Problem: Consider the markets for cigarettes and alcoholic beverages in a small town. Suppose that when the average consumer's income is $40,000 per year, the quantity demanded of cigarettes is 30,000 and the quantity demanded of alcoholic beverages is 21,000. Suppose that when the price of cigarettes rises from $8 to $12, the quantity demanded of alcoholic beverages decreases to 19,000. Suppose also that when the average income increases to $56,000, the quantity demanded of cigarettes increases to 34,000.
a. Using the midpoint method, what is the income elasticity of demand for cigarettes?
b. Considering the income elasticity, are cigarettes a normal good or an inferior good? Explain.
c. Using the midpoint method, what is the cross-price elasticity of demand for alcoholic beverages with respect to the price of cigarettes?
d. How does the cross-price elasticity of demand for alcoholic beverages and cigarettes in part (c) help policymakers better understand the consequences of a cigarette tax?