ch05 text - c05.qxd 7/21/07 3:54 PM Page 136 5 5.1 5.2 5.3...

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5.1 OPTIMAL CHOICE AND DEMAND APPLICATION 5.1 What Would People Pay for Cable? APPLICATION 5.2 The Irish Potato Famine 5 THE THEORY OF DEMAND CHAPTER 5.2 CHANGE IN THE PRICE OF A GOOD: SUBSTITUTION EFFECT AND INCOME EFFECT APPLICATION 5.3 Rats Respond When Prices Change! APPLICATION 5.4 Mexican Tortillas Are Good, but Are They a Giffen Good? 5.3 GOOD: THE CONCEPT OF CONSUMER SURPLUS APPLICATION 5.5 Automobile Export Restrictions and Consumer Welfare 5.4 MARKET DEMAND 5.5 NETWORK EXTERNALITIES APPLICATION 5.6 Externalities in Communications Networks: Telephones and Instant Messaging 5.6 THE CHOICE OF LABOR AND LEISURE APPLICATION 5.7 The Backward-Bending Supply of Nursing Services 5.7 CONSUMER PRICE INDICES APPLICATION 5.8 The Substitution Bias in the Consumer Price Index c05.qxd 7/21/07 3:54 PM Page 136
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During the 1990s and early 2000s, the tobacco industry became increasingly embroiled in litigation over the damages caused by cigarette smoking. Many states sued tobacco companies to recover health care costs related to smoking. Several tobacco companies agreed to pay billions of dollars to Minnesota, Florida, Mississippi, Texas, New York, and other states. The tobacco companies then faced a difficult question. How would they pay for these legal settlements? Their response was to raise cigarette prices repeatedly. Why did cigarette producers believe that they could collect more revenues if they raised ciga- rette prices? And what information would they need to estimate the size of the increase in their revenues from an increase of, say, five cents per pack? As we saw in Chapter 2, firms can predict effects of a price increase if they know the shape of the market demand curve. An article in The Wall Street Journal summarizes some of the extensive research on the market demand curve for cigarettes. “The average price for a pack of cigarettes is about $2. Prices vary by state because of taxes. Analysts say that for every 10 percent price increase, sales volumes drop between 3.5 percent and 4.5 percent. They say that small price increases generally don’t cause most consumers to try to give up smoking, but that they smoke fewer cigarettes each day.” 1 Based on this information, we would conclude that the price elasticity of demand for cigarettes is approximately 0.35 to 0.45. Thus the demand for cigarettes is relatively price inelastic. As we learned in Chapter 2, when demand is relatively inelastic, a small price increase will lead to an increase in sales revenues. In the cigarette market, if price rises by 10 percent, sales volume will fall by about 4 percent. This means that with a 10 percent price increase, the revenues from cigarette sales would increase by about 6 percent. This explains why cigarette producers believed sales revenues would rise if they increased cigarette prices.
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This note was uploaded on 11/18/2010 for the course ECO 300 taught by Professor Zhao during the Spring '10 term at SUNY Albany.

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ch05 text - c05.qxd 7/21/07 3:54 PM Page 136 5 5.1 5.2 5.3...

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