Why we should expect increasing tobacco taxes will increase corporate profits

I could have sworn I wrote all this here before, but I cannot find it, so I will write it again in response to this news that cigarette company profits have increased following the latest tax increase in Australia.  This is being spun as contradicting the companies’ assessments that “plain” packaging (which was implemented the year before and had no apparent impact on sales) would hurt profits, but this is incorrect.  There is every reason to believe that plain packaging will hurt profits of the legal market (and benefit the black market) even as it does not reduce smoking rates (as I have written about before).  There is also every reason to expect that tax increases will increase the profits of companies, especially those selling premium brands.  Here is why:

Consider a competitive free market where cigarettes sell at their natural price based on the unit cost for what it costs to manufacture, distribute and retail them, which I will set at $0.98/pack for concreteness.  Let’s assume that they need to sell for $1.0o per pack to stay in business (it has to be more than the unit cost per pack in order to cover fixed costs).  Company A would love to raise the price to $1.50 and make $0.50 pure profit per pack sold.  But Company B is going to offer a product for $1.02, making a small profit for their investors and competing with Company A on price — invisible hand, benefits of competition for the consumer, and all that.  Company A has a more desirable product (a “premium brand”) and so can still get a lot of business without lowering their price to that of their competitor, but if they raise it too much their extra profit per pack from the increase is more than made up for by the loss in volume to the cheaper competitor as well as causing some customers who might not switch brands to just say “it is not worth that” and to exit the market entirely.

Simple calculations from Econ 101 give us the sweet spot, where this tradeoff is optimized and profit is maximized.  Let’s assume that this works out to be $1.25 per pack, for net revenue of $0.25 per pack.  If they raised it to $1.26, they would increase the revenue per pack by 4%, but (we posit) they would lose more than 4% of their volume by doing that, and so they go with $1.25.  (Note: “net revenue” is what is often incorrectly called “profit” in the popular press and anti-tobacco literature.  But profit consists of net revenue minus corporate fixed costs; not all of the net revenue is profit.)

Now consider a world where there is an $8/pack tax.  Total sales volume is, of course, reduced dramatically by the higher prices.  But the exit of consumers from the market is not random.  Consumers who are most responsive to price either stop consuming the product or turn to the black market or substitute products with lower taxes.  If Company A now sells their product for $9.25/pack, they will still have a net revenue of $0.25/pack.  But wait!  With the much higher price (thanks to the government profiting by $8/pack — all pure profit because they are not contributing to the costs at all), many fewer customers are going to exit the market due to an increase from $9.25 to $9.26, as compared to $1.25 to $1.26.  That one cent is a much smaller increase in percentage terms, and the evidence shows that loss of customers for a price increase for (any) products tends to be proportional to the percentage change in price, not the absolute change.  This means that both companies in this scenario will raise their prices above $8+{their price in the no tax scenario} because the tradeoff between more net revenue per pack versus losing customers now favors a higher per-pack net revenue.

Moreover, Company A will even further increase their premium over Company B’s bargain product.  Not only have the more price-sensitive consumers exited the legal market, making price competition less of a constraint, but consumers tend to think in percentage terms.  That is, someone who is reluctant to pay a $0.25 premium to get their favorite brand rather than a competitor when the prices are all in the $1 range will not hesitate to do so when the prices are in the $10 range.  Arguably this is irrational and the advantages of the premium product should be worth a constant absolute amount to the consumer, but we know this is not how people act.  (Compare:  If you are overcharged $5 for a soda, you would object; when you find a mystery $5 added on to a price of a car, you just shrug. And yet those have exactly the same effect on your wealth.)

So now we have prices along the lines of Company B charging $9.10/pack and Company A charging $9.60.  They might still lose net revenue compared to the free market, due to the reduction in volume from that enormous tax.  But even this is far from certain since Company B is now making 5 times their original net per pack, while Company A is making more than double, thanks to a combination of rational and irrational reactions to price changes in this higher price range.

Now consider the impact of another $1 increase in the tax.  With this, added profit for the companies is almost guaranteed.  This roughly 10% price increase drives another few percent of consumers out of the legal market. But it also further lowers the volume impact of a price increase by the companies.  So let’s say that Company B raises their price to $10.12 (almost no consumer is going to care about their extra 1/5th of 1% increase, especially given that it is hidden by the tax shock so the change is not noticed, which might provoke a principled objection), more than making up for their loss in volume through a 20% increase in net revenue per pack.  Company A, following the logic above, now charges $10.75 (they lose a few customers to the competitor due to the extra margin they added, but the extra revenue per pack more than makes up for that).  And shareholders of both companies, if they are polite, send a nice thank-you note to the Aussie government.

Of course, I made up the specific numbers here to make the point clear.  But they are of plausible magnitude, and indeed tend to overstate how competitive the market is, especially given loyalty to premium brands.  That is, the price discipline from competition does not push the prices to consumers nearly as close to the break-even, perfect competition, invisible hand, level that I suggested (based on what the economic theory of perfect markets tells us we should get).  Thus, the implications for profits are understated.

[Update:  One key point thing that I should have explicitly explained rather than leaving it implicit as I did:  Upon reading this, you might find yourself asking, “wait a minute, if you can make more profit by increasing your margin when prices are forced to increase for some reason, why doesn’t it work in other cases?  For example, why doesn’t a candy manufacturer increase their per-unit margin, and thus make more profit, when the price of sugar increases dramatically and drives up the price they have to charge?”  A good question, and I alluded to the answer but perhaps did not make it sufficiently clear.

The answer is that, unless that market is perfectly competitive, the candy manufacturer probably will increase its margins a little bit if the price of sugar goes way up — and thus the price it has to charge to break even goes up.  This is due to the same reasons noted above (a 1 cent increase in per-unit margin will drive fewer customers away than it did before because it is on top of a higher total price).  But it will likely still lose profit as a result of the changes because it loses even more business due to the total price increase, and its profit-maximizing margin is not enough higher than it was to make up for this.  Why does it not work that way for cigarette tax increases?  It does, mostly.  However, the competitive pressure is less (brand loyalty), as is consumer willingness to just exit the market.  That is part of it.  But the real key is that  most of the profit that is lost due to a price increase is the government’s.

Recall that in the scenarios, the government’s net revenue from each pack sold is in the order of ten to a hundred times as much as the manufacturer’s.  So if the manufacturer increases the price and increases its net revenue per pack, total profits might drop, but >90% of the lost profits are lost by the government, while all of the new margin is gained by the manufacturer.

So, going back to the original narrative, this is not the case in the first (free market) scenario, and so competition keeps margins low because losing sales volume matters more compared to per-unit net revenue.  In the second scenario, with a large tax that has driven out the more price-sensitive consumers, it might be that the manufacturers’ total net revenues are lower compared to the free market because of the loss in volume.  Or it might be that reduction of pressure to compete on price, due to the much higher base price, is enough to make up for that.  It depends on the quantitative details of how people behave.  This is similar to the sugar-price-increase scenario, and probably cuts opposite ways due to those behavior details (tobacco companies profit more, candy companies profit less).

But the key step is when the tax is further increased.  Now we are in the world where the vast majority of the net revenue is already going to one entity (government), but it is another entity (the manufacturer) that chooses the sales price by choosing its own per-pack net revenue.  The latter does not care about costing the former some of its profit, so is better off raising prices so high that they reduce total profit (most of which is going to the government) in order to net more per unit (which is captured by the manufacturer).  Total profits drop, but the manufacturers’ profits increase.

And, finally, to circle back:  If all of this huge net revenue (recall that the break-even price is about $1 while the sales price has been pushed to around $10) were going to the manufacturer, then they would probably want to reduce prices to gain more volume, even if they were a monopoly, because they are netting so much per unit.  But since they are not a monopoly, a competitor would certainly cut their prices to gain market share, resulting in a price war that would drive down the price.  To where?  Back to the free-market scenario price.

I hope that is more clear now.  It is an occupational hazard to find myself offering a clarification that is as long as the original presentation.

End of update.]

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4 responses to “Why we should expect increasing tobacco taxes will increase corporate profits

  1. It is also likely that plain packing has a beneficial effect on premium brands by mere virtue of consumer awareness – if you walk into a shop, and have no idea which brands they stock, chances are you will ask for a famous brand, just to simplify the purchase.
    Similarly, if you are a stockist of tobacco products, and you have the hassle of stocking 50 identically branded packs, you are more likely to drop niche products, to simply sales, than big brands

    • Carl V Phillips

      Yes, I would agree that those are probably true also. Basically anything that makes competition more difficult favors the leading brands.

  2. Pingback: Predicting the black market in e-cigarettes | Anti-THR Lies and related topics

  3. Pingback: Economic illiteracy about tobacco, from the antepode | Anti-THR Lies and related topics

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