Tobacco's 'Big Four' Still Smokin' Despite Huge Penalty

Newswise — When Dr. William Ford, MTSU Weatherford Chair of Finance at Middle Tennessee State University, saw a sign in a convenience store indicating that a pack of cigarettes would jump 50 cents within the week, he wondered how companies could get away with that kind of increase in such a short time.

It soon became apparent to him that the Big Four tobacco companies not only had not been hurt by the quarter-trillion-dollar Master Settlement Agreement (MSA) of 1998, but they were still making a healthy profit. In fact, it appeared that Philip Morris, R.J. Reynolds, Brown & Williamson, and Lorillard might be better off than ever before.

"Could it be that these companies were just pushing the costs through to the smokers, and that it was the smokers who were paying this huge tobacco penalty?" Ford posed. "I became curious as to whether or not this was all coming out of the profits or what was happening. I discussed it with my colleague, Stuart Fowler [MTSU assistant professor, economics and finance], who is a super analyst at this kind of thing. We discussed how best to do the analysis."

From Ford and Fowler's collaboration emerged a published study titled "Has a Quarter-Trillion-Dollar Settlement Helped the Tobacco Industry?" which appeared in the Fall 2004 Journal of Economics and Finance.

"One of the first things we did was look at the data," stated Fowler, assistant professor, economics and finance. "Specifically, we looked at the stock prices for the four companies. Since 1998, the returns for those companies have been higher than average. We thought it might be attributed to the fact that the litigation was ended. Then we went deeper into the data. We looked at the sales and revenue of the companies and found that they had actually increased since the settlement." "Had the money been taken out of their profits, that would have been devastating to all four companies over a period of years to lose a quarter trillion dollars," Ford added.

"Looking at the actual cost, it turns out that more than the share of the costs was being passed to consumers," Fowler continued. "In economic terms, that would suggest that the monopoly power of the four firms had actually increased. If the MSA tax increased a pack of cigarettes by 34 cents, more than 34 cents per pack was being passed on to the consumer—roughly 50 cents."

After further examining the settlement agreement, Ford and Fowler observed that the MSA guarantees that the four signing firms have a fixed market share, resulting in less reduced competition from other companies.

"Part of the problem was the way the taxes were raised on the four companies," Fowler said. "Whenever you litigate and a settlement is reached, both sides give. And the states gave as well as the tobacco companies. In the states' giving, they gave up part of this monopoly power to the firms."

How could the companies get away with this? Ford called it the "elasticity of demand."

"Tobacco is an entry-level drug—people are addicted to it," he said. "Just like motorists are addicted to gasoline—we keep paying a higher price. People who smoke want to continue smoking, and the fact that smokers have a hard time giving it up even when the price goes up does create the environment in which companies might be able to pass through some of the increase of costs. It turns out that they passed through more."

Before the MSA was settled, companies actually lowered their prices, also a ploy to gain as much market share as possible, they explained. Then they would be protected once the agreement was signed.

"There is some good news," Ford said. "The total number of cigarettes produced and smoked in America is going down and has been going down since the end of World War II. It's even dropped quite a bit since 1998. What happened is that there are fewer people smoking fewer cigarettes, but the profits are going up because they are selling less product but raising the price to make up for it."

Ford added that the Big Four are only doing what a shareholder would expect the company to do. "If you're facing a product with a shrinking market, and people who use the product are willing to pay more, go for it," he said. "That way the value of the company remains high even though its product is falling out of favor."

Ironically, what the settlement did is to eliminate the desire of other smaller companies to compete in the open market, Fowler noted. "We have seen an increase in market share of the four signing firms, so this agreement has stifled competition."

A logical follow-up study, Ford and Fowler suggested, might be titled "As the Smoke Clears: Results of the Tobacco Settlement," to find out what the 46 states are doing with their MSA money.

"A lot of people thought the states would use it for education or non-smoking programs," Ford said. "I think that is not happening."