Staff Evaluation of the Tobacco Industry Analysis Submitted to Congress on October 8, 1997

By staff of the Federal Trade Commission (1)

I. Introduction

This evaluation has been prepared by the staff of the Federal Trade Commission in response to several congressional requests.(2) In September, the FTC staff prepared a report analyzing the financial impact of the proposed tobacco industry settlement in response to a request by the Congressional Task Force on Tobacco and Health.(3) After the FTC Staff Report was submitted to the Task Force, the tobacco industry responded to a congressional request by providing the industry's estimates of the potential impact of the settlement on cigarette consumption and tobacco company stock prices.(4) This industry analysis challenges many aspects of the FTC Staff Report. The FTC staff has reviewed the industry analysis and, as discussed below, concludes that the analysis has not identified any significant errors or omissions that would undermine the findings presented in the FTC Staff Report.

The industry's projections of future cigarette prices are much closer to the projections of the FTC staff than they appear. The industry predicts that the proposed settlement will increase the retail price of a pack of cigarettes by $1.52 in the year 2007. The industry estimate is given in nominal terms, which means that the effects of anticipated inflation are included in the estimate. Since the FTC staff analysis was conducted in real terms (i.e., in constant 1997 dollars), it is necessary to convert the industry estimate into real terms to compare it with the FTC staff estimate. When this is done, the industry estimate converts to at most a 79 cent increase, as compared to the FTC staff's baseline estimate of 72 cents.(5)

The industry's projections of the decline in cigarette consumption, while within the range of possibilities explored in the FTC Staff Report, probably overstate the likely magnitude of the decline. The industry uses estimates of the elasticity of demand that are higher than most published estimates, and it assumes that even in the absence of price increases there will be a substantial (2.5%) annual decline in cigarette sales. The industry does not say, however, what assumed price increase was used in its estimation, nor does it specify the exact form of the demand function used. The industry's projections of the decline in cigarette consumption are discussed below in sections III and IV of this evaluation.

The industry's analysis of industry profits is inaccurate due to the inconsistent use of adjustments for inflation. As discussed below in section V of this evaluation, Table 3 of the industry report adjusts some figures for inflation but not others, in effect mixing apples and oranges and leading to wrong conclusions. If the analysis were done on a consistent basis, it would support the FTC staff conclusion that manufacturers' profits would rise substantially under the FTC staff's scenario reflecting substantially more effective industry coordination (the 200% price-increase ratio scenario).

The industry analysis does not address several key conclusions of the FTC Staff Report: that the antitrust exemption and other features of the proposed settlement could lead to enhanced industry coordination, that more effective coordination would allow the industry to increase prices more than necessary to simply "pass through" to consumers the amount of the annual settlement payments, and that these price increases would lead to a substantial increase in industry profits. These conclusions remain valid even using the industry's assumptions of a greater elasticity of demand and a greater underlying rate of decline in cigarette consumption.(6)

II. The FTC Staff Report

The FTC Staff Report examined the history of the cigarette industry, the economic literature discussing industry characteristics, and the terms of the proposed tobacco industry settlement. The Report concluded that the broad antitrust exemption and other features included in the proposed settlement could lead to a lessening of competition that would result in substantial increases in cigarette prices and industry profits.

The report provided several illustrations of the potential effect of the settlement on prices, profits, and public sector revenues if coordination is enhanced and the industry raises prices by more than necessary to simply "pass through" to consumers the amount of the annual payments. In the scenario illustrating the effects of a substantial increase in industry coordination, the additional after-tax operating profits from enhanced coordination amounted to $123 billion over the next 25 years ($56 billion in present value).(7) Although the report acknowledged that it is difficult to predict prices and profits 25 years in the future because the settlement may substantially alter the nature of competition in the industry, it also emphasized that a wide range of plausible scenarios involving increased industry coordination would lead to substantial windfall profits for the cigarette industry.

Higher prices from increased coordination would result in greater revenues for the public sector as well as increased operating profits for the cigarette manufacturers. The public sector would benefit through greater excess profit penalties under the terms of the settlement and greater revenues from federal corporate income taxes.(8) In general, the examples suggested that the industry would retain about two-thirds of the financial benefits of increased coordination, leaving one-third for the public sector.

The FTC Staff Report also concluded that even without increasing coordination, the proposed settlement would lead to higher prices. Under the FTC staff's "baseline" scenario, in which the degree of industry coordination is presumed not to increase, cigarette prices would rise by roughly the per-pack payment required by the settlement. Even without the windfall profits generated by increased coordination, the cigarette industry could obtain the civil liability protections of the settlement, giving up as little as $10 billion (present value) in after-tax operating profits -- a reduction in the present value of the profit stream of about 17%.(9) With the increased profits from increased coordination, the industry could receive both the liability protections and substantial additional operating profits.

III. The Tobacco Industry's Analysis

The tobacco industry's analysis of cigarette prices and industry profits under the proposed settlement posits that the FTC Staff Report's estimates of future cigarette prices are too low and that the estimates of future industry profits are too high. The industry estimates that by the tenth year of the settlement, the increase in retail cigarette prices will reach the $1.50 level sought by the President, without any increase in the proposed settlement payments. The industry also submits that while prices will increase much more than suggested by the FTC Staff Report, industry profits will be much lower than estimated in the FTC staff's baseline scenario because the revenues from the price increase will be needed to cover additional costs that the FTC Staff Report did not consider.

The industry analysis also differs from the FTC Staff Report in at least two of the assumptions employed in estimating future cigarette consumption. First, the FTC Staff Report assumed a demand elasticity of -0.4 in its baseline scenario and elasticities of -0.2 and -0.8 in other scenarios. The industry analysis employs demand elasticities of -0.5 and -0.75. The elasticity of demand is a measure of the responsiveness of demand to changes in price. For example, an elasticity of -0.4 means that a price increase of 1% will cause a fall in the quantity of cigarettes demanded of 0.4%.

Second, in its baseline scenario the FTC Staff Report assumed that the secular decline in cigarette consumption would be 0.6% per year, and in other scenarios assumed that the secular decline rate would increase to 2.0% per year under the settlement.(10) The industry analysis assumes a decline rate under the settlement of 2.5%. As discussed in the FTC Staff Report, differences in assumptions of these magnitudes for both the demand elasticity and the secular rate of decline do not significantly alter the conclusion reached by the FTC Staff Report, i.e., that the broad antitrust exemption and other features included in the proposed settlement could lead to a lessening of competition that could allow the industry to coordinate more effectively, resulting in substantial increases in industry profits.(11) Differences in these assumptions, however, will affect estimates of future cigarette consumption.

Section IV of this evaluation addresses the different approaches to estimating cigarette prices, and examines more closely the industry's estimates of future cigarette consumption. Section V examines the different approaches to predicting industry profits. As noted above, the industry analysis does not address the anticipated impact of the antitrust exemption and other features of the settlement on industry coordination, which might cause industry prices and profits to rise. Therefore, no further consideration of this issue is presented in this evaluation.

IV. The Industry's Analysis of Retail Prices and Cigarette Consumption Under the Proposed Settlement

The industry concludes that the nominal price of cigarettes will increase by $1.52 per pack, which includes the effect of inflation, by the year 2007. The FTC staff estimate that the real price, which does not include inflation, will increase by $0.72 per pack (if price increases due to increased industry coordination are not included).(12) Other analysts have predicted a similar increase.(13)

It is important to emphasize that the industry's estimate of a $1.52 price increase is in nominal terms, meaning that it includes price increases due solely to inflation. Table 5 in the industry analysis presents the various components of the industry's estimated price increase. The table shows that the industry inflates the $0.62 per pack settlement payment to $0.829 to reflect inflation.(14) Additional increases due to inflation appear to be included under the heading "industry price."(15) Finally, increases due to inflation are included in the increased trade margin and sales tax figures because they were calculated based on the other inflated figures noted above.(16)

Because the industry's $1.52 estimate is in nominal terms, it cannot be used to address the question of how changes in the price of cigarettes will deter smoking in general and youth smoking in particular. Increases in price due solely to inflation will not affect consumers' decisions to purchase cigarettes, since inflation also raises consumers' money incomes and the prices of all other goods as well as the price of cigarettes. Consumers will not buy less gasoline or ice cream in 2007 simply because the price of those goods has increased at the general rate of inflation; likewise, inflationary increases in the price of cigarettes will not lower the number of cigarettes sold. Use of nominal prices would lead to an overestimate of the reduction in cigarette consumption. Since only real changes in price affect consumers' purchasing decisions, estimates of future demand must be calculated in real (i.e., constant-dollar) terms to control for the effects of inflation.(17)

Before one can assess the effect of the industry's estimated price increase on cigarette consumption, therefore, the industry's nominal price increase must be converted to a real value by removing the effects of inflation. The industry estimates that the nominal price of cigarettes will be $3.34 per pack by the year 2007.(18) If the annual inflation rate is assumed to be 3%, the industry's $3.34 nominal price corresponds to a real price of $2.49, implying a real price increase of only $0.67 by the year 2007.(19) Alternatively, if the annual inflation rate is assumed to be 2.5%, the industry's $3.34 nominal price corresponds to a real price of $2.61, implying a real price increase of $0.79 by the year 2007.(20) Thus, the industry's estimated $1.52 nominal price increase is equivalent to a real price increase of only $0.67 to $0.79.(21) This range is substantially the same as the FTC staff's $0.72 estimate.(22)

In examining the effect of the industry's estimated price increase on future cigarette consumption, one must therefore use the real price increase of $0.67 to $0.79 and not the nominal price increase of $1.52 highlighted in the industry analysis. The industry analysis, however, does not explain what price increase was used to calculate the consumption estimates presented in Table 1 of its analysis. Neither a $1.52 nominal increase nor the $0.67 to $0.79 real increase appears to be consistent with the estimates presented in Table 1 and the other assumptions made by the industry in its analysis. It appears instead that the industry may have been using a real price increase of approximately $0.95.(23) Unless the industry further explains its calculation method and the real price increase assumed, the consumption estimates presented in the industry's Table 1 and the industry's analysis of the effect of the proposed settlement on cigarette consumption cannot be fully evaluated.(24)

In sum, although the industry appears to forecast a much larger price increase by the year 2007 than do the FTC staff and other analysts, the difference arises almost entirely from the fact that the industry presents its price increase estimate in nominal terms (which includes inflation) rather than in real terms (as do the FTC staff and other analysts). The industry's estimate of a nominal price increase of $1.52 corresponds to a real price increase of only $0.67 to $0.79. This range is substantially the same as the $0.72 estimate of the FTC staff. The industry's analysis of future cigarette consumption is harder to evaluate because the industry's assumptions are not fully specified. Nevertheless, it appears that the assumptions used tend to exaggerate the likely future decline in consumption, unless the real price of cigarettes to the consumer rises by substantially more than the amount necessary to pass on the cost of the annual payments and the scheduled increases in excise taxes.

V. The Industry's Analysis of Industry Profits Under the Proposed Settlement

The industry also challenges the FTC staff's view that an increase in retail cigarette prices beyond what is necessary to pass through to consumers the per-pack payments required by the proposed settlement will confer windfall profits on the cigarette manufacturers. In the discussion concerning the industry's Table 3, the industry indicates that the additional revenue derived from higher retail prices will go to parties other than the manufacturers. In addition, the industry submits that the FTC Staff Report ignores various factors that would diminish industry profits. These criticisms are unpersuasive.

Table 3 of the industry analysis reworks the "200% price-increase ratio" scenario contained in the FTC Staff Report.(25) According to the industry (but not the FTC Staff Report), the wholesale price corresponding to the FTC staff's estimated retail price ($3.04) is $1.42 per pack. The industry claims, however, that if the cost components of this retail price are estimated correctly, the corresponding wholesale price is actually much lower ($0.77 per pack). This latter estimate of the wholesale price is lower than the per-pack figure ($0.80) that the industry claims as the actual 1996 wholesale price.(26)

The analysis reflected in the industry's Table 3 errs in two fundamental ways. First, the analysis incorrectly mixes real and nominal prices.(27) When considering payments the tobacco industry will make, the industry includes nominal cost increases due solely to inflation. For example, the FTC Staff Report's value of $0.62 for the settlement payment is the correct value of the payment in real terms, while the industry value of $0.83 incorporates increases due to inflation.(28) Yet the industry does not simultaneously include inflation in the retail price figure (which would increase it beyond the $3.04 real level). Because the industry analysis treats inflation inconsistently -- inflating its costs but not its revenues -- it creates the fictitious appearance that manufacturers' prices and profits would be significantly lower than the FTC Staff Report suggests.

Second, the industry misconstrues the FTC Staff Report's analysis. The retail price of $3.04 was not assumed, but rather was derived from the current price of $1.90 by adding a hypothesized price increase reflecting increased industry coordination, adding the cost of the annual payments, and subtracting anticipated savings in advertising and legal costs. If the settlement were to impose costs on the industry in addition to the annual payments, as the industry supposes, the FTC staff analysis would treat these costs in the same way as the annual payments: they would be passed through to consumers. Thus, if the costs imposed by the settlement are higher than assumed in the FTC staff's scenario, as the industry claims, then they would push the retail price up higher rather than reduce the manufacturers' price (the wholesale price).(29) The industry's table creates the misleading impression that profit margins would shrink; instead, the primary distributional effect that would arise if the settlement imposes additional costs on the tobacco industry is that these costs will be shifted to cigarette consumers (with little effect on industry profits).

The tobacco industry paper also submits that the FTC Staff Report failed to consider, or gave insufficient weight to, various factors that would diminish future industry profits. Each factor is addressed below.

1. Current Profit Margins

The analysis in the FTC Staff Report assumed that the average domestic cigarette firm earns a $0.32 operating profit per pack. The industry indicates that this assumption exaggerates company profits and that the correct figure (including Brown & Williamson in the calculation) is $0.30. If the industry is correct, this adjustment does not materially affect the conclusions of the FTC Staff Report. The level of profits would fall slightly in scenarios that assume a settlement as well as in those that do not.(30) Such an adjustment would not materially affect the analysis of the settlement's effect on industry profits, because that effect is derived from the difference in profits between two scenarios and not from the specific level of profits in those scenarios.

2. Fixed Costs

According to the industry, the FTC Staff Report incorrectly assumes that all industry costs are variable, and that therefore proportionate declines in revenues are matched by a similar rate of decline in costs. The industry claims (at p. 6) that under the Staff Report's assumption that all costs in the industry are variable, "a sales volume loss of one billion cigarette packs would erode industry profits by $300 million," when the loss would actually approximate $640 million (because $340 million in fixed costs would remain).(31) The industry's analysis implicitly assumes that domestic factories would reduce their output and would be forced to sell idle plant and equipment at liquidation prices. The industry's assumption is questionable and would represent a departure from recent history: domestic cigarette output has risen even as domestic consumption has declined, because exports have increased.(32), (33)

3. Shift Toward Discount Brands

The examples in the FTC Staff Report assumed that the settlement would not alter the mix of industry sales between premium and discount brands. The industry submits that this assumption fails to recognize that smokers are likely to shift away from premium brands and prefer discount brands in the wake of the settlement, thereby reducing industry profits. The industry analysis, however, does not explain why this shift would occur. In fact, various market forces that come into play under the proposed settlement appear to point in opposite directions. On the one hand, the settlement's limitation on advertising could reduce the attraction of premium brands, and thus reduce their sales relative to discount and generic brands. Alternatively, the significant increase in the price of all brands would reduce the percentage difference in price between premium brands and discount brands, possibly making the former more attractive to consumers. Historically, the price gap between premium and discount brands, rather than the absolute level of cigarette prices, has been an important variable influencing the mix of products sold.(34) Accordingly, there appears to be no compelling reason to anticipate a shift away from premium brands.

4. Legal Costs

The industry posits that the FTC Staff Report incorrectly assumes that industry marketing and legal costs will decline under the settlement. The industry argues that legal costs may not fall in view of the industry's continued exposure to individual trials and its additional burden of complying with new regulatory schemes, notwithstanding the provisions of the settlement that will prohibit or deter some lawsuits. Even if the industry correctly forecasts higher legal costs of a few cents per pack, the effects on industry profits will be small.

5. Interest Costs Associated with the Up-Front Payment

The FTC Staff Report recognized the up-front settlement payment of $10 billion as a cost imposed on the industry. The industry suggests (at page 6) that the Staff Report also should have included the "interest costs" of financing that payment. That suggestion is inappropriate: to include both the $10 billion and the interest charges that would arise if the cigarette companies borrowed the $10 billion would count the same cost twice.(35)

6. Post-Settlement Increases in State and Federal Taxes

Because the FTC Staff Report's analysis was conducted in real (constant 1997 dollar) terms, increases in federal and state taxes at the rate of inflation were implicitly incorporated. There is no support for the industry's claim that the Staff Report ignores the likelihood that state and federal excise taxes will continue to rise after the settlement.(36)

7. Youth Surcharge

The examples in the FTC Staff Report do not take into account the possible payment of "look-back" surcharges if youth smoking is not reduced to target levels. The Staff Report explains that the magnitude of the surcharge is hard to gauge because up to 75% of the surcharge could be abated if the industry complies with the terms of the settlement. The industry analysis implies that this exclusion leads the Staff Report to overstate industry profits. But a substantial overstatement is unlikely even if the youth smoking targets were not met and the FDA did not rebate the penalty: the maximum penalty amounts to $0.08 to $0.10 per pack at expected output levels and likely would be passed on to consumers.(37)

VI. Conclusion

Although any estimates of industry prices and profits for 25 years into the future are subject to much uncertainty, the industry critique of the FTC staff analysis did not uncover any significant biases in the analysis. The FTC staff remains of the view that the antitrust exemption and other features of the proposed settlement could permit firms to fix prices or otherwise increase coordination, and that such coordination would be expected to generate dramatic increases in industry profits.

1. This evaluation has been prepared by staff members of the Bureau of Economics. The views expressed do not necessarily reflect those of the Commission or any individual Commissioner.

2. The Senate Subcommittee on Antitrust, Business Rights and Competition of the Committee on the Judiciary, the Congressional Task Force on Tobacco and Health, and the Senate Democratic Task Force on the Tobacco Settlement have requested this evaluation.

3. "Competition and the Financial Impact of the Proposed Tobacco Industry Settlement," Report prepared by the staff of the Bureaus of Economics, Competition, and Consumer Protection of the Federal Trade Commission, requested by the Congressional Task Force on Tobacco and Health, September 1997 ("FTC Staff Report").

4. Lorillard Tobacco Company, Philip Morris Companies Inc., R.J. Reynolds Tobacco Company, and UST, Inc., "Impact of the Proposed Resolution on the U.S. Cigarette Industry," submitted to the Senate Democratic Task Force on the Tobacco Settlement, October 8, 1997.

5. In a letter dated October 31, 1997 from Meyer G. Koplow (representing Philip Morris) to Senator Orrin G. Hatch, Philip Morris states that the $1.52 nominal increase is equivalent to a real increase of $1.19. This calculation appears to be erroneous, as explained in note 22, infra.

6. Under the industry assumptions about demand, the industry would receive windfall profits of $40 billion (in present value) from more effective coordination of the magnitude considered in the FTC Staff Report. In particular, when the FTC staff estimates are calculated using the industry demand elasticity of -0.75 and the downward trend of 2.5%, the present value of industry after-tax profits in the substantially more effective coordination case (200% price-increase ratio) is $76.7 billion, compared to $36.3 billion in the baseline case (100% price-increase ratio). In contrast, public sector revenues are nearly the same in the two price-increase ratio cases, because the additional taxes on corporate profits are largely offset by the reduction in excise tax payments due to the decline in cigarette sales.

7. See FTC Staff Report at 36 and Table 12.

8. FTC Staff Report at 30 and 35, note 78.

9. FTC Staff Report at 33 and Table 9.

10. The "secular decline" rate refers to the rate of decline that would be expected independent of reductions due to changes in the price of cigarettes.

11. See FTC Staff Report at 37-39.

12. The annual payment under the proposed settlement from the year 2002 onward is $0.62 per pack, which the settlement anticipates will be passed through to consumers in the form of higher prices. The FTC Staff Report also assumed that the settlement would lead to advertising and legal cost savings of $0.05 per pack that the industry would pass through to consumers. If so, and assuming no additional price increase as a result of more effective coordination (as in the FTC Staff Report's 100% price-increase ratio baseline scenario), the price per pack would increase by $0.57 after five years as a result of the settlement. Adding the recently passed $0.15 increase in the federal excise tax yields an estimated total price increase of $0.72 beginning in 2002. (The FTC Staff Report gave a figure of $0.42 as the estimated price increase due to the settlement in the baseline scenario. The $0.42 figure is less than the $0.57 figure noted above because the Staff Report deducted $0.15 from the settlement payments to reflect the credit for the new excise taxes specified in the current law. Since it now appears likely that the credit will be removed, the $0.15 should be added back to the settlement payments, yielding the $0.57 figure given above for the estimated price increase due to the settlement.)

13. Professor Jeffrey Harris, for example, has predicted that by the year 2007 the real price of cigarettes will increase by $0.71 over the 1996 price. J. Harris, Prepared Statement before the Senate Democratic Task Force on Tobacco, October 21, 1997.

14. While the proposed settlement specifies that the annual payment will be adjusted each year by the rate of inflation or by 3%, whichever is greater, the adjustment is likely to have no noticeable effect on the real value of the payments. If the inflation rate is greater than 3%, the payments will be adjusted by the rate of inflation, leaving the real value unchanged. If the inflation rate is less than 3%, the 3% minimum adjustment will increase the real value of the payments, but this effect will be small unless inflation is significantly less than 3% for a sustained period of time. Such an inflation rate, however, would be at odds with recent economic history. Over the past 5 years, the inflation rate has averaged 2.9%, and this average is far below the average rate over the past 30 years. If the 2.9% average continues in the future, the 3% minimum adjustment would increase the real value of the settlement payments by only six-tenths of a cent per pack by the year 2007. (Inflation rate figures from Economic Report of the President 1997, Table B-61, "Changes in special consumer price indexes, 1958-96," Year-to-Year Change, All Items (CPI-U), percent change.)

15. The footnote to the "Industry Price" heading in Table 5 of the industry analysis states that the "industry price" figure "[o]nly reflects adjustment for inflation of 2.5%." The industry analysis does not provide any explanation of what is included in "industry price" or what calculation is made to derive the figures under this heading in Table 5, but the footnote indicates that the figures either partially or wholly represent price increases due to inflation.

16. Inclusion of real increases in the trade margin and sales tax is also questionable. As the FTC Staff Report notes, the trade margin of distributors and retailers is unlikely to rise in proportion to the increase in cigarette prices because the competitiveness of the cigarette distribution and retailing sectors is unlikely to be affected by the proposed settlement. In the absence of any increase in the costs of distribution or retailing, there would be no reason for the aggregate trade margin to rise in real dollar terms. (See FTC Staff Report at 27, note 72.) Including increases in sales taxes is also inappropriate unless the 1997 price used in the industry analysis similarly included sales taxes, which is not made clear in the industry paper.

17. The industry appears to recognize this point, stating on the first page of its analysis that "[e]conomists measure the impact of real price movements on the purchase of any product through econometric modelling which yields a price elasticity ratio." (Emphasis added.)

18. The $3.34 nominal price in the year 2007 is obtained by adding the industry's estimated nominal increase of $1.52 to the industry's assumed 1997 price of $1.82. The industry presents this calculation in Table 5 of its analysis.

19. The $2.49 real price is obtained by adjusting the industry's $3.34 nominal price for a 3% inflation rate using the formula: $3.34/(1+0.03)10. The $0.67 real price increase is obtained by subtracting the industry's $1.82 figure for the 1997 price from the $2.49 estimate of the real price in 2007.

20. The $2.61 real price is obtained by adjusting the industry's $3.34 nominal price for a 2.5% inflation rate using the formula: $3.34/(1+0.025)10. The $0.79 real price increase is obtained by subtracting the industry's $1.82 figure for the 1997 price from the $2.61 estimate of the real price in 2007. (The industry employed an annual inflation rate of 2.5% for at least some purposes, as indicated in note 15, supra.)

21. The range would extend higher than the $0.79 figure only if the annual inflation rate was assumed to be less than 2.5%. This is unlikely, however, because a sustained inflation rate of less than 2.5% is contrary to recent economic history, as discussed in note 14, supra.

22. Philip Morris has recently stated that the industry's estimated $1.52 nominal price is equivalent to a real price increase of $1.19. See note 5, supra. Although Philip Morris does not explicitly say how this figure was calculated, it appears to have discounted the increase of $1.52 at a rate of 2.5% over a period of 10 years to obtain the result. This method would be incorrect, because the entire nominal price of $3.34 in 2007, not just the part of the price that represents an increase, must be discounted back to 1997 dollars.
 

To gain a better appreciation of why such a calculation would be wrong, consider a different example. Suppose the price of bread increased by 4% in one year from $1.00 a loaf to $1.04, while the overall rate of inflation was 10%. The real price of bread has actually decreased by approximately 6%. (More precisely, the real price in the second year is $1.04/$1.10 = $0.945, a decrease of 5.5%.) But by the type of calculation apparently employed by Philip Morris, the real price of bread would incorrectly appear to have risen. In particular, under the erroneous calculation, the nominal price increase of 4 cents would be discounted by 10% to yield an alleged 3.6 cent real increase. But it would be incorrect to say that the real price of bread went up by 3.6 cents, or 3.6%, when the price of bread rose less than the general rate of inflation.

23. The additional assumption required to deduce the price increase used is the specific functional form of the demand function used by the industry. If a constant elasticity demand function is used, it can be calculated that in order to reach the results reported in Table 1, the industry must have used a real price increase of approximately $0.95 in the year 2007. Specifically, Table 1 presents a consumption estimate for the year 2007 of 269.3 billion cigarettes when a demand elasticity of -0.75 is assumed. The industry analysis indicates that the industry calculations also assumed a secular downward trend in demand of 2.5% per year, a 1997 price of $1.82, and a 1997 consumption level of 477 billion cigarettes. The 269.3 billion consumption estimate for the year 2007 is consistent with these assumptions only if a real price increase of $0.963 is used in the calculation, using the formula: 269.3 = 477 x ((1.82+0.963)/1.82)-0.75 x (1-.025)10. The implied price increase is similar but slightly lower ($0.933) for the year 2007 estimate using the -0.5 demand elasticity.
 

Alternatively, the use of a linear or semi-log demand function would be consistent with lower real price increases. However, a property of these demand functions is that the elasticity of demand increases as real price rises, which may not be true in the cigarette industry. See FTC Staff Report at 37.

24. If the industry assumed a real price increase of $0.95 in its consumption analysis, and did not intend to incorporate a price rise reflecting the greater exercise of market power, this high increase (compared to the $0.72 projected by the FTC staff) would likely cause the decline in consumption to be overstated.

25. See FTC Staff Report at 34, note 92.

26. The FTC staff did not derive the $1.42 figure provided in the industry table and has never attempted to estimate manufacturers' prices. Instead, the FTC staff analyzed industry profit margins, based upon data from the firms' SEC 10-K submissions.

27. The FTC staff analysis, in contrast, consistently uses real prices in constant 1997 dollars.

28. Similarly, the industry figures for the trade margin include increases due solely to inflation. The industry has not explained why trade margins would increase in real terms in the competitive cigarette distribution sector. See discussion at note 16, supra. Finally, the FTC staff's retail price of $3.04 was the retail price before sales tax. Since sales tax was not included to begin with, it is not appropriate for the industry to subtract it.

29. Indeed, the FTC Staff Report recognized that if the law crediting the $0.10 to $0.15 per-pack excise tax against the settlement payments is rescinded, as now seems likely, the result will be to raise cigarette prices with little effect on industry operating profits. See FTC Staff Report at 33, note 90.

30. For example, adding two cents per pack to industry costs would result in a reduction of less than 7% in industry profits in the baseline scenario over the 25-year time span ($97 billion versus $104 billion).

31. Fixed costs are those costs that are independent of the quantity of goods produced in a short period of time, such as a year. Variable costs vary according to the quantity of goods produced. Even so-called "fixed costs" can vary over longer periods of time.

32. For example, total output from domestic plants increased from 714 billion units in 1990 to 760 billion units in 1996 -- despite a reduction of 40.2 billion units of output sold in the U.S. during this period. Accordingly, even an increase in the rate of decline in domestic consumption would not necessarily result in a reduction in total domestic production, due to the increasing demand for U.S. cigarettes abroad. Exports of U.S.-made cigarettes rose almost 50% over the 1990-96 period. See the following Internet site: http://usda.mannlib.cornell.edu/data-sets/specialty/94012/.

33. Moreover, the FTC Staff Report's assumption that all costs become variable over time recognizes, as the industry's criticism does not, that firms may have the opportunity to save on fixed expenditures by choosing not to replace depreciating plant and equipment as demand declines.

34. This price effect has been observed in state markets: the higher the average price of all cigarettes in a state, the greater the share of the market accounted for by premium brands. R. Sobel & T. Garrett, Taxation and Product Quality: New Evidence from Generic Cigarettes, 105 J. Pol. Econ. 880 (1997).

35. If the $10 billion is borrowed at market rates, the stream of loan payments would have a present value of $10 billion.

36. The examples in the Staff Report do not account for the possibility that tax increases would occur at a rate greater than the inflation rate. Yet even in this event, the overall impact on the Staff Report's estimates of changes in profits under the settlement would be minimal under the baseline assumption that manufacturers completely pass taxes through to consumers.

37. The penalties likely would be passed on to consumers because they are tied to the output of the firms in much the same manner as the annual payments are tied to output. In particular, they are allocated among manufacturers in proportion to their market shares in any given year for all domestic sales, not just youth sales. See Appendix V.B.3, p. 54 of the proposed settlement. Thus, the penalties are a cost of selling more cigarettes, just as the cost of tobacco is a cost of selling more cigarettes, and they would be passed on to consumers for the same reasons that other variable costs are passed on to consumers.