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Tobacco Industry: Demand And Supply

The following essay helps us know what demand and supply concept and that we are explaining with the example of cigarette industry. And we have also mentioned the factors affecting the demand and supply for cigarettes in the market. The essay also includes the income effect, impact of close substitutes and compliments, and also the price and income elasticity of the product of the industry. A cigarette is a product consumed through smoking and manufactured out of cured and finely cut tobacco leaves and reconstituted tobacco, often combined with other additives,[1] then rolled or stuffed into a paper-wrapped cylinder (generally equal to 100 mm in length and 10 mm in diameter). Rates of cigarette vary widely. While rates of smoking have leveled off or declined in the developed nations, they continue to rise in developing nations.

Cigarettes are the most frequent source of fires in private homes and the European Union willing to ban cigarettes that are not fire-safe by 2011.

Fixing the price of a product is a very important factor for an organisation and the product success. Organizations look at the effective demand (demand) and effective supply (supply) of a product to set the best price to generate the maximum revenue for the organisation. If the price of the product increases or decrease then it can affect the demand of the product. “As the price of a good rises less will be demanded, and if the price falls more will be demanded” (Philp & Galt, 2009, Lecture Notes, p: 2). The increase or decrease in price can happen due to the either external or internal or both environments of the organisation.

The major companies that are the major share holders of the UK market are

1. Gallaher Group Ltd with the 37.90% of the market share.

2. Imperial Tobacco Ltd with the 35.40% of the market share.

3. Rothmans Ltd with the 18.20% of the market share.

The other have the market share of 3.80% and the private label are of 4.70% holds the market share respectively.

(Data monitors, 2005)

Demand of a product or service can be defined as the amount of a particular economic good or service that a consumer or group of consumers will want to purchase at a given price over a specific period of time. The demand is usually downward sloping, since consumers will want to buy more as the price decreases. Demand for a good or service is determined by different factors other than price, such as the price of substitute goods and complementary goods. In extreme cases, demand may be completely unrelated to price, or nearly infinite at a given price (in the case of the tobacco industry) (Beardshaw, 1991).

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According to Philp, Dan and Galt (2009) it could be deduced that demand relative to the tobacco industry is caused by a number of aspects in which the key driver is the price of the cigarettes. As a result, for a cigarette (t) the quantity demanded (QtD) represents a function of its price (pt), individual customer (n) income levels (Y1… Yn), other forms of substitutes like electronic cigarettes and herbal cigarettes (r1…rt-1) and other external factors (E) such as labour, raw material. Then, demand within the tobacco industry can be represented as

QtD = f (pt, Y1… Yn, r1…rt-1, E)

Being consistent with this, influential demand in economics (tobacco industry) would be hard to figure the quantity demanded due to the number of determinants required to make-up the cigarette packets price and quantity, therefore, it is assumed that all factors are held constant and the market (quantity demanded) is analysed as a function of packet price. So the quantity demanded

QtD = f (pt, Y1… Yn, r1…rt-1, E)

Graphically illustrated will be

Following the above figure, managers would be able to depict that the higher the price of the cigarette packets in the industry, the lower the demand for it. Consequently prices will have to move from p0 to p1 in order to increase demand from q0 to q1.

Consider two extreme cases. Suppose the price of all cigarettes rises by 1 per cent. The quantity of cigarettes demanded will not affect that much. People who can easily quit smoking have already done so. In contrast, suppose the price of a particular brand of cigarettes rises by 1 per cent, all other brand prices remaining unchanged. We expect a much larger quantity response. Consumers switch from the dearer brand to other brands that also satisfy the nicotine habit. For a particular cigarette brand the demand elasticity is quite high.

From the above figure it can be noted that the same $1 tax has a much larger impact on quantity when demand is more elastic than when it is inelastic. Elasticity is the responsiveness of one variable (e.g. demand) to a change in another (e.g. price). This concept is fundamental to understanding how market works. The more elastic variable is, the more responsive the market to changing circumstances (Sloman, 2005).

The law of demand states that a fall in the price of a good raises the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price.

(Mankiw, 1998)

Cigarette consumption is totally found to be negatively related to price. As far the result of the test, surveys and the studies done before, there result says that increase in price on cigarettes are not that much affected on the demand of it. Many economists viewed that cigarette smoking is illogical and therefore not suitable for usual economic analysis. They believe that demand for cigarettes does not follow the basic law of economics including the downward-sloping demand curve.

Findings on how demand for cigarettes changes as consumers’ income increases is inconsistent. From a number of studies it found that income has either negative effect or insignificant effect on the demand of cigarettes. As far as the government and other health concern trust are trying to stop smoking in public place and in the private work sites because it is very harmful for other who is non smoker and it is not environmental friendly (Bradford, 2003, Vol 9).

Government at all levels are adopting the policies to limit smoking. Government also banned that it the customer should be above a legal age to buy the cigarettes. World health organisation survey of smoking control policies in lot of countries indicated that the mostly all the countries have adopted policies to limit smoking in public places. Although the restrictions are primarily intended to reduce non-smokers, they can also affect the smokers since the restrictions reduce the smoker’s opportunities to smoke or otherwise raise the “cost” of smoking (Reuijl & Leeflang, 1985, Vol 49). Cigarettes was the one of the most advertised and promoted product in the world. But due to some controversial issues many countries restrict it. While some other countries have few restrictions, others ban advertising and promotion completely.

Due to the restriction on the advertising and the promotion the demand of the cigarette industry was affected. A lot of new opportunities of the new organization to enter are hard. And the new customers or consumers are decreased. And due to this there is less increase in the quantity of the young generation.

Cigarettes are been long been taxed by the government and due to this there is rise in the price in some countries. Taxes are varying from country to country and the price also. The inelastic demand off the product makes good revenue for the government. But in recent taxation has been applied to cigarettes are in order to health. Cigarette taxes in some countries such as the United States have been imposed by various levels of government, national, state and local level. Governments in nearly every country impose taxes on cigarettes and other tobacco products.

One of the major factors that affect the demand for any product is due to the substitutes. The more substitutes, the more elastic the demand will be. For example, if the price of petrol went up by £0.25, consumers could replace public transport. This means that petrol is an elastic good because a raise in price will cause a large decrease in demand as consumers start travelling by the public transport more from private transport. The rise of the fuel price can affect the automobile industry. This factor is also known as the “invisible hand” (Adam Smith Cited in Mishan, 1993, p 91) which is affected from the variation of the other product or substitutes which affects the main product demand in the market. For the tobacco industry the invisible hand factor is not that much affected but the competition in the market within the industry is high.

If the price of alcohol goes up as a whole, there will be probably a little change in the consumption of beer and other products because there are only few substitutes for alcohol. Most people are not willing to give up their enjoyment at any cost and even the alcohol is used in several medicines also so no matter what the price is the consumption of alcohol will be not affected by the substitutes. Therefore, we would say, that alcohol is an inelastic product because of its lack of substitutes. So we can say that a product is elastic in the industry but the complete industry tends to be inelastic.

This is the second factor that effects the demand elasticity and it refers the total amount of a person that can be spend on a particular product or good. Like, if the price of a chocolate goes up from £1 to £2 and income of the customer remains the same, the amount that is available to spend on chocolate is for e.g. £4, is now enough for only 2 rather than 4 chocolates. In other words, the customer is forced to reduce the demand of chocolate. Thus if there is an increase in price and no change in the amount of income available to spend on the product then there will be an elastic reaction in demand. But in cigarette industry it is not that much affected because of the addiction of the consumer.

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Time is the third factor which influences the demand elasticity. If the price of packet of cigarette goes up £1, a smoker with a very few available substitutes will continue buying the daily cigarettes. It means that cigarettes have inelastic demand because the changes in price will not have a great influence on the quantity demanded. But if the customer or consumer finds that they are not capable or cannot afford to spend the increased amount then they will definitely try to quit it but in a long run. Then for that customer price elasticity of cigarettes becomes elastic in the long run.

If quantity demanded is completely unaffected by a price change, then

“If the absolute value of the elasticity of demand is less than 1 at some point, we say that demand is inelastic at that point” (Varian, 2006, P 282). You would say that demand is perfectly inelastic at that price, to reflect the fact that quantity demanded is completely unresponsive to a change in price. On a graph with price on the y-axis, perfectly inelastic demand appears as a vertical demand curve. Its slope is negative infinity, which leads to Ed = 0.

Looking at the graph above, we can see that a 5 percent increase in price causes no change in quantity demanded. Therefore, Ed = 0 and demand is perfectly inelastic for the tobacco industry. Hence, manager of a cigarette company within the industry should not worry about the taxation from the government or increase in price due to the external environment due to the inelastic demand for the tobacco industry.

(Source by Begg & Ward, 2007)

The variation in consumer demand for cigarettes with respect to income is ambiguous from a theoretical stand point. Cigarettes consumption could be a normal good for which the level of consumers demand increases with income. Alternatively, it could also be a lower good for which the consumer demand drops with income levels. In either case, the presence of such behavior gives us no guidance whatsoever with respect to the extent to which these decisions are rational.

Similarly the other major factor which can be affected by the price of the cigarettes is supply. Supply for a product or a service can be defined as the quantity of a good, seller wishes to sell at each possible price. Supply of a good refers to various quantities of good which a seller is willing and able to sell at different prices in a given market, at a particular point of time, other things remaining the same. An aspect of supply which needs attention is that supply is related to scarcity. It is only the scarce good which has a supply price. On the contrary, goods which are available freely have no supply price, e.g. Air is available freely and hence, does not have a supply price (Begg et al, 2005).

According to Philp, Dan and Galt (2009) supply relative to the tobacco industry is reflective of the number of competitors (m) setting the price of providing cigarettes packets as a function of the level of technology (T) determines the price (pt), cost of resources, for example, labour, taxations, substitutes, and quality within the manufacture process (F1, F2 …Fm) and other charge (w) i.e. cost of machines and salaries of work force, all add up to become determinants of the number of cigarettes packets to be supplied at each given price. It is represented as

QtS = T (pt, F1, F2 …Fm, w)

Identical to economics in demand, in the analysis of supply all factors are held constant and quantity is seen as a function of price;

QtS = T (pt, F1, F2 …Fm, w)

Graphically illustrated as;

From the above figure managers can know that a investing in manufacturing the product needs a certain level of supply to overcome from they break even point, therefore higher the investment in price the more the supply. Hence cigarette manufacturing companies offer different brands for the taste e.g. long cigarettes, strong and light cigarettes. Consequently, the managers will push for a higher supply in p1 to maximize profit.

If there is plenty of spare capacity of Cigarettes then a business should be able to increase its output without a rise in costs and therefore supply will be elastic in response to a change in demand.

If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand quickly by supplying these stocks onto the market – supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand.

If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be switched.

Supply Elasticity is a measure of the degree of responsiveness of quantity supplied to changes in the product’s own price. Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one (Lipsey & Chrystal, 2004)

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

As we have seen that demand of cigarette is inelastic we can observe from the graph that supply of cigarette is also inelastic i.e. even a big change in price does not have major change in quantity supplied. It means that when a price increases consumers will not demand for more quantity that’s why supply will also remain the same.

After knowing that the demand and supply for the tobacco industry is inelastic but the competition within the industry is high. The higher price than the competitors can result less demand for the product, the lower price can increase the demand for the product. It influences managerial decision to look for the new markets where they can reduce their operational and manufacturing cost like cheap labour, as well as look for the new market so that the organisation can generate maximum revenue.

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This essay completely shows us that how the demand and supply take effects into the market and how principles of demand and supply inform the managerial decision making. From this essay we come to know that the cigarette industry is not that much affected from the higher price that much and its demand in the market is almost remain same. From this essay we come to know that both the supply elasticity and demand elasticity for cigarette industry are inelastic, they are not affected by the price. From the essay we come to know that income effect is significant and positive in case of cigarette industry.

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