COMMENTARY ON

MICROECONOMICS

MARKET FAILURE –
NEGATIVE CONSUMPTION EXTERNALITIES

Subject: ECONOMICS (HL)

Word Count: 1,122 words
Number of pages: 7

Done by: Josh Vir

School: Genesis Global School, India

Date of Submission: Feb 3, 2020

 Commentary on Microeconomics Josh Vir

https://www.rappler.com/nation/236312-duterte-approves-higher-excise-tax-tobacco-products

Duterte approves higher excise tax for tobacco products

Under the new law, excise tax on cigarettes will go up to P45 from P35 starting
January 1, 2020, to be followed by more increases in succeeding years

Published 6:47 PM, July 25, 2019

MANILA, Philippines – President Rodrigo Duterte signed into law the bill raising
excise tax for tobacco products, a measure he certified as urgent last May.

"To address the urgent need to protect the right to health of the Filipino people and to
maintain a broader fiscal space to support the implementation of the Universal Health
Care Act, the President has signed into law HB (House Bill) No. 8677 or SB (Senate
Bill) No. 2233 increasing the excise tax on tobacco products," said Executive
Secretary Salvador Medialdea on Thursday, July 25.

The law, Republic Act No. 11346, raises cigarette tax from the current P35 to P45 for
the first year of implementation. This will be followed by 5-peso increases every year
until the rate reaches P60 in 2023.

Starting 2024, a 5% increase would be imposed annually.

Here is the schedule:

 January 1, 2020 - P45/pack
 January 1, 2021 - P50/pack
 January 1, 2022 - P55/pack
 January 1, 2023 - P60/pack
 January 1, 2024 onwards - 5% indexation

The measure is expected to generate P15 billion in revenue in 2020 and P140 billion
until 2023. – Rappler.com

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COMMENTARY: MICROECONOMICS

The article talks about a raise in excise taxes on cigarettes in the Philippines.
It is an effort by the government to reduce cigarette consumption, which is a
demerit good. The excise tax is being increase from its current peso 35/pack
to peso 60/pack in 2023 with subsequent 5% increase every year after that.
Note, an excise tax is any levy on manufactured goods, which is levied at the
moment of manufacture, rather than at sale.

Cigarettes are demerit goods that are over-provided by the market and whose
consumption is harmful to not just the people addicted to consuming it but
also to the passive smokers around them. They thus produce a negative
externality where the costs (represented as negative benefits) lead to
marginal social benefits being lower than the marginal private benefits.

Smoking in the short run provides private benefit to the consumer since given
its addiction it gives him relief from experiencing withdrawal symptoms.
However in the long run continued consumption of cigarettes causes major
health issues for the consumer leading to increase in healthcare spending, as
well as lower workplace productivity.

As you can see clearly illustrated in the Fig.-1, on the next page, there is a
problem with the over-allocation of resources as Q m (or Market Quantity)
exceeds Qopt (or Optimum Quantity). This overconsumption leads to market
failure and external costs. Welfare loss (as seen in the figure below) is the
negative externality that is resulting from the overconsumption of cigarettes.

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Fig.1: Negative Consumption Externalities (for Cigarettes)

The PED of cigarettes also comes into play as cigarettes are inelastic
products given their addictive nature to smokers and as such the increase in
prices of the additional excise tax may not have the desired effect since even
if price increases quantity demanded may decrease by only very little in the
short run.

The Philippine government has seen the ill effects of smoking on their general
population. It is not just the smokers that are affected by adding to their
overall healthcare costs but also the passive smokers who add to the external
costs. Seeing these negative external costs as a result of overconsumption of
cigarettes, the Philippines government has decided to put an excise tax on
each pack of cigarette sold. The excise tax will almost be doubled in the span
of 4 years. The net impact on the price increase for the consumer per pack of
cigarettes will be around 30%. The government hopes that in doing so they
may discourage people from buying cigarettes.

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A common argument against cigarette taxation is on socio-economic grounds.

Typically lower income groups smoke far more than people falling within the
higher income categories. And as such this raises a concern that that any
further tax will be excessively burdensome for those within the lower income
brackets. This certainly brings to light the regressive nature of taxes on
cigarettes. The lower income groups are extremely price sensitive and this
very argument of a price increase can act as an effective self-control device
because it will have more of the desired effect of reducing their smoking.

Fig. 2: The Effect of imposing an excise tax on cigarettes

Fig-2 above is a better representation of the effect of an indirect tax (such as

excise tax) on the marginal private cost of the production of cigarettes. The
increase in excise tax reduces the overall Supply (the Supply curve moves to
the left), and in doing so also raises the marginal private cost (to MPC + tax),
which is now higher than the marginal social cost.

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For the consumers, the tax increases the price to P c – the price that
consumers have to now pay to buy the reduced quantities at Q opt. The
suppliers of cigarettes meanwhile collect Qopt at Price Popt – reflecting an
overall decrease in overall sales as a portion of it is paid to the government in
taxes. The government meanwhile collects the difference between Consumer
Price and Supplier price at the reduced quantities (P c less Popt) x Qopt.

There are many disadvantages of the excise tax being added by the
Philippine’s government. The first one being that income inequality may
increase due to the fact that taxes such as excise tax are often regressive due
to the fact that the rich and the poor have to pay the same amount per pack of
cigarettes. This leads to the poor shelling out far more as a share of their
incomes than the rich. This can also lead to lower living standards as more of
the disposable income of the poor consumers will be taken and many of those
who smoke are from the lower income categories.

Another disadvantage could be that the reduction of cigarette consumption

would be low in the short run. This is due to the fact that price elasticity of
demand is inelastic for cigarettes due to their addictive nature. And so, the
government may not achieve its objective, which is to discourage the people
from the use of cigarettes.

It may also increase unemployment as producers will earn lower revenues

leading them to have to cut costs to make the same level of profits and since
many of those who work in the cigarette industry are from a manufacturing
level whom can easily be replaced as they are unskilled labor. It will be hard
for them to find other jobs since their skills are focused in only one industry.
The government will also now have to contend with greater unemployment
and connected social consequences.

However, there are also advantages of raising the excise tax by the Philippine
government. One is that because PED is inelastic the government will be able
to raise greater revenue, as the demand will remain almost the same given

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the addictive nature of cigarettes. And the government can reinvest this
excess money into other social projects like healthcare or infrastructure.

There will also be a greater reduction of smoking in the long run. As seen in
the article tax rates will continue to rise over the subsequent years making
cigarettes more expensive to those low-income consumers. There will come a
price threshold at which some would not be able to afford cigarettes. This will
lead to a reduction in the number of smokers, thus reducing the external
costs.

CONCLUSION
In conclusion, while the consumption of cigarettes may not decrease in the
short run because of its addictive nature. In the long run the price thresholds
and the continual increase of the tax rates will deter potential customers to
start consuming cigarettes and the old customers from lower income groups
will have to think twice before buying more cigarettes. Thus, in the long run it
will achieve the government’s goal of reducing cigarette consumption in the
Philippines.

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