit trade ,initiation ,cessation and the type of
tobacco(Chaloupka et al.,2000).
The income elasticity indicates that a 10% increase in per capita real
income will result a 1.0% increase in per capita consumption and is in
line with what the literature suggests we should expect.

Initial line

M1/Py M/Py

Mo/Py Increase in consumption

New budget

M2/Py Decrease in consumption

X M/P1x
M/pox X

M2/Px Mo/Px M1/Px

Increase in the price of cigarettes

Changes in income Shrink or expand opportunity

The absolute magnitude of the price elasticity is relatively m ,


Results of the econometric models

Model lnP lnY D(lim) D(comp)

constant R^2

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All countries

OLS Di & Dt -0.123(-4.512)*** 0.192 (1.999)** -0.026(-0.709) - 0.067(-1.830)*

5.5439(6.745)*** 0.96

Developing countries

OLS Di -0.099(-2.928)*** 0.086(1.040) -0.136(- 2.199)** - 0.235(- 4.434)***


Di and Dt represent country and time effects included in the model . Dependent variable is ln C ***
Significant at 1% **Significant at 5% and * Significant at 10% .

3. Would cigarette pricing policy (say, tax increases) be more

effective than
advertising bans for cigarette consumption? Elaborate your

Nowadays, smoking of cigarettes is a major cause of preventable

premature death in
the world. For instance, in Europe 1.6 million people die per year due
to the negative impact of smoking. For 2020, a number of 2 million
affected people is projected. This trend can be seen in many parts of
the world. However, some countries have managed to decrease
smoking by advertising policies and / or pricing policies (WHO, 2003).
In the following it will be explained under which circumstances pricing
policies or advertisement bans have a greater impact on cigarette
consumption. Whereas the first part is dedicated to all countries, the
second part will focus exclusively on developing countries.
According to Blecher (2008), limited bans reduce smoking in
developed and
developing countries by 2.6% and comprehensive bans by 6.7%.
Furthermore, Blecher

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demonstrates that a 10% increase in the real price of cigarettes

results in a 1.2% reduction of per capita consumption (see Figure 4).
In comparison, an empirical research of Chaloupka and Warner (2000)
shows that the price elasticity of tobacco products might be higher.
They suggest that a 10% increase
in the cigarette price results
in 2.5 – 5.0% reduction in
per capita
Hence, considering all
countries and both
empirical studies, it cannot
clearly be said if a 10% tax
increase of cigarette price
or limited and / or
comprehensive bans have
a greater impact on the consumption of tobacco. However, if the
excise tax increases by 70- 100% instead of 10%, the impact on
cigarette consumption is definitely greater than the impact of
advertisement bans in developed and developing countries. This
approach was taken by some European countries which raised taxes
on cigarettes by 70%–80%, resulting in significant reductions in per
capita consumption of tobacco (WHO, 2003).
The picture changes if only developing countries are considered.
According to Blecher

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(2008), limited bans reduce smoking in developing countries by 13.6%

and comprehensive
bans by 23.5%. In
the 10% increase in
products has a
relatively low
impact on cigarette
(compare Figure 5). It seems to
be that advertising bans are much
more effective in developing
countries than in developed
It can be summarized, that a low (10%) tax increase in developed and
countries has a similar effect on cigarette consumption than
advertising bans. However, a
stronger increase of taxes on tobacco products leads to a more
powerful decrease of tobacco product consumption. In the special
case of developing countries, limited and comprehensive bans are
more effective than a 10% tax increase of cigarette products.
However, a greater increase of taxes on cigarettes would overcome
the effect of limited and / or comprehensive bans as well. According to
the WTO (2003), a comprehensive approach, combining tax increases
and advertisement bans, is the most powerful technique to reduce
cigarettes consumption.

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4.Why do you think the author concludes that the impact of

advertising bans are more effective for controlling cigarettes
consumption in developing countries than developed countries ?

The author concludes that the impacts of advertising bans are more
effective for controlling cigarette consumption in developed than
.developing countries depends on literature view and data analysis

Economists have added much value to this debate with many studies
showing that advertising has had a positive impact on aggregate

Nelson (2003) uses the fitted values for the advertising restriction
score as an instrumental variable in estimating tobacco demand.7
Nelson (2003) finds that income and prices are statistically significant
in predicting demand, while warnings are only statistically significant
in the first sample period while the advertising restriction score is not
statistically significant in any of the samples. Although not
statistically significant the coefficients are negative in all samples,
which are inconsistent with the results Nelson (2003) found in the
single equation models. The t-statistic also falls over the three
samples indicating that advertising restrictions have become less
important in determining consumption. In order to test the
endogenously of the advertising bans, a Hausman test was performed
which failed to reject the null hypothesis that advertising bans were
exogenous, indicating that the two stage model is important in
explaining the relationship between the political economy and
advertising bans and their relationship with consumption. Nelson
(2003) concludes that advertising bans and restrictions have had no
effect on consumption although the final model he presents does

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suggest that this is not the case and that in fact, advertising bans and
restrictions have had a very small, albeit insignificant, effect on

Moreover for one the literature indicates that the impact of price
change has a large impact on consumption in developing countries
via-a-vis developed countries. VanWalbeek(2005,p.80)indicates that
“the consensus view is that the price elasticity of demand is a round
-0.4developed countries and between -0.4and -0.8 for developing
countries” farther more, changes in income also have a great impact
on consumption in the developing world than the developed world
.Thus it can be said that tobacco demand is more sensitive to its
determinants in the developing world relative to the developed world.
Consumers are more sensitive to demand sided intervention. Whether
it be price increases as result of tax increases or non-price measure
including advertising bans, public smoking bans and social factor.
There are a number of reasons for this greater sensitivity, firstly the
price of cigarette takes up a greater portion of a consumer’s income
in the developing world than in rich country (Blecher and Van
Walbeek, 2004).Thus as a result an increase in price has a relatively
greater impact on a person’s relative budget. Farther more, consumer
in poorer countries are likely to have lower education levels and thus
have a poorer understanding of the health consequences of smoking.
Thus the impact of advertising may be weaker in high income
countries since a fewer number of smoker are enticed by advertising
due to the better understanding of the health consequence.

By Haitham A.Karim


Ibrahim saleh omar rababah