A bit more on the economics of cigarette (dis)branding

In my last post, I offered some analysis about how the efforts to reduce the brand equity of premium cigarette brands (via plain packaging) will tend to eliminate the existing incentives for social responsibility among manufacturers.  I have two additional observations:

First, I probably should have offered a motivating example, so here is the most obvious one:  Apple recently got a lot of front-page bad press about the working conditions in some of their subcontractors’ manufacturing facilities.  This mattered because it was Apple.  The largest of the subcontractors is a gigantic Chinese electronics assembly company that does similar work for a lot of Apple’s competitors.  Do you remember which ones?  Me neither.  But Apple got grief because part of what they sell when they collect a premium price for their products is a feeling of membership in their club, and people care about the social responsibility of the club they are a part of to an extent that does not extend products without premium brands.

Consider:  When the Asus/Google tablet is off of backorder and I am finally able to get one — a reward for resisting the iPad all this time even though I have pretty much all the rest of the Apple Club membership items — that device will quite likely have been manufactured under worse conditions than my Apple products were.  But I will not think much about that, and the story will likely not be featured on the front page of the New York Times.  I will just be buying an item, not a sense of identity that leads me to care about the brand and how those associated with the brand behave (no more than I care based on general concern about humanity, that is).

Second, a related point that I chose not to cover at the same time to avoid confusion.  From Snowdon:

The premium brands are about to lose much of their appeal and so people are going to turn to cheaper cigarettes. Pushing people onto cheaper cigarettes is not generally considered to be best practice in public health. But fear not, because [anti-tobacco industry leader and all-around muddled thinker, Simon] Chapman has the solution…

But the Australian government can simply raise tobacco tax overnight as often as it needs to effectively maintain a floor price for cigarettes that will deter smokers from buying more than they could have afforded previously.

The man’s a genius! Make cigarettes more expensive and fewer people will buy them. Why has no one thought of this before?! 

He is right (Snowdon, not Chapman, obviously) about the general effect of making cigarettes cheaper, and the point that he goes on to make that Chapman’s “solution” will just drive more people to the black market.  A bit more economic science about these points can help clarify what would happen and why:

The existing segmentation of the market creates a bunch of sub-markets that are for slightly different products (they are all cigarettes, but of different perceived quality) but whose prices still affect each other.  For example, if the price of the really cheap cigarettes were to plunge, it would exert downward price pressure on the premium brands also because people would still be willing to pay more for them, but not that much more.  (You may be thinking, “aha, that is why the makers of the premium brands work so hard to fight the black market.”  Exactly so.)  Similarly, if you drive down the price of the premium market because it does not seem so premium anymore, it will tend to push down the prices of all the other sub-markets because if the better brands get cheaper, they will take sales away from the cheaper brands unless they get cheaper too.

The result is that everything gets cheaper.  This was the conclusion of an independent consultant report produced for BAT about the Australia situation.  They mostly phrased it in terms of “if there is less competition based on image then there will be more competition based on price.”  This is basically saying the same thing, but I find it useful to consider the slightly deeper economic analysis of what is going on.

The responses to that report from the ANTZ were (a) “those evil cigarette companies are threatening to start dumping cheap product in our market if we do this!” and (b) what Snowdon quoted above.  Point (a) reflects basic illiteracy (no one was saying anything of the kind, as anyone who could read could see), as well as economic innumeracy:  Anyone who understands basic economics knows that producers cannot just pick the price they want to sell something for.  They want to charge as much as possible.  More precisely, they want to profit as much as possible, selling at a high price that has lots of profit, but not so high that they lose profit by driving customers away.  A monopolist would shoot for the sweet spot that such that any additional profit from raising the price would be lost because of losing too many customers.  But market competition pushes the price down from what the monopolist would charge (which is why competition is good for consumers).  The analyses of what will happen (either my brief analysis here which I am giving away free, or the one from the consultants that probably cost six figures) identify how the ability to charge more will be eroded and the competition will drive the price down.

The raising taxes idea is equally innumerate:  Taxes on cigarettes in most places are already about as high as they can be without tipping a large portion of consumers who buy at the cheap end of the legal market into the black market instead.  In some places (e.g., Canada, New York City) the taxes are even higher than that level, and so the black market is really thriving.  In most places there is little room to raise taxes any more.  This is presumably what Snowdon was pointing out with his response to Chapman.

But it gets worse (for the likes of Chapman):  Recall that I said that due to competition, companies cannot just set the price at the level where they would make the most profit.  They are not allowed to collude to avoid the effects of that competition.  But the government can do what companies are prevented from doing by antitrust laws:  They can raise the price to the monopoly price and keep the premium for themselves — and that is basically what they do.  To a large extent, this is because branded cigarettes offer a lot of room for monopoly profits before consumers will exist the market in favor of perceived-inferior substitutes (the black market, but also roll-your-own, grow-your-own, and anything else that avoids some or all of the taxes in a particular jurisdiction).

In most jurisdictions that have sufficient government to enforce tax collection, government makes a lot more from the sale of cigarettes than do the manufacturers or the retailers.  Indeed, in places like Australia and Britain, the taxes are intentionally pushed to about the maximum the market will bear — before too many people exit to substitute sources of smokes — to maximize revenue and to a lesser extent to discourage smoking.  Raise the taxes any more, and revenue would drop, but also many smokers would switch to an alternative that is a lot cheaper, thereby losing the anti-smoking effects of the higher prices.

The segment of the legal market that competes most closely with black market is at the lowest end, where brands are not worth much.  That is where the marginal customers are right on the cusp of switching to the black market, and where most of the switching would occur if taxes were increased.  The premium brands are much less vulnerable to this competition because they offer something more than the commodity.

So with that in mind, the story is:  Those who are motivated by their hatred of cigarette companies want to drive the price of the premium brands down and ideally make the whole legal market look like the current market for the cheapest brands.  It is that cheap end of the market that is the constraint on current tax rates, to keep from driving those consumers to the black market.  Since under the de-branding plan the entire market will look like that end of the market, there will be even more switching to the black market at any given tax rate.  Anywhere the taxes are already at the estimated sweet spot (driving many, but not too many, consumers to the black market) where raising them any more would tip too many people into the black market, the optimal response to the situation is to decrease taxes.  If the taxes are already on the verge of tipping too many people into the black market (etc.), thereby losing revenue and the anti-smoking incentive effect, then eliminating brand premiums will make the current taxes higher than the optimum, requiring a decrease to get back to the optimum.

And so the plan is to raise the taxes for the legal market even more.

Really?  Did I miss something there?

I am pretty sure not.  But someone sure did.  I assign the blame in equal parts to poor basic education about economics and the even poorer education in graduate-level public health, sociology, and related fields, where science is treated as decoration to dress up ideological conclusions.

[Update: More on this here.]

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6 responses to “A bit more on the economics of cigarette (dis)branding

  1. Carl, excellent analysis and well explained for those who need the explanations. But one doesn't have to be an economist. A little bit of common sense will lead to the same conclusion. But since when has common sense been the ANTZ forté?

    Iro

  2. Call me cynical, but I honestly believe that the tobacco control industry (TCI) **wants** the illicit market to thrive. If a higher percentage of smokers turn to the illicit market, then that is a statistic TCI can use for further laws against tobacco products, i.e. smokers are more likely to be criminals so let's criminalise smoking even more. The goal for TCI is prohibition and/or abolition. The more perceived “crime” associated with tobacco use, the more likely they'll be able to influence politicians for further tobacco control measures, such as licensing smokers, or requiring a prescription before they can ban tobacco altogether.

    However, in respect of plain packaging, there is another scenario to consider. The illicit market also will be able to raise prices on genuine, illegally-imported branded products. The consumer's perceived value (or image) of a branded pack versus the government's pack of hate (plain pack) will afford an opportunity for black marketers to sell those branded goods at a premium price in the illicit market. Still cheaper than duty paid tobacco products, but now the illicit market makes much more money. Likewise, the counterfeit market will also capitalise on a branded pack, even if that branding is dodgy. People who obtain genuine branded products from other markets will be considered as having a higher status.

    It's kind of like selling the same product but with different designs in two markets, with one market being envious of the other's. For instance, one version of the same product is branded with cute “Hello Kitty” logos and designs, and the other is a simple, plain black plastic. The Hello Kitty version will be viewed as a “designer” product by consumers, more valuable, more special, so the people in the plain black plastic market will seek means of getting their hands on the designer brand. It's the same product inside, just a different design on the outside. Those in the plain black plastic market who do get the designer version will consider their version superior to the one that is available in their home market. The Hello Kitty branded version cost them a bit more, so it has more value. It will be considered exclusive, and trendy. Those that have it are better-to-do than those who don't have it.

    Again, all of this plays into the hands of TCI. They want this to happen, so they denounce smokers (and so that they can have something to do for the next few decades…)

  3. Thanks. Maybe the problem is the general uncommonality of common sense. I agree that common sense is sufficient to realize that raising taxes after de-branding the packages will tend to increase the flight to substitute markets, including the black market. I am not sure, though, that common sense is enough to figure out that taxes will need to decrease with plain packaging (assuming they are already at the maximum for doing their intended jobs, which is close to true, and that the goal is to keep them there), or that raising them will probably have even greater unwanted consequences after the de-branding than it would now. Those points were not obvious to me, anyway, until I ran through an equilibrium analysis.

  4. You are right that I intentionally simplified out (ignored) the fact that there are at least three distinct elements of the black market, as I mentioned a few posts ago (ep-ology.blogspot.com/2012/07/unhealthful-news-216-smuggled.html). I mentioned counterfeiting but then went on to discuss what seems to be the dominant part of the black market in the long-run, the grey market for generic product that would be legal if taxes were paid (and other regulations adhered to). The third element is what you note, the diversion of legitimate product. Historically that would have been motivated by tax differences, but you are probably right that there would be a prestige market for branded packs anywhere that forced plain packaging on the legal market.

    An interesting idea, that TCI wants the illicit market to thrive. The dominant players in TCI clearly want to hurt the legitimate producers, even if it does nothing for public health — indeed, even if it hurts public health. The black market has always been seen as just a side effect of that. But it is quite clear to me that TCI is more anti-THR than they are anti-smoking — I have seen that up-close. They need to make sure that tobacco/nicotine users are doing something harmful, because if they are using non-invasive low-risk alternatives there will be no support for prohibition. So why not extend that logic to them being pro-black-market, something else that makes tobacco use more harmful than it needs to be, so they can justify continuing to exist as a prohibitionist industry. It does make sense.

    It is harder to see or be sure, I guess, because if it is so, then the cynical corporate brains behind the TCI have effectively kept their trained monkeys out front to distract us decrying the black market and insisting that they will be able to prevent its expansion. This contrasts with THR where, despite some feeble efforts to try to coopt the concept, they have not tried to hide that they are on the anti-public-health side. But, yeah, hmmmm. I will definitely have to consider that possibility as I think about this more.

  5. Plain packaging – common sense or nonsense? You decide…

  6. Pingback: Why we should expect increasing tobacco taxes will increase corporate profits | EP-ology

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