Tobacco control gets another failing grade in economics

This failing grade adds to their already underwater marks in epidemiology and philosophy, to say nothing to their ethics which would simply get them thrown out of school.

A few stories about tobacco smuggling came across my desk this week including these two that were sober and balanced, as well as this “reefer madness”-esque one from the Daily Mail.  The latter described the detection of contaminants in black market cigarettes as (emphasis added) “Fake cigarettes made from human excrement, asbestos, mould and dead flies”.  (I think a “mould” is some kind of British house pet — not sure.)  I hate to complain about the newspaper that gave me a smile by calling me one of the US’s most distinguished epidemiologists, but what can you do.

Those reminded me that I had meant to comment on this post by Chris Snowdon, following on his and my previous posts on the subject of the interaction of taxes and “plain packaging”.  Snowdon’s post quotes a prediction:  Because the Australian “make cigarette packages ugly” initiative was unlikely to have much effect on consumption, but that the tobacco control people had staked their meager reputations on there being an effect, they would probably do something like raise taxes at the same time so they could claim that the packaging had an effect.  And guess what has been proposed?

But here is the thing:  Camouflaging the lack of effect of the packaging with a simultaneous tax increase only works if there is room to drive down consumption by increasing taxes, and it seems unlikely that this is the case.

The possibility of consumers switching to a black or grey market is the “competitive discipline”, as it were, that keeps the government from further raising the price.  It is similar to any market situation where a producer would like to raise its prices but cannot because of the discipline imposed by competition.  In this case, the government acts as a near monopolist in a sense — they can increase the price on all legal market cigarettes and capture the monopoly rents (profits) for themselves — but not quite:  They still have an imperfect substitute to compete with in the black market.

Now I realize that many readers might not quite follow all of that, but you probably get the gist of it (and there is more explanation in my previous posts).  The thing is, the people making government policy need to thoroughly understand things like that — and if they do not, they need to at least hire a second-semester economics student to explain it to them.  But apparently economics students have ethical standards that prevent them from working for Big Tobacco Control, because the tax proposal that Snowdon cited seems to be grounded on serious ignorance of some fairly unambiguous economics.

As I mentioned in the previous posts, there is general agreement that plain packaging will tend to drive down consumers’ willingness to pay for premium brands, driving down the prices.  This will then make the cheaper brands less competitive and so the prices of those will be driven down also.  The distinction between any brand and black market product will also be reduced, so more consumers will be inclined to switch to the black market.  This will put additional downward price pressure on the legal market to reduce switching to the much cheaper black market.  But since most of the price of cigarettes is taxes, if the adjustment in price relies entirely on manufacturers cutting into their net revenue, it will likely not be “enough”.

What do I mean by “enough”?  Well, there is a tradeoff in setting prices between making more profit and driving customers away.  Let us be charitable and assume that the government is not merely interested in making monopoly rents from cigarette sales, but genuinely want to drive down demand too.  Their tradeoff, then, is keeping prices high to lower demand (and capture revenue), but not so high that they tip too many people into the black market (at which point they lose all revenue, lose the ability to regulate at all, increase profits of organized crime, etc.).  It seems safe to conclude that the current taxes are set pretty close to what is considered the optimum for that tradeoff — some consumers are driven into the arms of the competition, but not too many, and this cost is just balanced by the benefit (as defined by government: income and demand reduction) of having the price as high as it is.

So if the black market becomes relatively more attractive, as is expected with ugly packaging and the loss of premium brand cache, then to keep prices at the optimal level, they will have to come down.  Since the manufacturers make so little of the total profit (the government makes most of it), it is almost certain that the adjustment that manufacturers will make in prices to keep their profits maximized will not lower prices nearly enough to maintain the optimal tradeoff from the government’s perspective (it would require running some numbers to calculate how far short the change will fall, but it seems likely that it would be substantial).  So too many consumers will be driven to the black market, and a lower price would be better to optimize the government’s tradeoff described above.  Thus the government, which collects most of the profit and has the most room to adjust, needs to adjust their per-unit profits (taxes) down too to fulfill their goals.  Of course, this will not happen.  The result will be “too many” people switching to the black market (again, from the perspective of the government’s preferred tradeoff between the advantages and disadvantages of higher prices).

Thus if they raise taxes, the prices are going to be even more “too high”.

The result of the camouflaging tax increase will indeed be lowered consumption of legal cigarettes, providing faked support for what was dishonestly predicted by tobacco control.  But there will also be an increased shift to the black market, increasing the effect that was honestly predicted by everyone else.  Indeed, there is a good chance that total consumption will increase:  Once someone crosses the behavioral barrier (“tipping point”) to start buying their cigarettes from the black market, they do not have much difficultly continuing to do so.  And since they are then paying a much lower price per unit, this quite likely results in them consuming more.  Moreover, the greater the market penetration by the black marketeers, the more likely they will become the first choice of new smokers.

Of course, as the black market increases in market share, both the legal industry and Big Tobacco Control will be scrambling to get their pet media outlets to publish scare stories about that nasty black market product, and this alliance might get some traction with the message.  But ultimately, the forces of economics always win — millions of people acting in their own interests are a force that a few people acting against those interests can do little to stop.  Not until they get to the point of have troops on the street and a tenth of the population informing for the secret police, and that is still a while off, even in Australia.

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