Elasticity Revision – Claire Helsby

QUESTION 1

Read the article and answer the questions to follow:

The costs of driving smoking underground

24 Jul 2020 ~ David Christianson

It is not surprising that the total ban on cigarette sales in South Africa, under COVID-19 lockdown
regulations, has generated a thriving black market. This impact of banning sale of goods with an
inelastic demand profile has been understood since at least the lifting of the Volstead Act
(prohibition) in the United States (US) in 1933.

But 14 years of prohibition in the US (1919-33) allowed racketeers like Al Capone to entrench their
activities and remained a problem long after alcohol sales became legal again. South Africa’s ban on
tobacco products shows a similar pattern. Not only is the ban itself of dubious efficacy but is also
undermining attempts to rebuild state capacity to deal with a long-standing illicit tobacco problem.

The ban was imposed when South Africa entered a strict lockdown (subsequently defined as Level
5), on 26 March 2020, to combat the spread of the coronavirus. All tobacco and tobacco products
sales were declared illegal. Most of the other activities which were temporarily banned have been
allowed again as the lockdown has been eased through Level 4 to its present Level 3. But tobacco
remains outlawed.

This constitutes a considerable loss to the national fiscus. A group of companies centred on South
Africa’s biggest cigarette manufacturer, British American Tobacco (BAT), estimated that when the
ban reached the 100-day mark, on 5 July 2020, government had lost R3.5 billion. Most of this is in
excise taxes which made up just under half the over-the-counter cost of each BAT packet of
cigarettes before the lockdown. Former South African Revenue Services (SARS) official Bernard
Sacks estimates that government loses R1.2 billion in excise duties per month in addition to R300
million in Value Added Tax (VAT).

Significantly, the ban appears to have had only a small impact on aggregate tobacco use. A study in
late April/early May by the Research Unit for Excisable Products at the University of Cape Town
(UCT) found that more than 90 per cent of smokers had bought cigarettes during the lockdown
despite the ban.

The online study of 12 200 smokers found that only 16 per cent of smokers in the sample had
successfully quit in response to the ban. According to government, there are an estimated 8 million
smokers in South Africa, consuming an estimated 26 billion cigarettes per year. What is probably
most significant is that the 84 per cent of smokers who did not or could not quit consuming tobacco
products have continued to source their fix from what would, prior to the lockdown, have been
regarded as illegal and informal sources.

The source of illegal (untaxed) tobacco products in South Africa has been a matter of some
controversy. What is clear is that this was a thriving market even before cigarette sales were
declared illegal. The UCT Research Unit on the Economics of Excisable Products estimated that the
illicit market constituted 30 per cent of the total market in 2017 (up from 5 per cent in 2009). A 2018
survey of 6 townships in 4 provinces, by the same unit, produced a figure of 35 per cent.
Illicit tobacco products have mostly come from one of two sources:

 Illegal smuggled imports from Zimbabwe, accounting for 57 per cent of the illicit market.
 ‘Ghost exports’ – cigarettes produced in South Africa, ostensibly for export (and therefore
excise exempt) but in fact sold locally.

What is not clear, however, is what the sources are of the cigarettes sold illegally in South Africa
since the March lockdown. Products offered by big formal companies like BAT do not seem to be
available. Anecdotally, it would appear that the most widely available products are those made by
Gold Leaf, an intermediate sized firm with factories in both Zimbabwe and South Africa.

On the other hand, what is clear is that criminal distribution networks are thriving. Illicit dealers
make up to R30 million per container. The margins on illegal tobacco products exceed those of
heroin (2 400 per cent for tobacco compared to 1 800 per cent for heroin).
The ban on cigarettes has not succeeded in reducing the size of the market but, by rendering
distribution illegal, has handed that activity back to criminals and racketeers. It is an unfortunate
unintended consequence but, as the US experience with the Volstead Act should tell us, it should
not have been an unexpected one.

This article has been shortened.

Christianson, D. (2020). The Costs of Driving Smoking Underground. Tralac. Available
at: https://www.tralac.org/blog/article/14785-the-costs-of-driving-smoking-
underground.html (Accessed: 23 February 2020).
Read the above article and answer the questions to follow:

The below extract from the article provides important insight into the price elasticity of demand for
cigarettes.

“A study in late April/early May by the Research Unit for Excisable Products at the University
of Cape Town (UCT) found that more than 90 per cent of smokers had bought
cigarettes during the lockdown despite the ban.”

More recent research published after the article has indicated that the price of cigarettes increased
by 250% during the Covid pandemic.

1.1 What does the above extract and exorbitant price increase in cigarettes suggest?

Complete the paragraph below:

The above extract suggests that the consumption of cigarettes decreased by a

far percentage when compared to the 250% price increase. Smokers will
continue to demand cigarettes despite the exorbitant price increase because smoking is addictive
and, therefore, demand for cigarettes is . In other words, cigarette

producers can their prices and not worry about how a drop in the quantity

of cigarettes demanded will impact .

Drop down options:

Lesser
Increase
Greater
Flexible
Total expenditure
Sticky
Total revenue
Decrease

MEMO

The above extract suggests that the consumption of cigarettes decreased by a

far percentage when compared to the 250% price increase. Smokers will
continue to demand cigarettes despite the exorbitant price increase because smoking is addictive

and, therefore, demand for cigarettes is . In other words, cigarette

producers can their prices and not worry about how a drop in the quantity

of cigarettes demanded will impact .

1.2 Which graph below depicts the elasticity of demand for cigarettes as described in the above
article? Motivate your answer.

Graph B, because graph B represents inelastic (or sticky) demand with an elasticity coefficient less
than one.
QUESTION 2

2.1 Suppose product A currently sells for R27 and the quantity demanded at this price is 4000
units. If the price fell to a new price of R22, the quantity demanded would increase to
5300 units. Calculate POINT elasticity of demand at the price of R27 (round off to one
decimal place).

ep = Q x P
P Q

= (5300– 4000) x R27

(R27-R22) 4000

= 1300 x R27
R5 4000

= 35100
20000

= 1.755

= 1.8 (rounding)

(Note: Ignore the minus sign throughout the calculation)

2.2 What type of price elasticity of demand was calculated in question 1.1 above? Motivate.

Elastic demand
Because the elasticity coefficient is greater than one.
2.3 Circle the graph below which represents the type of elasticity reflected in question 2.1
above?

2.4 Calculate the total revenue at R27. Remember the currency sign. Round off to zero decimal
places.

TR = P x Q
R27 x 4000
= R108000

2.5 Calculate the total revenue at R22. Remember the currency sign. Round off to zero decimal
places.

TR = P x Q
= R22 x 5300
= R116600

2.6 Which price should product A be sold for?

R22