October 31, 2010

Smokin Inelasticity

According to the article, Cigarette Prices on Fire, cigarette prices are increasing. Even with the increase in price, the cigarette firm, Reynolds American, is still able to make a handsome profit. In fact, their profit is even larger than normal years with out the effects of a recession. Mr. Tate, the author of this article cites statistics showing the cigarette company’s increasing profits during recession. However, Tate does not give any reason for this seemingly unlikely increase in profit. In fact, if anything, Mr. Tate seems more astounded at this economic activity than anything else.

It is important to realize that we are discussing the change of revenue within a particular cigarette firm. In this example, demand of cigarettes is not changing but instead the quantity demanded is decreasing. Tate finds it odd that the company can increase their price on cigarettes and still make a sizeable profit. Mr. Tate is unable to tell the reader why this has occurred. Cigarettes are an inelastic good. Therefore people will continue to buy the good at even a greater price. The utility that buyers find in cigarettes is so high that they are willing to pay very high prices. However, it is also important to realize that some people are not willing to pay the higher price; therefore, the good is not perfectly inelastic. If cigarettes were perfectly inelastic, buyers would buy cigarettes to an infinite price.

This tobacco company is acting wisely. They have recognized they can increase their total revenue and maximize profit through increasing the prices. The company may not realize it, but this is all due to the inelasticity of cigarettes. The company has also wittingly decided to develop substitutes such as chewing tobacco. These substitutes are directed towards people unwilling to pay the higher price. These are the people for whom the utility they gain from the cigarettes does not account for how much money they would have to give up to purchase them. In the end, Tate’s statistics show the truth; the firm is doing well. They have correctly taken every avenue to ensure the maximization of their profit.


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