Question

Despite being the cornerstone of introductory economics, supply and demand curves are notoriously difficult to determine. Because prices and quantities are jointly determined by supply and demand, a regression of quantities on prices might look like a demand curve, like a supply curve, or like neither. Explain how an instrumental variables regression using cigarette tax rates (such as the amount of tax per pack of cigarettes) could be used to determine the demand for cigarettes.

Answer 1

An instrumental variables regression using cigarette tax rates can identify the demand curve for cigarettes by isolating the impact of price changes on the quantity demanded while holding other factors constant.

Step-by-step explanation:

To understand the demand for cigarettes, we can use an instrumental variables regression with cigarette tax rates as an instrument. This statistical method allows us to isolate the causal impact of prices on the quantity demanded, helping us to identify the demand curve for cigarettes.

The normal regression of quantities on prices may be confounded by the simultaneous influence of prices on supply and demand. However, cigarette tax rates are likely to affect the quantity demanded without affecting the supply directly, hence they serve as a good instrument. When we use tax rates as an instrument, we assume that any change in the quantity of cigarettes sold is primarily due to the change in consumer behavior caused by the new price after tax, rather than a supply-side change.

This approach separates the demand effect from any supply effect. The resulting demand curve indicates how cigarette consumers respond to changes in price, holding other factors constant and using the ceteris paribus assumption. Thus, it provides a clearer picture of demand elasticity and consumer preferences toward cigarettes.