How Cigarettes Price Influence Cigarette Manufacturers Profits

U.S. cigarette manufacturers have the market power to pass through very substantial cost increases to consumers in the form of higher prices. The U.S. cigarette industry is a 4-firm oligopoly. No significant new competitors have entered the domestic market for over 40 years, and barriers to new entry remain high. There are no close substitutes for cigarettes as a product. Other tobacco products and current nicotine replacement therapies are only partial substitutes. The demand for cigarettes is inelastic. As a result, an increase in price will raise more revenue even though it causes consumption to fall. ¹ Historically, U.S. cigarette manufacturers have consistently passed on the costs of higher Federal excise taxes to their customers. ²

Cigarette manufacture in the U.S. is a profitable enterprise. In recent testimony before the Senate Agriculture Committee, I estimated that in 1996, the operating profit per pack of cigarettes was $0.30. ³ With about 24.2 billion packs of cigarettes sold that year, ⁴ the total operating profits of the domestic tobacco-producing subsidiaries of U.S. manufacturers came to about $7.2 billion. So long as U.S. manufacturers can pass their costs through to customers – and thus retain their 30- cent-per-pack operating margins – cigarettes will remain profitable. Even if manufacturers were saddled with tens of billions of dollars of settlement payments or Federally-imposed assessments, and even if the resulting price hikes caused consumption to decline by 50 percent, domestic tobacco profits would still be $3.6 billion in 1996 dollars.

¹ The demand for a product is considered to be inelastic when a 1-percent increase in real price results in a drop in consumption that is less than 1 percent. Although consumption falls, total sales revenue (which equals price multiplied by consumption) rises. For cigarettes, the best estimate is that consumption falls about 0.4 percent for every 1-percent increase in real price. See: Sweanor D, Ballin S, Corcoran RD, et al. Report of the Tobacco Policy Research Study Group on tobacco pricing and taxation in the United States. Tobacco Control 1992;1(Suppl):S31-6; Harris JE. The 1983 increase in the federal excise tax on cigarettes. In: Summers L, ed. Tax Policy and the Economy, vol 1. Cambridge, Massachusetts: MIT, 1987:87-111; and Harris JE. A working model for predicting the consumption and revenue impacts of large increases in the US Federal cigarette excise tax. Working Paper No 4803. Cambridge, Massachusetts: National Bureau of Economic Research, Jul 1994. ): Working Paper No. 4803. One group of economists claims to have measured 0.8-percent long-run decline in consumption for every 1-percent price increase, based upon pre-1985 data on states’ tax receipts. See Becker GS, Grossman M, Murphy KM, An empirical analysis of cigarette addiction. Am Econ Rev 1994;84(3):396-418. Such an extreme finding has thus far not been clearly replicated. Even if the demand for cigarettes were as elastic as these authors suggest, price increases would still raise revenue.

² Harris JE. The 1983 increase in the federal excise tax on cigarettes. op. cit.

³ Harris JE. Written Testimony Before the Senate Committee on Agriculture, Nutrition, and Forestry Hearings on the Tobacco Settlement and the Future of the Tobacco Industry, Washington DC, September 11, 1997; Appendix Table 2.

⁴ Maxwell Report for 1996. Tobacco Reporter April 1997.

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