Cigarette is a demerit good1 because it is "harmful to human health". Government intervened to internalize negative externalities2 in consumption.

Figure 1: Market for Cigarettes

Price Ptax MSB MPC1

MPC0=MSC Value of negative externality (Ptax - Ps)

Pp

Ps MPB Actual welfare lost Qs Qopt Qp Quantity

In Figure 1, prior to any intervention in the market for cigarettes, the private market sets equilibrium price at Pp and equilibrium quantity at Qp where marginal private benefit curve (MPB) and the marginal private cost curve (MPC0) intersect. However, due to the deleterious impacts of cigarette smoking on human health, marginal social benefit(MSB) is lower than the MPB at any quantity. The shaded triangle illustrates the actual welfare lost due to the misallocation of resources. Cigarette is overprovided in private market. Indirect taxation3 was levied on cigarettes in an attempt to offset the negative externality. MPC0 shifts left to MPC1. At original equilibrium price Pp there is a shortage (Qp > Qs). The upward pressure pumps up the equilibrium price to Ptax, as the equilibrium quantity achieves its social optimum at Qopt.

1 2

a socially undesirable private good with negative externalities. cost derived from consumption or production which is not taken into account by the consumers or the producers and which adds to the costs of other consumers or producers 3 an expenditure tax on a good or service imposed by the government

Theoretically a tax on a private good should generate more tax revenue for the government, However, the spiking tax rate in fact reduces the overall tax revenue collected because of the emergence of parallel market.

Figure 2: Market for Cigarettes and tax revenue

Price S1 Ptax S0 Indirect tax per unit of cigarette (Ptax - Ps) or (Ptax1 - Ps1)

Tax Revenue
Ptax1 Ps

Tax Revenue due to black market

D1

D0

Ps1

Qb

Qopt

Quantity

In Figure 2, the expected tax revenue is the product of the indirect tax per unit of cigarette and the equilibrium quantity Qopt. Nonetheless, black market forms with smugglers and "their cheaper products". This entices consumers into buying illegal cigarettes, resulting in loss of consumers in the legal market. The demand shifts to the left in private legal market for cigarettes from D0 to D1. The downward pressure on price sets new equilibrium at Ptax1 and lowers equilibrium quantity at Qb; the latter causes the diminution of tax revenues, as mentioned in the article "billions in annual tax revenues are robbed from governments". Legal consumers suffer from paying higher taxes, and ironically the government is the loser due to loss of revenue. The impact might pass on to citizens who benefit from government-funded programs and services. This might cause the living standard to decline in the long run. On the other hand, the black market of cigarette flourishes due to a surge in demand. Cheap cost in production, as "it costs only P8.65 (20 US cents) to produce a pack of fake cigarettes of any popular brand", will further increase black market revenue. Cigarettes smugglers will also prosper. On the other hand, legal producers of cigarette will be forced out of

the market because the lowered price provides no incentive in producing more, resulting in unemployment. This calls on the question whether indirect taxation is a viable solution to correct externalities in market for cigarettes, or even in this scenario an effective way to raise tax revenue. The emerging black market reflects on the ineffectiveness of government regulation, as "Chinese authorities are unable to stop some 200 illicit cigarette factories", but this may not be corrected within a short term. Cigarette is addictive, and by its very own nature is price elastic in demand. The change in price will not significantly affect the quantity. Rather, it serves as a signal for consumers to seek alternative supplies. Thus, supply side policies do not directly address the problem. Intervention on the demand side, in this case, might be a better solution. For example, negative advertising on cigarettes can dissuade smokers from further purchases. The promoted working productivity will in the long run increase income. While economy acts as a circular flow, income will transfer into spending, thus will indirectly augments government tax revenue. However, aforementioned speculations could be questioned by the improbability in comparing the benefits and drawbacks of indirect taxation quantitatively in the market for cigarettes. Furthermore, the impacts could be simply explained as a transfer of purchasing power. The real influences of soaring black market can be seen only after long term observation.