Measurement of Monopoly Behavior: An Application to the Cigarette Industry

Author(s): Daniel A. Sumner

Source: Journal of Political Economy, Vol. 89, No. 5 (Oct., 1981), pp. 1010-1019
Published by: The University of Chicago Press
Stable URL: https://www.jstor.org/stable/1830817
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 Measurement of Monopoly Behavior:
An Application to the Cigarette Industry

Daniel A. Sumner
North Carolina State University

A simple scheme is proposed to measure monopoly pricing behavior.

The coefficient of the tax rate term in a price equation identifies the
ratio of price to marginal cost. No direct measurement of costs is
required, so a major problem for other empirical studies of monopoly
is avoided. Empirical results for cross-section time-series data sup-
port rejection of atomistic competition but also provide evidence
against the operation of an effective cartel in the cigarette industry.
The model represents an alternative interpretation of related results
in a recent paper by Barzel. Application of the methodology to other
markets is feasible.

I. Introduction

The cigarette industry is often used as an example of a less than

perfectly competitive industry. For example, in the famous Tobacco
Case of 1946, the major cigarette manufacturers were accused of
operating an illegal cartel; though they were convicted, the consensus
was that company behavior was not altered by the verdict.1 This paper

This is a revised version of "Interstate Cigarette Price Differentials and the Mea-
surement of Firm Level Demand Elasticities" (October 1979). I wish to thank Yoram
Barzel, Robert Clark, James Easley, David Flath, Charles Knoeber, Michael Kusnic,
Thomas MaCurdy, Michael McElroy, Ronald Schrimper, Michael Wohlgenant, and an
unknown referee for their comments. This paper is no. 6626 of the Journal Series of
the North Carolina Agricultural Research Service, Raleigh.

1 See Nicholls (1949), Bain (1968), or Tennant (1971) for discussion of the 1946 case
and of the "structure, conduct and performance" of the cigarette industry. Stigler
(1966, p. 244) presents a table of industries with high concentration; cigarettes rank
fourth in the share of assets held by the "giant firms." Friedman (1953, p. 37) also

[Journal of Political Economy, 1981, vol. 89, no. 5]

( 1981 by The University of Chicago. 0022-3808/81/8905-0009$01.50

1010

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MEASUREMENT OF MONOPOLY BEHAVIOR 101 1

attempts to investigate the alleged market power of cigarette man-

ufacturers with a simple scheme for measuring the weighted-average
price elasticity of demand facing firms in this industry.
The empirical examination of the pricing behavior of the cigarette
industry finds an absence of evidence of an effective cartel, but the
hypothesis of atomistic competition is also rejected. The approach
uses data on excise taxes, but it does not depend on measuring the
cost of production. Since reliable cost data are not generally available,
this paper avoids an important weakness of directly measuring
monopoly power by the ratio of product price to marginal cost. The
model suggested here is also applicable to other industries with varia-
tion in excise taxes or some other directly measurable components of
marginal cost.2

II. A Simple Model

The equilibrium output condition, that marginal revenue equals

marginal cost, implies that

Pi = [7n)jIn j + l)]Mj, (1)

where Pi is the product price, Mj is the

and -qj is the price elasticity of the dem
industry is purely monopolistic, -qj is equ
while if it is perfectly competitive, q j =
Thus q j is a measure of the degree to wh
price taker.3 However, since good measur
find, equation (1) does not offer a practical solution to the problem of
determining potential monopoly power.
For a product like cigarettes, which has a per unit excise tax, the
marginal cost term may be expanded as

Mj=Xjf+Ej+R, (2)

discusses potential monopoly power of cigarette firms, predicting that in an analysis of

response to tax rate changes, "broadly correct results will be obtained by treating
cigarette firms as if they were producing an identical product and were in perfect
competition."
2 The empirical model derived in this paper is similar to that used for a different
purpose by Barzel (1976) (and also in a comment by Johnson [1978]). The present
paper was well under way when the Barzel results were pointed out to me by Charles
Knoeber. A paper by Manchester (1976) also presents (in an appendix) a regression
related to those estimated below. However, Manchester does not interpret his tax rate
coefficients in that paper.
3For multiproduct firms, optimal pricing decisions require attention to cross elas-
ticities of demand. I will simply ignore this refinement and implicitly assume that it is
not empirically important. In what follows I use the term "firm" to mean the relevant
pricing decision maker for the given product.

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1012 JOURNAL OF POLITICAL ECONOMY

where Xjf represents the set of observed factors determining mar-

ginal costs, Ej represents unobserved factors, and R is the tax
rate, which does not vary by firm or brand. Equations (1) and (2)
may be combined to show that even without direct measurement of
Mj, the firm-level elasticity of demand may be estimated as a func-
tion of the coefficient of the tax rate variable.
Equations (1) and (2) apply to pricing decisions made by firms.
However, since firm-level data on prices are generally not available,
some discussion of aggregation is in order. The observations are on
the average price of cigarettes, defined as

P -zSPj,

whereJ is the number of firms and Sj is

firm. Analogously define

M - SMj9
i=l

n _ Ein j9

and

0 =l
i=l

where Oj = q}jl(-qj + 1). From these definitions it follow

+ 1) and

P = OM + ZSj(Oj - 0)(M, -M). (3)

i=1

This result shows the relationship between aggregate prices and costs
that follow from the firm-level theory.
From equation (3) there are three conditions under which the
simple aggregate relationship, P = OM, approximately holds: (1) The
variation in elasticity of demand across firms is small, that is, (0j - 0) is
small on average; (2) the variation in marginal costs across firms is
small, that is, (Mj - M) is small on average; and (3) there is little line
relationship between the elasticity of demand and marginal costs
across firms. The term after the plus sign in equation (3) is simply an
estimate of the covariance between 0j and Mj. In the empirical model
this term is assumed to be negligible, so P = OM will be fit to aggregate
data. This is supported by the facts that retail cigarette prices vary
little across brands within any market and that costs of production

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MEASUREMENT OF MONOPOLY BEHAVIOR 1013

differences across brands are likely to be small since cigarettes are

produced in a single region of the country with a standard technol-
ogy. Finally, since firm- or brand-level data are not available, no
adjustment for the potential covariance is empirically possible.
A linear price equation for cross-section time-series data may be
written as

Pit = Xitq + ORit + Uit, (4)

where i refers to states, t refers to years, and Uit is a random distur-
bance term. This says that as the tax per pack varies across states and
years, the price varies by a proportion equal to or greater than 1.0.
For example, if the tax in Washington is 4 cents per pack higher than
the tax in Oregon then, ceteris paribus, if there is some monopoly
power, the price in Washington will be more than 4 cents higher.4
The model just presented notes that monopoly power would give
cigarette manufacturers an incentive to charge different prices in
states and years with different excise tax rates.5 However, the obser-
vation of this behavior is limited by the extent of interstate (and
interyear) arbitrage. A cigarette merchant in a high-tax state who is
charged a higher price by the manufacturer (because 0 > 1) would
want to buy in a low-tax state, transport the cigarettes back to his own
state, and thus, by competition, eliminate price differentials.
In fact, the legal institutions regulating the distribution of cigarettes
place strong restrictions on the potential for arbitrage. The federal
tax is paid by manufacturers on all cigarettes sold in the domestic
market with the tax stamp affixed at the factory and so is unrelated to
across-state arbitrage. Distributors buying these cigarettes from the
manufacturers are required to have state licenses in the state where
they operate; they must pay the state tax and affix the state tax stamp

4 For eq. (4) to be the pricing equation, the demand elasticity, 7q, must be a constant
with respect to P so that q, and 6 are constant parameters. If the underlying firm-level
demand curve does not have a constant elasticity, the price equation is nonlinear.
Nonlinear variants of (4) are developed below by allowing 71 to be an explicit function of
price. The methodology of this paper is applicable under any functional form for the
firm-level demand curve. There is also variation across states and years in sales tax rates
applied to cigarettes. However, if the ratio of the sales tax rate to I q I is small, the ef
of sales taxes on (4) is negligible. Since the sales tax rates range from 0 to 0.06 and |
is much larger (well above 1), I have ignored this complication in the sequel.
5 Wholesale prices for cigarettes are published by the U.S. Department of Agriculture
in its "Tobacco Situation" reports. These figures show that all brands and companies
charge the same price. (There is a small price difference between regular cigarettes and
long cigarettes.) Furthermore, these prices have remained the same over several years
and move up together in periodic discrete jumps. (The jumps have been more frequent
recently, given the inflation of the last few years.) However, these published prices are
of little interest here. They do not necessarily reflect the price at which cigarettes are
actually sold-only the "list" price. Thus discounts, promotional aids, and special
consideration are not included. For the purposes of this paper, only actual transacted
wholesale prices would be useful.

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 1014 JOURNAL OF POLITICAL ECONOMY

within a few days of receiving a shipment. In some states a distributor

may receive shipments to be sold and taxed in another state, but that
typically requires a special permit from the state government which
gives information on the quantity of the shipment and its final desti-
nation. Since distributors must be licensed to pay the state tax and
hence to sell cigarettes legally within a state, manufacturers have avail-
able (from public records) a list of all wholesalers of their products for
each state. Furthermore, since to resell cigarettes out of state takes a
special permit, the manufacturer can easily know the final state of sale
for cigarettes which they ship. Thus it would be very difficult for
cigarette distributors to arbitrage legally across state lines without the
knowledge of manufacturers. This allows the manufacturers to dis-
criminate on the basis of tax rate in the state of final sale. Further-
more, profitable legal interstate arbitrage depends on price differen-
tials generated by the monopoly power in the market and on the cost
of shipping and handling. There is room for a differential of several
cents per pack before distributors would be able to avoid manufactur-
ers' sanctions profitably or engage in illegal movements. Thus for
implied differentials in the range found below, the estimates should
be relatively free of the influence of potential arbitrage. This issue
might warrant further analysis if large differentials were generated by
monopoly power.6
Monopoly on the part of wholesalers or retailers could also
influence the relationship between Pit and Rit and hence could bias the
interpretation of q as revealing monopoly power of the manufactur-
ing firms. My assumption of a high degree of competition at these two
levels is supported by the large numbers of retailers in each market
area as well as significant numbers of distributors and chain-store
organizations at the wholesale level. (For data on the retail and
wholesale tobacco distribution industry and a summary of laws, see
the National Association of Tobacco Distributors' Coordinator [1979].)

6 Two effects, related to illegal arbitrage ("buttlegging"), may generate a relationship

between tax rates and the average price net of taxes. First, in states with relatively low
tax rates, a significant portion of cigarettes sold may be sold in large lots for transfer t
another state. The average transaction cost per pack on these sales will likely be low,
and therefore the measured average price of cigarettes sold will be low. This yields a
positive correlation between the tax rate and the price net of taxes. Second, in states
with relatively high tax rates a significant portion of cigarettes consumed may be bought
outside legal channels. Competition from the illegal market (which does not pay the
state tax) will cause a lower average price among the legal dealers. The result is a
negative correlation between tax rates and average price net of taxes. Putting these
together implies a concave relationship between tax rates and price. (Very-low-tax and
very-high-tax states should lie below the regression line.) Below, I test for the impor-
tance of smuggling in affecting the relationship between the retail price and the excise
tax across states. Note that if smuggling were dominant, all tax-related price differen-
tials would collapse, and the coefficient between price and tax rate would be near zero.
This has not taken place.

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 MEASUREMENT OF MONOPOLY BEHAVIOR 1015

III. Empirical Model

The empirical specification of equation (4) requires a discussion of

the Xit vector and the disturbance term Uit. The focus of this paper is
on the effect of excise taxes on pricing; therefore, the purpose of
specifying Xit is to avoid bias in estimation of 0. The Xit vector is
included to account for attributes of states and years that directly
affect P and are correlated with R. In the estimation, several alterna-
tive sets of variables were used and compared. The most complete
specification uses a full set of dummy variables for states and years in
Xit. Factors which vary from year to year are accounted for by a set of
DYt variables with one variable for each year in the sample (with one
excluded to avoid singularity). Factors which vary from state to state
are accounted for by a set of DS1 variables with one variable for each
state in the sample (with one excluded to avoid singularity). In an-
other specification, the national consumer price index is used in place
of the DYt variables. In each case the price variation remaining, which
is represented by Uit, is assumed to be uncorrelated with Rit. This Uit
term either is treated as a single disturbance or is modeled in a
variance-components framework with separate random effects for
the time-series and cross-section observations.7
In this paper, tax rate variation is treated as exogenous. Research
explaining the pattern of cigarette taxes would be interesting but is
not included in this paper.8 Note that with the whole set of individual
state dummy variables included in the price equation, a stable pattern
of state tax rates is accounted for by these intercept terms. For exam-
ple, the location of the tobacco and cigarette industries has not
changed over time, so the effect that their location has on state prices

Nonlinear models related to (4) were also applied. To allow for demand elasticities
that were not constant, let [r/l(rq + 1)] _(P) = yP(1l). Two plausible specifications o
the error term yield models which may be estimated conveniently by nonlinear least
squares. These are

Pit= [Xitiq + yRit]lI" + Vit (4')

and

Pit = [(Xittq + yRit) lI]Vit. (4")

In both cases X = 1 implies that 6 = y, and this parameter is a constant.
8 Some basic facts concerning the cigarette excise tax which might guide a theory of
taxation are as follows: The federal tax rate has remained 8 cents per pack for more
than 25 years. The median level of state taxes has risen from 3 cents per pack in 1954 to
12 cents per pack in 1978. This amounts to a fall in combined taxes in real terms and a
fall from 48.7 percent of retail price in 1954 to 35.5 percent in 1978. In 1978 state taxes
ranged from 2 cents in North Carolina to 21 cents in Florida, Connecticut, and
Massachusetts. The three states with a significant stake in production of cigarette
tobacco and the manufacture of cigarettes (North Carolina, Virginia, and Kentucky) all
have low tax rates. Variation across the rest of the states cannot be explained by a local
cigarette-producing industry.

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 ioi6 JOURNAL OF POLITICAL ECONOMY

is captured by state dummy variables and does not bias the coefficient
of Rit.

IV. Empirical Results and Interpretations

The major empirical results of this study are reported in table 1. In

this section, these results are presented and interpreted. A potential
alternative interpretation suggested by Barzel (1976) is also consid-
ered.
The estimates reported are based on annual tax rates and price data
for the years 1954-78 for 47 states and the District of Columbia.
Alaska, Hawaii, and New Hampshire are excluded from the sample
for the analysis reported in the table because of lack of data and
peculiarities in their tax laws. (See n. 11 below for more discussion of
the New Hampshire case.)
Information on cigarette prices and tax rates is collected and pub-
lished by the Tobacco Tax Council. The "weighted-average price per
package" published for each state and year uses national weights for
type of cigarette (regular, king, 100 mm) and for type of transaction
(carton, single pack, machine). Wholesalers around the country are
asked to provide estimates of the average retail price in their area for
each type of cigarette and type of sale. These numbers are turned into
state averages by the council. (This information is from corre-
spondence with the very helpful personnel at the Tobacco Tax Coun-
cil.)
Table 1 shows estimates of the linear model of equation (4) under
three alternative specifications of the Xit vector and the disturbance
term. The table reports the estimated 0 and, to aid in interpretation,
the implied price elasticity, -R. In row 1, Xit consists of a dummy
variable for each state and for each year. The tax rate effect in this
row is 1.074, which says, for example, that a 10 cent difference in tax
rates causes a 10.74 cent increase in price. The coefficient is
significantly above 1.0 (standard error = 0.013), which is support for
rejecting the hypothesis of atomistic competition in this industry.
However, the implied price elasticity is - 13.5, which indicates a
rather flat demand curve. Row 2 replaces year dummies with the
National Consumer Price Index and drops the state dummy variables,
while row 3 shows estimates from an application of a variance-
components model with the price index as the only additional explan-
atory variable. The estimates of 0 for these rows are 1.029 and 1.069,
and both are significantly above 1.0. Other specifications of Xit and Uit
yielded estimates of 0 similar to those reported.
This basic model was also estimated separately for each year using
states as the unit of observation. The estimates of 0 were generally in

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 MEASUREMENT OF MONOPOLY BEHAVIOR 1017

TABLE 1

ESTIMATES OF THE EFFECT OF THE TAX RATE ON CIGARETTE PRICE IN ALTERNATIVE

SPECIFICATIONS OF THE LINEAR MODEL (Eq. [4])

Implied Price Other Variables

Estimated 0 Elasticity 7v Included* Method

1.074 -13.5 DYtDSi OLS

(.013)
1.029 -34.5 NCPI OLS
(.011)
1.069 -14.5 NCPI VCt
(.013)

NOTE.-The R2's in each of these models were high, those with dummy variables were about .99, and those
without the dummies were around .95. There were 1,200 observations (25 years for each of 48 states). SEs in
parentheses.
* DY, is a dummy variable for each year with 1978 excluded, DSj is a dummy variable for each state with Wyoming
excluded, and NCPI is the national consumer price index for each year.
t In this equation a variance-component (VC) error scheme with an individual random effect for each state and
each year was used. See Fuller and Battese (1974) for a discussion.

the range reported in table 1 for the pooled model and were not
significantly different from one another. No trend in these estimates
was noted. Time-series changes in the industry do not seem to have
caused biases in the estimates in table 1.9
Two further comments should be made in relation to these results.
First, these estimates are not consistent with an effective cartel in the
cigarette industry. The firm-level elasticity estimates are well below
the range of the industry demand elasticity estimates usually found
for cigarettes. (These are generally between -0.3 and -0.8.)10 Second,
the effect of monopoly power as a source of price variation in the
industry is small compared with tax rate differences and other cost
differences over time and space.

9 In fitting the nonlinear specifications presented in n. 7 above, the hypothesis that X

= 1 is not rejected. For (4') X = 0.972 with SE = 0.027, and for (4") X = 0.981 with SE =
0.026. These tests support the appropriateness of the linear model results presented in
table 1. The estimate of y from (4') is 1.029, and from (4") it is 1.062. These, together
with the X estimates above, imply values of 6 in the range of those in table 1 or slightly
lower. This supports the hypothesis that while perfectly competitive pricing behavior is
rejected, monopoly power is not a major factor in determining cigarette price differen-
tials. The hypothesis that interstate smuggling would imply that price is a concave
function of tax rate, as discussed in n. 6 above, is not supported by these results. As a
further nonlinear specification, a squared tax rate term was added to the separate
yearly price equations. In most years the (R t)2 variable had an insignificant effect on
price. In only a few years out of 25 were the coefficients for Rit positive and (Rit)2
negative.
10 In related work (Sumner 1979), using cross-section time-series data for the last 10
years, which attempts to indirectly quantify the extent of interstate cigarette bootleg-
ging ("buttlegging"), I find the national industry-level elasticity of demand for cigarettes
to be approximately -0.40. This is in the range of other estimates from time-series
data.

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 ioi8 JOURNAL OF POLITICAL ECONOMY

Barzel (1976) has suggested an alternative interpretation for the

coefficient on Rit in the pricing equation. He argues that a higher per
unit tax on a good will induce a higher quality per unit to be sold.
Since the relative price of quality is lower in high-tax areas, substitu-
tion of quality for quantity will occur. The after-tax price per unit will
be higher in a higher tax rate area to reflect the higher quality of the
product. He also notes that ad valorem taxes fixed as a percentage of
retail price (as was the practice in New Hampshire prior to 1975)
would not have this effect.
As Barzel points out, products actually traded are combinations of
many characteristics, most of which are extremely difficult for either
the government or the empirical economist to measure. Thus, when
Barzel argues that the quality of cigarettes varies positively with the
tax, no direct measurement of quality changes could reject that hy-
pothesis. Barzel turns instead to price data on cigarettes across years
and states as published by the Tobacco Tax Council. The nature of
these data is crucial. As noted above, the price data available for
cigarettes have the most obvious quality variations (type of sale and
type of cigarette) held fixed across states. Furthermore, given cen-
tralized manufacturing and national distribution of brands, there is
little scope for direct product-quality variation. This leads one to
question the strength of the expected Barzel effect in these data even
if it were present in the real world. Hence it would appear that the
"elasticity of demand" interpretation of 0 is a serious contender with
Barzel's quality shifter for explaining a 0 coefficient greater than 1.0.
Finally, note that the Barzel effect would cause an upward bias in the
measurement of monopoly power so that there is an even stronger
case for concluding that the cigarette industry does not act as a
cartel.II

11 As further consideration of the strength of the Barzel effect in cigarettes, some

estimation was done which included data from New Hampshire with the other states.
These results were essentially identical to those reported in the table. New Hampshire,
which had an ad valorem cigarette tax until 1975, was found to have a strongly negative
state dummy variable. However, it may be the case that New Hampshire has a low price
of cigarettes net of taxes not because its tax was ad valorem as suggested by Barzel but
for the same reason that the per capita sales of cigarettes in New Hampshire are more
than double the average of the other New England states. That is, residents of nearby
states buy a significant portion of their cigarettes in New Hampshire. Given size
economies for sales transactions, a high proportion of this interstate trade would tend
to reduce the average price net of taxes in New Hampshire. Barzel's ad valorem tax
hypothesis implies that the special position of New Hampshire would have evaporated
after 1975 (when a fixed per unit tax replaced the ad valorem tax). The transaction cost
hypothesis (among others) predicts that there will be no effect of the 1975 law change. I
found that the New Hampshire residuals from the linear model estimated for each year
are just as negative after 1975 as before 1975, which indicates that the ad valorem tax
was not the different New Hampshire characteristic. This is not to suggest that the
Barzel effect is not theoretically sound but, rather, that interstate cigarette prices may
not be useful to test the theory.

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MEASUREMENT OF MONOPOLY BEHAVIOR 1019

The statistical results presented in table 1 support rejection of the

hypothesis of atomistic competition in the cigarette industry. The
demand curves facing cigarette firms are not flat but are close to it by
most standards. Taking 0 = 1.05, a 1 percent rise in the price of a
firm's product would cause a 20 percent fall in the quantity sold. If the
cigarette prices are above marginal cost by 5 percent, monopoly
power adds approximately 3 cents to the average price of a package of
cigarettes.

This paper has proposed and demonstrated the applicability of a

scheme for measuring monopoly behavior that may be relevant to
several different industries. For example, application to the U.S.
gasoline market is currently being pursued. Data requirements are
information on product price and some factor that has a directly
measurable per unit cost. Variation over time or space or some other
dimension is required for statistical implementation.

References

Bain, Joe S. Industrial Organization. 2d ed. New York: Wiley, 1968.

Barzel, Yoram. "An Alternative Approach to the Analysis of Taxation."J.P.E.
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Friedman, Milton. "The Methodology of Positive Economics." In Essays in
Positive Economics. Chicago: Univ. Chicago Press, 1953.
Fuller, Wayne A., and Battese, George E. "Estimation of Linear Models with
Cross-Error Structure." J. Econometrics 2, no. 1 (May 1974): 67-78.
Johnson, Terry R. "Additional Evidence on the Effects of Alternative Taxes
on Cigarette Prices."J.P.E. 86, no. 1, pt. 1 (April 1978): 325-28.
Manchester, Paul B. "Interstate Cigarette Smuggling." Public Finance Q. 4, no.
2 (April 1976): 225-38.
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