The United States cigarette industry faces a number of business uncertainties that have adversely affected the growth prospects of companies operating in the segment. These have translated into a shrinking market size of cigarette sales by volume over the past years, and we expect the trend to continue going forward as well. Altria (NYSE:MO), Lorillard, Inc. (NYSE:LO), Reynolds American Inc. (NYSE:RAI) as well as other players now rely on raising cigarette prices to counter declining volumes.
The big question is however, how long can these companies rely on raising prices to offset the falling volumes, and what will the future of the U.S. cigarette industry look like in the long run?
Challenges to the Cigarette Industry
- Restrictions already imposed and those proposed by the FDA under the Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) enacted in June 2009;
- Actual and proposed excise tax increases;
- Bans and restrictions on tobacco use imposed by governmental entities and private establishments and employers;
- Illicit trade practices, including the sale of counterfeit tobacco products by third parties; and
- Increasing awareness on harmful effects of smoking
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Externalities and Government Intervention
In economics, an external cost or a negative externality is a cost that is suffered by a third party as a result of an economic transaction. These are also known as negative social costs. Governments in theory should intervene in markets having significant negative externalities through indirect taxes, which lead to higher price and lower demand, depending upon elasticity.
In The Economics of Welfare, British economist Arthur Pigou suggested that governments tax polluters an amount equivalent to the cost of the harm to others. Such a tax would yield the market outcome that would have prevailed with adequate internalization of all costs by polluters. By the same logic, governments should subsidize those who generate positive externalities in the amount that others benefit. ((Externalities: Prices Do Not Capture All Costs, IMF)) A good example of negative externalities is the impact of CO2 emissions on the environment caused by the use of fossil fuels. It’s also one of the reasons behind government subsidies on ‘cleaner’ sources of power, like solar and wind.
The economics of the tobacco industry is such that its an overall losing game for countries due to direct health costs and indirect costs in the form of lost productivity by smoking-related diseases. From 2000 to 2004, $71 billion per year on an average was spent on cigarettes in the United States while cigarette smoking accounted for an estimated $193 billion in annual health-related economic losses, according to the Center for Disease Control and Prevention. ((Economic Facts about U.S. Tobacco Production and Use, CDC – Lead federal agency for comprehensive tobacco prevention and control))
As the U.S. government raises taxes on cigarettes in order to meet expenses borne by the public health due to issues related with the consumption of these products, the prices of cigarettes will continue to rise, which should also lead to lower demand. In addition to this, greater awareness of the health consequences has led to lower demand. We have factored in a declining cigarette market in terms of sales volumes for Altria.
Marketing Restrictions Can Deteriorate Brand Equity
Strong brand loyalty and the addictive nature of cigarettes have largely been responsible for a low price elasticity of demand for cigarettes. In one case last year, a federal judge ordered tobacco companies to say in product warnings that the industry deceived the public about the dangers of smoking and manipulated tobacco products to increase addiction. 
The Food and Drug Administration has also implemented several restrictions on cigarette marketing and advertising, including:
- prohibiting the sale of cigarettes in vending machines, self-service displays, or other impersonal modes of sales, except in very limited situations;
- prohibiting sampling of cigarettes;
- prohibiting cigarette brand name sponsorships; and
- prohibiting non-tobacco gifts or other items in exchange for buying cigarettes.
As the brand value of cigarettes deteriorate, prices rise and smokers choose to quit smoking, we feel that raising prices could become increasingly difficult. This could potentially mean a faster rate of decline in cigarette volume in the U.S. than what we have factored already. For example, in a scenario where cigarette volumes fell 15% beyond our estimates to 200 billion sold annually in the U.S., this would lower our price estimate by 10%.Notes: