Pricing of Tobacco Products

curring pattern and were therefore modeled as
unusual events. The result of the use of interven-
tion analysis was a substantial improvement in
the quality control statistics for tobacco prod-
ucts and cigarettes, versus the contro! statistics
with no prior adjustment for x-11 ARIMA/80.2
The evolution in 1991 to a pattern where price
increases were spread over more than 1 month
at a time led to a decision to add another sea-
sonal shift, from December to November, be-
cause now there were 2 consecutive years marked
by strong November price advances. Interven-
tion analysis continued to be used in later years,
but with a deterioration in the quality of all re-
sults, as the trend towards less stable seasonality
and greater random patterns became more estab-
lished. The previous step pattern with price in-
creases at certain, more-or-less definite times of
the year has given way to a pattern of changes
set more by competition than by the calendar.

Control statistics. Table A-1 provides informa-
tion and statistics regarding seasonal adjustment
for the cigarettes index during the 1991-94 pe-
riod. The statistics for each year list the time in-
terval analyzed, the control statistics for the
X-1 1 ARIMA/80 (no prior adjustments) and those
Telated to the “with prior adjustment” model se-
lected. This model is derived from Intervention
Analysis Seasonal Adjustment methods, which
uses X-11 ARIMA/80 as a starting point. Various
models and time intervals are tested to see which
produces the best statistical results and best
matches expectations of future price change for
the index. Testing and analysis generally occur
soon after the December indexes are available,
so that a model and factors for the next year are

Footnote to the appendix

ready for use before the January index release
for that year. The data in table A-1 are for the
cigarette index, but in most cases the numbers
and trends for the tobacco products index are
identical or close.

The PPI has various guidelines or thresholds
that the preceding tests are expected to meet be-
fore the index is seasonally adjusted when using
Intervention Analysis Seasonal Adjustment.
These thresholds are as follows: The F-statistic
for stable seasonality should be greater than 7;
the F-statistic for moving seasonality should be
less than 3; and the M, and Q statistics should
each be less than 1, These are general guidelines,
and exceptions are made for statistics that are
borderline (for instance, an index with an F-sta-
tistic less than 7 may be seasonally adjusted when
other circumstances are weighed).

Obviously, use of Intervention Analysis Sea-
sonal Adjustment has improved the control sta-
tistics from what they would have been using
standard X-11 ARIMA/80 in each of the 4 years
listed in table A-1. It is also obvious that as the
magnitude and timing of price changes have
shifted over the last several years, the quality of
X-1] and Intervention Analysis Seasonal Adjust-
ment has been dropping, especially for the last 2
years. If the pattern continues to shift and change
in 1994, the control statistics may continue to
fall near or below the thresholds discussed above.
What model to use for 1995, or whether to sea-
sonally adjust the tobacco products and cigarette
indexes, will be based on the control statistics
for the best model available and other factors,
such as what the future seasonal pattern is ex-
pected to be relative to current and past index
data.

"James A. Buszuwski and Stuart Scott, “On the Use of
Intervention Analysis in Seasonal Adjustment,” paper pre-
sented at the asa Section on Business and Economic Statistics,
1988; and Buszuwski and Scott, “Some issues in Seasonal
Adjustment when Modeling Interventions,” paper presented at
the asa Section on Business and Economic Statistics, 1993.

16 Monthly Labor Review December 1994

? x-11 arima/80 with no prior adjustments (no interven-
tions) generates seasonal factors that are similar, but not
identical, to those for Census x-11.A direct comparison with
Census x-11 control statistics is not possible, because this
index series was removed from the production system that
generates seasonal factors using Census x-11 methodology.



total production costs in 1990 than in 1980, both
in absolute and relative terms. What did expand
from 1980 into the 1990’s were advertising costs®
and, even more, gross markup. Gross markup is
defined here as the remaining value of shipments
of the industry after subtracting the industry’s
major costs of doing business listed above. Most
of this is revenue to the industry before taxes,
and a small portion is other expenses such as util-
ity, rent, and miscellaneous expenses, not defined
in the Bureau of Census or Federal Trade Com-
mission reports. Gross markup in 1990 accounted
for $15 billion of the shipment value of cigarettes,
compared with $10 billion for all other costs as-
sociated with cigarettes, including advertising
costs.® (See chart 3; all figures exclude excise
tax payments.)

As would be expected, the increase in prices
charged by the cigarette manufacturers to whole-
salers is the single most important factor explain-
ing the concurrent rise in retail cigarette prices.
This disputes media accounts that often explain
rising cigarette prices as resulting primarily from
tax increases. While taxes on cigarettes steadily
increased over the duration of this study, they
actually represent a smaller proportion of the
average retail price in 1993 than they did in 1980,
(See chart 4.)

According to data published by the Tobacco
Institute, the average retail price for a pack of
cigarettes in 1980 was about 63 cents, with 21
cents, or 33 percent, being excise taxes. By 1993,
the average price for a pack of cigarettes had risen
to about $1.70, which included a little less than
53 cents, or 31 percent, in excise taxes. In 1992
(prior to the Federal excise tax increase and the
sharp price decreases among manufacturers that
occurred in 1993), excise taxes accounted for
only about 25 percent of the average price for a
pack of cigarettes, well below their historical high
of 51 percent in 1965.7

Domestic cigarette production

Even as the value of shipments for cigarettes was
more than doubling from 1980 into the 1990's,
and as gross markup expanded several times, the
total number of cigarettes produced in this coun-
try remained remarkably constant at around 700
billion per year.’ (See chart 5.) This stability
marked a balance between two offsetting mar-
ket phenomena: (1) a 35-percent drop in per
capita consumption of cigarettes in the United
States over the 1980-93 period, and a 24-per-
cent decline in total consumption, reflecting an
intensive campaign to educate current and po-

Chart 3. Components of value of shipments for cigarettes and changes in the components, 1980-90

Billions Billions
of dollars of dollars
30 3

L 1 Materials Labor

1980

1981 1982 1983

Wi Capital O Advertising Ill Gross Markup

1964 1985 1986 1987 1988

1989

1990

SOURCES: Report to Congress for 1990 Pursuant to the Federal Cigaratte Labeling and Adverrtising Act (U.S. Federal Trade Com-
mission, 1992); and U.S. Department of Commerce, “Preliminary Report for Tobacco Products," Census of Manufactures, 1992.

Monthly Labor Review December 1994. 7



Pricing of Tobacco Products

This type of change, in which producers ad-
just their prices in the same month and at regular
intervals is often termed a “step pattern.” A chart
of the PPI index for cigarettes showing sizable
increases at regular intervals with little or no
changes for the months in between resembles the
steps on a staircase. (See chart 7.) Also, the CPI
for tobacco and smoking products in chart 2 re-
veals a subtle step pattern. This is because the
PPI reflects the full impact of a manufacturer’s price
increase in a single month, while the CPt captures
such increases over a span of 2 to 3 months, as they
work their way through the producer-wholesaler-
tetailer-consumer pipeline. The pattern in the CPI
is also less distinct, because not all retailers pass
the price increases to consumers and because manu-
facturers’ price increases will always have a smaller
effect on the CPI because the CPI collects prices that
include excise and sales taxes.

The January and July step pattern continued
through July 1987. The next major price hike was
implemented, not in January as previous experi-
ence would have projected, but in December
1987.The price hike that followed occurred in
July 1988 in accordance with the older pattern.
Subsequent price increases over the next 2 years
shifted to a December and June pattern instead
of the previous January and July standard.

During 1991, the seasonal pattern of price
change shifted again, in two respects: (1) pro-
ducers raised cigarettes prices three times that
year, not twice; and (2) producers spread each
of those three price boosts over a 2-month pe-
riod. During the 1983-87 period, when one of
the price leaders for cigarettes announced a boost,
all other producers would normally follow within
a week. But in 1991, there were 6 months in
which the ppt for tobacco products jumped |
percent or more: a spring increase in March and
April, a midyear increase in June and July, and a
late autumn advance over November and Decem-
ber. Producers would, at times, announce and
implement price increases immediately; at other
times, they would defer increases for up to 2
months, using special rebate or “buy-in” programs.

In 1992, cigarette producers again raised their
prices in the spring, spread out over 2 months,
but starting a month later than in the previous
year (April and May in 1992, versus March and
April in 1991). For the first time since 1981, there
were no price increases in June or July. Then, in
August, there was a large price decrease for the
first time since early 1983, as producers made
significant cuts in prices for their discount ciga-
rettes. Following this, a price increase was split
between November and December.

Chart 7. The Producer Price Index for cigarettes, January and July of 1983-91

Index level Index level

(1982 = 100) (1982 = 100)
300 300
250 [|- 7] 250
200 -| 200
150 | 150
100 1983 1984 1985 7986 1987 1988 1989 7990 100
NOTE: The January-July pattern of price increases changed to December-June beginning in 1989. Data are not seasonally adjusted.

12 Monthly Labor Review December 1994



Chart 5. Domestic consumption and exports of cigarettes, 1980-93

Billions Billions
of cigarettes of cigarettes |
800 800

@ Domestic consumption EI Exports 7

700 700
600 600
500 500
400 400
300 300
200 200
100 100

t)

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

SOURCES: Bureau of Alcohol, Tobacco and Firearms; and Bureau of the Census.

When demand for a product is highly respon-
sive to price change (that is, when the percent-
age change in quantity demanded exceeds the
percentage change in its price), the price elastic-
ity of demand for that product exceeds 1.0, and
the demand curve is termed elastic at that point.
Conversely, if the price elasticity of demand for
another product is less than 1.0, demand for that
product is considered inelastic (price changes do
not induce a proportionate change in quantity
demanded).!!

Producers confronted by an inelastic demand
for their products have an incentive to raise prices
until they reach a point where demand drops so
much that price hikes result in less net revenue;
at this point, demand becomes elastic. Even
though domestic demand for cigarettes has fallen
somewhat since 1980, the 24-percent drop in to-
tal cigarette consumption has been more than
matched by the 223-percent jump in retail prices,
and the 207-percent rise in producer prices.
Clearly, this indicates that demand for cigarettes
has been inelastic.

One of the dangers to producers in such a
market, short of reaching that point of consumer
tesistance, is that the high profits generated by
the excess of unit revenue over unit cost might
attract added competition. New producers might

undercut established producers by offering prod-
ucts at a lower price that is still sufficient to se-
cure profitability. This has not occurred in the
cigarette industry because effective barriers to
entry do exist. The barriers consist primarily of
the massive advertising expenditures necessary
to achieve some level of brand recognition and
the huge capital expenditures necessary to
achieve the production efficiency scale enjoyed by
the six major domestic cigarette manufacturers.
Several attempts have been made to estimate the
price elasticity of demand for cigarettes in the
United States; the results of some of the more re-
cent studies are shown in the following tabulation!

Price elasticity

Author and date estimates
Baltagi and Lexin (1986) . 0.215
Porter (1986) ....... seseesee 0,051 to 0,290
Baltagi and Goel (1987)..... 0.114 to 0.917
Kao and Tremblay(1988) 0.495 to 1.019
Russo (1989) .... 0.573
Chaloupka (1991) bb eeeeeae 0.27
Wasserman, Manning, Newhouse,

and Winkler (1991) ........... 0.283

Becker, Grossman, and
Murphy (1994).......... 0.4 (short-run)

"0.75 (long-run)

Monthly Labor Review

December 1994 9



Pricing of Tobacco Products

tential smokers about the health problems asso-
ciated with cigarettes; which was offset by (2) a
rise in foreign sales of American-made cigarettes.
The number of cigarettes exported surged from
82 billion in 1980 to 195.5 billion in 1993, a jump
of 138 percent.? Japan, Southeast Asia, and West-
ern Europe provided the principal expanding
markets for American-made cigarettes in the
1980’s; in the 1990’s, growth has focused on
Latin America, Eastern Europe, most countries
of the former Soviet Union, and the Middle
East,!°

Exports were excluded from the PPI for to-
bacco products until December 1982. Since then,
exports have been eligible for inclusion in the
PPI, as this was the date for the phase-in o'
dustry-based Standard Industrial Classification
(SIC) indexes that include all domestic produc-
tion. However, there were no export prices in the
cigarette index through June of 1994. Three fac-
tors led to the dearth of exports in the cigarette
index:

© The relatively low volume of production for
export versus production for domestic con-
sumption when the first samples of products
were collected in 1982 and 1988. Exports were
10.6 percent of total production volume for

1982 and 17 percent for 1988. This share rose
to nearly 30 percent in 1993, and tobacco ex-
ports were included in the sample of products
introduced in July 1994.

Reluctance on the part of producers to give,
and Bureau of Labor Statistics analysts to ac-
cept, intracompany prices based on cost of pro-
duction for use in the index. Some producers
transfer sales for export to overseas divisions
of their company at the cost of production. But,
as is evident in chart 3, the pricing of ciga-
rettes by producers since 1982 has had little to
do with costs.

Confidentiality concerns of the producers. Be-
cause producers consider sales for export to
be more price competitive, they are often wary
of releasing such information.

Demand—elastic or inelastic?

The price elasticity of demand is defined as the
percentage change in quantity demanded divided
by the percentage change in price. When price
elasticity is equal to 1.0, the demand curve for
that product is said to exhibit unitary elasticity;
in this instance, the percentage change in price
is equal to the percentage change in quantity sold.

Chart 4. Average price and excise taxes per pack of cigarettes, 1980-94
Dollars Dollars
per pack per pack
2 2
1.75 + 1.75
155 4415
Average price
1.25 + 4 1.25
tr 41
0.75 F > 0.75
06 + Excise taxes + 05
0.25 F- + 0.25
0 L 1 1 L 1 1 1 1 1 1 1 1 1 1 °
1980 1981 1962 1983 1964 1985 1986 1987 1988 1989 1990 1991 1992 1993
SOURCE: Data are from the Tobacco Institute.

8 Monthly Labor Review December 1994



Chart 6. The "discount" segment share of cigarette sales by volume, 1984-93

Percent of U.S. Percent of U.S.
cigarette market cigarette market
40 40
30 4 90
2b 4 2
tob 4 10

o 1 1 1 1 1 1 1 J 1 1 0

1984 1985 1986 1987 1988 1989 1990 1901 1992 1993

SOURCE: John C. Maxwell, The Maxwell Consumer Report, Aug. 9, 1994.

and to 36.8 percent in 1993. Chart 6 shows the sales
growth of the discount segment since 1984,'6

By mid-1992, the percentage difference be-
tween prices for brands in the discount segment
and the premium segment had narrowed. (The
manufacturers raised cigarette prices six times
in 1990 and 1991; prices for premium brands rose
about 25 percent while prices for discount brands
jumped nearly 40 percent.'’) In response, some
manufacturers cut their prices on several discount
brands in mid-1992. That adjustment caused a
large drop in the August 1992 ppt for cigarettes
and slowed the increase in this index to 7.0 per-
cent for the entire year. The price cut also muted
the 1992 increase in the CPI for tobacco and
smoking products. Up to this point, wide-scale
cigarette price reductions of this sort were un-
precedented. But, as events in 1993 unfolded, the
1992 price decrease for discount brands was a
foreshadowing of additional major changes in the
cigarette market.

By the second quarter of 1993, the discount
segment’s market share by volume soared past
40 percent, forcing the major producers to do
something to save their more profitable premium
brands from extinction. They responded by low-
ering prices on their premium brands. Coupon
discount and rebate programs were first an-

nounced in April 1993 for selected major pre-
mium brands. Producers eventually decided that
they could not retain their premium brand mar-
ket shares unless they dropped prices of all pre-
mium products. The price decrease to wholesal-
ers for premium cigarettes was announced and
implemented in late July 1993, causing the large
drop reflected in the August 1993 Pri for tobacco
products. Thus far, the strategy seems to be
achieving its goal—by the second quarter of
1994, the discount segment’s share of the mar-
ket had fallen to 32 percent.

Seasonal patterns of price change

Prior to 1983, changes in the Producer Price In-
dex and the Consumer Price Index for tobacco
products occurred at relatively random intervals
and at different times of the year, with little con-
sistency from year to year. Beginning with July
1983 data, however, a distinct seasonal pattern
emerged as the indexes regularly made substan-
tial advances in January and July of each year.
The PPI policy is to use the prices of the Tuesday
of the week that contains the 12th of the month.
Some of the price increases in this period oc-
curred late in June and December, so the PPI did
not reflect them until the following month.

Monthly Labor Review December 1994 11



Craig Howell,
Frank Congelio,
and

Ralph Yatsko

Craig Howell is an

economist formerly with
the Division of Industrial
Prices and Price Indexes,

Bureau of Labor Statistics;

Frank Congelio is an
economist in the Division
of Consumer Prices and
Price Indexes; and Ralph
Yatsko is an economist in
the Division of Industrial
Prices and Price Indexes,

Pricing practices for

tobacco products,

1980-94

An analysis of producer and consumer

price indexes reveal that escalating
prices for cigarettes cannot
be attributed to higher input costs

consumer price indexes for tobacco prod-

ucts accelerated throughout the 1980's. In
1991, the indexes began to slow, and in 1993, the
Producer Price Index (PPI) for tobacco products
dropped nearly 25 percent in just 1 month, and the
corresponding Consumer Price Index for All Ur-
ban Consumers (Cp!) fell nearly 6 percent. Since
then, tobacco prices have been relatively stable.

An analysis of price indexes over the 1980-94
period reveals that the price i es for tobacco
products did not result from higher manufacturing
input costs. What factors, then, drove tobacco prod-
ucts and, specifically, cigarette prices up?

This article sheds light on the price movements
of tobacco products by looking at the pricing
strategies of the U.S. tobacco industry, because
prices for tobacco products have become a ma-
jor factor in the swings in the inflation rate. The
analysis focuses on movements of prices for ciga-
rettes, given that cigarettes account for 80 per-
cent to 90 percent of both the CPi and the PPI for
tobacco products, and because prices for ciga-
rettes have been far more volatile than prices for
other kinds of tobacco products.

Te Bureau of Labor Statistics producer and

Price trends

For more than a decade, prices for tobacco prod-
ucts have behaved quite differently from prices
in the overall economy. While prices for most
items in both the cpl and the PPI have risen mod-
erately since 1980, prices for tobacco products

climbed rapidly throughout the 1980’s and into
the 1990s, and then fell sharply in 1993. Each
year of the 1987-91 period, for example, the PPI
for tobacco products advanced between 12.5
percent and 13.5 percent a year, while price
movements in the broad-based Pri for Finished
Goods ranged from 5.7 percent in 1990 to ~0.1
percent in 1991. During the same period, in-
creases in the CPI for tobacco and smoking prod-
ucts ranged from 7.9 percent in 1987 to 14.7 per-
cent in 1989, while the broad-based cpt for All
Items moved up 4.5 percent a year, on average.
By December 1991, the level of the PPI for to-
bacco products had reached 267.2 (1982 = 100),
compared with 121.9 for the per for Finished
Goods. That same month, the CP! for tobacco and
smoking products reached 211.7 (1982-84 = 100);
the CPI for All Items was 137.9. (See chart 1.)
More recently, the price trend for tobacco
products moderated, and then reversed. In 1992,
the increase in the PPI for tobacco products
slowed to 6.7 percent, barely half as much as its
199} advance. The deceleration of the CPI for
tobacco and smoking products was somewhat
slower, moving from 11.1 percent in 1991 to 8.1
percent in 1992. Then, in mid-1993, reflecting a
decline in the wholesale price for some cigarettes,
the pp for tobacco products dropped nearly 25
percent in just | month. For 1993, this index was
down 22.4 percent; the corresponding CP! fell 5.9
percent. (The CPi decrease was smaller because
a boost in Federal excise taxes on cigarettes at
the beginning of the year offset part of the pro-

Monthly Labor Review December 1994 3


Pricing of Tobacco Products

When raw data for tobacco products showed
no change in May, the seasonal adjustment fac-
tors translated this into a substantial advance.
Conversely, when raw data for June also showed
no change, the seasonally adjusted tobacco prod-
ucts index slumped 2.7 percent because the nor-
mal midyear seasonal pattern failed to material-
ize. Largely as a result of this considerable drop,
the index for finished goods other than foods and
energy edged down 0.1 percent in June, vindi-
cating the perspective that the May uptick was a
statistical fluke. Thus, still reflecting the steep
drop in the August 1993 tobacco products index,
the PPI for finished goods other than foods and
energy in June 1994 was merely 0.6 percent
higher than its level of a year before. This over-
the-year change, which remained below | per-
cent for a full 12 months, automatically jumped
in August 1994, once the drop from July to Au-
gust 1993 no longer affected this calculation.

Footnotes

THE RESURGENCE of competitive forces that led
to the unprecedented rollback in cigarette prices
in 1993 and that ended the pattern of periodic
large price advances is all the more remarkable
in that it occurred without the emergence of new
competitors. Instead, the pricing revolution was
accomplished by the same six companies that
have dominated the domestic cigarette industry
for many years. The collapse of pricing practices
of the cigarette industry has reduced, for the time
being at least, what had been a significant source
of inflationary pressure in the consumer and pro-
ducer price indexes. The shifts in cigarette pri-
cing practices that have occurred for each of the
last 5 years (the drop in prices in 1993 being the
most dramatic, of course) also invite discussion
on whether even flexible seasonal adjustment
methods such as Intervention Analysis Seasonal
Adjustment can continue to be used to season-
ally adjust indexes for tobacco products.

' Tobacco Tax Guide (as of October 1,194] (New Jersey,
Tobacco Merchants Association of the United States, 1994),

? The Tax Burden on Tobacco (Washington, oc, The
Tobaccco Institute, Vol. 28, 1993), table 13-B, p. 118.

John C. Maxwell, The Maxwell Consumer Report, July
6, 1994 and Aug. 9, 1994,

* U.S. Department of Commerce, Preliminary Report for
Tobacco Products,” Census of Manufactures, 1992,
table 1, p. 3.

5 Report to Congress for 1990 Pursuant to the Federal
Cigarette Labeling and Advertising Act (U.S. Federal Trade
Commission, 1992), tables 3A-3D, pp. 22-25.

6 “Preliminary Report for Tobacco Products.”

” The Tax Burden on Tobacco, tables 13,13-B, pp. 86-
118,

5 U.S. Tobacco Statistics, 1935-1992 (U.S, Department
of Agriculture, 1992), table 1, p. 13; and Tobacco Situation
and Outlook Report (U.S. Department of Agriculture, June
1994), table 1, p. 4,

9 US. Tobacco Statistics, 1935-1992.

'© U.S. International Trade Commission, compiled from
official statistics of the U.S. Department of Commerce.

"' Edgar K. Browning and Jacquelene M. Browning,
Micoreconomic Theory and Applications (Little, Brown &
Company Limited, 1983), pp. 86-89.

APPENDIX:

'? Authors listed in the tabulation are cited in Gerard G.
Russo, “An Optimal Cigarette Tax” (Ph.D. diss., Northwest
ern University, 1989), table 14; for the last two citations,
see Gary S. Becker, Michael Grossman, and Kevin M.
Murphy, “An Empirical Analysis of Cigarette Addiction,”
American Economic Review, June 1994, pp. 396-418; and
Jeffrey Wasserman, Willard G. Manning, Joseph P.
Newhouse, and John D. Winkler, “The Effects of Excise
Taxes and Regulations on Cigarette Smoking,” Journal of
Health Economics, May 1991, pp. 43-64.

'3 Becker, Grossman, and Murphy, “An Empirical Analy-
sis of Cigarette Addiction.”

'4 John Bloom, American Cancer Society, compiled from
data gathered by Centers For Disease Control and Preven-
tion, Office on Smoking and Health.

'S The Maxwell Consumer Report.
\6 The Maxwell Consumer Report.

"7 Tobacco Situation and Outlook Report (U.S Depart-
ment of Agriculture, September 1994), tables 5~6, pp. 6-7.

'® See James A. Buszuwski and Stuart Scott, “On the Use
of Intervention Analysis in Seasonal Adjustment,” paper
presented at the asa Section on Business and Economic Sta-
tistics, 1988; and James A. Buszuwski and Stuart Scott,
“Some Issues in Seasonal Adjustment when Modeling In-
terventions,” paper presented at the Asa Section on Busi
ness and Economic Statistics, 1993.

Intervention Analysis Seasonal Adjustment in the Prt

The standard method for seasonal adjustment of
time series data in the Producer Price Index sys-
tem, the X-11 program developed by the U.S.
Bureau of the Census, is not suitable when the
timing of price movements changes as abruptly
from year to year as it has for tobacco products,
While the conventional x-11 seasonal adjustment
program does adapt to changes in seasonal pat-
terns over time, this adaptation is slow. BLS has
therefore employed Intervention Analysis Sea-

14 Monthly Labor Review December 1994

sonal Adjustment methods to accelerate the ad-
aptation of seasonal factors to the seasonal shifts
described above.'

By 1987, the large January and July move-
ments that had become the pattern for the PPI for
tobacco products since 1983 were firmly en-
trenched in X-11 seasonal factor calculations.
When the pattern of price increases switched to
a December and June pattern of price increases
in place of the previous January and July pat-



In 1993, producers implemented a price in-
crease in April, but several producers announced
substantial discounting programs for their lead-
ing premium brands that same month. Despite
this much-publicized announcement, producers
did not report actual price decreases to BLS for
several months, and those they reported were
fairly small in magnitude. In late July (too late
to be reflected in July pri data), producers slashed
their prices to wholesalers for all brands except
their deep discount brands. The result was a large
drop in the August PPI for Finished Goods that
was curiously unanticipated by many analysts,
even though the news of the steep cigarette price
cut had been widely reported both in the general
media and in the trade press. A modest price in-
crease at the close of 1993 occurred entirely in
the December data and thus was not spread over
2 months.

In the first 6 months of 1994, the PP! for to-
bacco products inched up in January and then
remained unchanged through June. For the same
period, the CPi for tobacco and smoking prod-
ucts rose modestly (2.4 percent). Many tobacco
analysts believe that cigarette producers are hold-
ing the line on prices as they evaluate the long-
term effect of the large price decrease for pre-
mium brands implemented in 1993. Also, the
uncertainty of congressional action on increas-
ing the Federal excise tax on cigarettes is con-
tributing to the wait-and-see posture.

Interpreting seasonal adjustments

The PPI and CPI indexes are seasonally adjusted
based on their historic pattern of price change.
In January, the PPI and the CPI calculate seasonal
factors for each month of the upcoming calen-
dar year that are used to calculate the seasonally
adjusted index. The unadjusted index is divided
by the seasonal factor previously calculated for
that month to derive the seasonally adjusted in-
dex. For tobacco products, the seasonal pattern
traditionally had been much stronger in the PPI
than in the CPI, because the price changes in the
PPI were of a higher magnitude and occurred in
1 or 2 months, while changes in the CPI were of
a smaller magnitude and were spread over more
months. The shift in the step pattern that began
to occur in 1987 had a more profound effect on
the PPI, so the following discussion is primarily
on this index.

The traditional method of seasonally adjust-
ing the PP! adapts slowly to sudden shifts in pric-
ing patterns, so instead of smoothing the seasonal
pattern, the first shift in the step pattern caused
the seasonally adjusted index to spike upward
for the months it shifted to, and fall for the
months it shifted from. For example, in 1989,

tobacco products increased 5.0 percent in June
and 0.6 percent in July before seasonal adjust-
ment. The seasonally adjusted figures published
initially for these months were 5.4 percent and
~2.5 percent. Due to the relative importance of
tobacco products, such large changes had an ef-
fect on higher level indexes as well. Once this
new pattern began to establish itself, the PPI be-
gan to explore the use of Intervention Analysis
Seasonal Adjustment modeling to cope with the
problem of slow adjustment to the new pattern.'®
Seasonal factors based on Intervention Analysis
Seasonal Adjustment modeling were introduced
in January 1991. In that year, and in each year
that followed, the pattern of price change for pro-
ducers continued to shift. (See the appendix for
a detailed explanation of Intervention Analysis
Seasonal Adjustment modeling used for the to-
bacco products index in the PPI.)

Properly interpreting recent monthly changes
in seasonally adjusted data for the PPI for tobacco
products requires an appreciation of how shifts
in pricing patterns have affected the seasonal ad-
justment process. An example can be found in
May and June 1994 data:

There was no change in the PPI for tobacco
products before seasonal adjustment in ei-
ther May or June. However, on a season-
ally adjusted basis, the tobacco products
index climbed 1.9 percent in May. This ad-
vance, in turn, was one of the principal fac-
tors behind the 0.4-percent rise in the
closely followed PP! for finished goods other
than foods and energy, which had risen only
0.1 percent in each of the 3 immediately pre-
ceding months.

Because of the role of tobacco products, BLS ana-
lysts downplayed the significance of this seem-
ing uptick in the underlying rate of inflation.
Seasonal adjustment factors for tobacco products
currently decline considerably from April to May,
but then more than recover from May to June.
This pattern is the result of the sizable midyear
price increases that had occurred in earlier years.

If the seasonal factor declines from one month
to the next, and if the index before seasonal ad-
justment is unchanged, then the seasonally ad-
justed index would increase in roughly inverse
proportion to the drop in the seasonal factors. A
month-to-month increase in the seasonal factor
has the opposite effect. If the unadjusted index
for June had increased according to its normal
midyear seasonal pattern, the higher seasonal
factor used for June would have produced a sea-
sonally adjusted change that is less than the un-
adjusted change. But change due to the “non-
seasonal” components of the index would
remain.

Monthly Labor Review December 1994

13



10 Monthly Labor Review

Pricing of Tobacco Products

Nearly all of these estimates are well below 1.0;
in fact, most are below 0.5, pointing to unusu-
ally inelastic demand. In the most recent study,
Becker, Grossman, and Murphy estimate the
short-run elasticity of demand for cigarettes at
about 0.4, consistent with most other analyses. '?
They, unlike most of their colleagues, derived
an estimate for the long-run elasticity of demand,
which they put at 0.75. In other words, if ciga-
rette prices rise 10 percent, cigarette consump-
tion can be expected to drop 4 percent initially,
and eventually fall 7.5 percent.

The generally low responsiveness of consumer
demand for cigarettes to price changes, at least
in the short run, largely explains why cigarette
manufacturers were able to keep raising their
prices so sharply for so long. While no single
answer fully explains why the demand for ciga-
rettes is so price inelastic, two are offered: First,
because no real comparable substitute product
exists for cigarettes, consumers cannot switch to
another relatively less expensive product, and still
achieve the same level of utility derived from
consuming cigarettes; second, although the is-
sue of whether the amount of nicotine delivered
by currently marketed cigarettes leads to addic-
tion has not been definitively settled in scien-
tific terms, the data on smoking cessation rates
may provide useful anecdotal information. The
Centers for Disease Control report that in 1990
(the most recent year for which data are avail-
able), about 46 million Americans smoked. About
15 million of them tried to quit in 1990; 1.15
million, or 7 percent, were successful.'*

Pricing practices for cigarettes

Until 1980, virtually all cigarette brands in the
market were termed “premium” or “full margin”
brands. The prices for cigarettes from producers
were fairly uniform across all brands. There was
some price variation for length, filter versus
nonfilter, and menthol versus regular, but these
differences were relatively small and generally
Teflected the differences in input and manufac-
turing costs. For these premium brands, top qual-
ity tobaccos were used, and these brands were
promoted by the producer through all normal
channels of marketing (billboards, newspapers,
magazines, direct mailings, and so forth). In this
environment, producers vied for market share
solely through advertising and marketing cam-
paigns. Brand image, not price, differentiated the
products, and thus defined the consumer’s choice.

Competition on this basis favored the largest
companies with the most money and resources
to devote towards advertising campaigns; as a
result, smaller producers steadily lost market
share. In 1980, the smallest of the six major U.S.

December 1994

cigarette manufacturers, Liggett Group Inc., intro-
duced the first plain label, or “generic” cigarettes.
These cigarettes were sold in simple black-and-
white packages with names such as “Flavor Lights”
and sold for approximately 25 percent to 40 per-
cent less than premium brands. Consumers now
had a new way to choose cigarette products—price.
With this move, Liggett established a second, lower
priced “discount” segment in the cigarette market,
and thus began the ongoing cigarette price war.

During the early to mid-1980’s, sales of ge-
neric cigarettes grew at a rather slow pace. Then
in 1984, the second shot of the cigarette price
war was fired. RJ Reynolds, the second largest
cigarette producer, introduced another category
of cigarettes into the discount segment. These
so-called branded discount cigarettes cost less
than premium cigarettes, but more than generic
cigarettes. For the most part, branded discount
cigarettes were repositioned as premium brands,
so they had more “traditional” packaging and
advertising budgets. The larger producers under-
stood that sales of discount brands were canni-
balizing sales of their more profitable premium
brands. Therefore, the larger manufacturers
sought to position branded discount cigarettes
to compete directly against generics and not
against premium brands. The branded discount
cigarettes were an attempt by the larger cigarette
manufacturers to capitalize on the growing num-
ber of price-conscious consumers while offer-
ing them some semblance of image or brand rec-
cognition. It was also true that branded discount
cigarettes provided a greater profit margin than
generic cigarettes and that, because some adver-
tising was done for these brands, competition was
not limited to price, thereby again giving the
larger producers a competitive advantage over
their smaller rivals. The volume of discount ciga-
rette sales—branded discount and generic ciga-
rettes—gradually increased until it reached 15
percent of all cigarette sales in 1989.'5

Then, in 1989, Liggett, the industry’s small-
est producer, again countered the larger manu-
facturers by introducing an additional brand cat-
egory into the discount segment. Their “Pyramid”
brand established the new bottom rung on the
cigarette price ladder, creating the “deep dis-
count” category. Brands in this category sold for
even less than generic cigarettes. The once mono-
lithic cigarette market had been broken into two
segments based on price: premium and discount.
Within the discount segment, three price catego-
ries of brands existed; in descending order of
price they were: branded discount, generic, and
deep discount. From 1989 forward, the volume
sales of the discount segment grew sharply: its
market share increased to 19.2 percent in 1990,
to 25 percent in 1991, to 30.2 percent in 1992,



Pricing of Tobacco Products

Table 1. Relative importance of tobacco products in the
Consumer Price Index for All Urban Consumers (cP!)
and the Producer Price Index (PPI), 1980-93
corey PPI
Year Finished

All Items Core Goods Core
1980 . 1.05 1.47 1.50 2.31
1981. 1.04 1.44 1.53 2.34
1982 1.39 2.02 2.19 3.47
1983... 1.47 2.412 2.12 3.31
1984 1.49 2.13 2.04 3.19
1985 ..... 1.54 2.19 2.21 3.51
1986 . 1.61 241 2.33 3.58
1987..... 1.29 1.69 2.64 4.09
1988 1.35 1.76 2.86 4.38
1989 1.49 1.94 3.12 4.81
1990 1.54 2.04 217 6.32
1991 1.87 247 2.85 4.44
1992 . 1.75 2.27 3.08 4.84
1993... 1.60 2.07 237 372

able drop in the price of tobacco products.

As shown in table 1, tobacco products are not
as central within the CPI. Over the 1980-92 pe-
riod, the substantial advances in the CPI for to-
bacco and smoking products typically accounted
for 0.1 or 0.2 percent of the annual increases for
the CPI, and 0.2-0.3 percent of the increases for
the core CPI rate. In 1993, the increases in both
the CPI and its core rate would have been 0.1
percent higher if not for the 5.9-percent drop in
the tobacco and smoking products index.

Treatment of taxes

A crucial difference between the Producer Price
Index and Consumer Price Index estimation
methodologies involves the handling of taxes.
The CPI measures changes in average retail prices
for a market basket of goods and services pur-
chased by urban consumers; therefore, CPI data
reflect sales taxes (that is, taxes assessed as a
percentage of the retail price) and excise taxes
(actual dollar amounts per unit assessed on an
item). Conversely, the PPI excludes direct taxes
from its calculation because sales and excise
taxes represent revenues to government rather
than to the producers. This difference in meth-
odology is critical because cigarettes are among
the relatively few commodities (gasoline and al-
cohol are other prominent examples) to have
excise taxes levied against them.

The Federal, State, and several local govern-
ments (such as in New York City) impose excise
taxes on cigarettes. During the 1980-94 period
under review, the Federal excise tax per pack of
cigarettes doubled from 8 cents in 1980 to 16
cents in 1983, and went to 20 cents in 1991, and
most recently, to 24 cents in 1993. During this

6 Monthly Labor Review December 1994

period, the average State excise tax per pack of
cigarettes more than doubled, from about 13
cents per pack to 29 cents. Currently, State ex-
cise taxes range from 2.5 cents per pack in Vir-
ginia to 75 cents in Michigan.'

The inclusion of sales and excise taxes (as well
as wholesaler and retailer margins) in the CPI for
tobacco and smoking products helps to explain
why that index is usually not as volatile as its PPI
counterpart. To illustrate:

In 1993, the average retail price of a pack
of cigarettes was about $1.70; this includes
53 cents in excise taxes (the 24-cent Fed-
eral excise tax and the 29-cent average State
excise tax) and the margin of wholesalers
and retailers.? The average producer price
for cigarettes consumed domestically was
91 cents a pack, excluding all excise taxes.?
If a manufacturer had raised its price by 5
cents, the relative of change used in the PPI
for cigarettes calculation would have ad-
vanced 5.5 percent, representing the change
in the unit price the manufacturer would
receive from a 91-cent price per pack to a
96-cent price. Assuming the full change was
passed through to the consumer without any
markup, the CPI would reflect a change in
the average retail price from $1.70 to $1.75,
an advance of just 2.9 percent. By the same
token, the CPI changes when excise taxes
change, but the ppt is not affected, making the
cPI more volatile in tax change situations.

What drove cigarette prices?

The steep advances in prices charged by ciga-
rette producers since 1980 were not a reaction to
escalating material costs, From December 1979
to December 1993, the Producer Price Index for
leaf tobacco moved up 30.7 percent, far less than
the increases for either producer or consumer
prices for tobacco products. The sharp cut in ciga-
rette prices in 1993 can hardly be explained by
citing the 0.6-percent drop in the leaf tobacco
index that year.

Data from the Bureau of the Census and the
Federal Trade Commission provide further evi-
dence that higher cigarette prices cannot be
chiefly attributed to changing input costs. From
1980 through 1990, the value of shipments for
cigarettes more than doubled, from about $10
billion to more than $25 billion. Material costs
hardly budged during this span, remaining well
below $5 billion each year.* Labor costs also
showed little net change, and, in fact, were over-
shadowed by material costs, a reversal of the rule-
of-thumb that says labor accounts for two-thirds
of all costs in the manufacturing sector. Capital
expenditures accounted for a smaller portion of



ducers’ price cut, and because not all of the
manufacturers’ decline was passed through to the
retail level.) During the first half of 1994, prices
for tobacco products hardly changed in the Ppt
(before seasonal adjustment) and rose only mod-
estly in the CPI. (See chart 2.)

Changing importance. Because tobacco prod-
ucts account for a substantial portion of both the
CPI and the PPI, the sustained record of large price
changes in tobacco products has had a notable
impact on the measures of inflation in the Ameri-
can economy. In December 1980, tobacco prod-
ucts accounted for about 1.5 percent of the weight
of the PPI for Finished Goods. By the end of the
1980’s, they accounted for more than 3 percent
of the weight. The impact of the dramatic mid-
1993 cigarette price cut can be gauged by the
drop in the relative importance of tobacco prod-
ucts in the PPI, from 3.08 in December 1992 to
2.37 in 1993. In the CPI, the shifts in the relative
importance of tobacco and smoking products
since 1980, while not as substantial as that in the
PPI, are still noteworthy, rising from 1.05 in De-
cember 1980 to 1.75 in December 1992, then
retreating to 1.60 by December 1993.

The relative importance of tobacco products
is heightened when the volatile food and energy

components are excluded from the PPI for Fin-
ished Goods and from the CPi for All Items. For
example, the index for finished goods other than
foods and energy accounted for 63.67 percent of
the PPI for Finished Goods in December 1992;
tobacco products accounted for 4.84 percent of
the weight ((3.08/63.67) x 100 = 4.84). By De-
cember 1993, the weight of tobacco products
within this so-called core or underlying rate of
inflation in the pi had declined to 3.72 percent.
Similarly, the CPI for all items less food and en-
ergy accounted for 76.93 percent of the total
weight for the CPI at the end of 1992, and to-
bacco and smoking products accounted for 2.27
percent of the core index; by December 1993, the
relative importance of tobacco and smoking prod-
ucts was down to 2.07 percent. (See table 1.)
Price changes in tobacco products can play
important if not dominant roles in the measure
of inflation. This was demonstrated in 1993,
when the PPI for tobacco products dropped 24.2
percent for the month of August. This single-
month change accounted for nearly all of the 0.8-
percent decline reported in the PPI for Finished
Goods that month, and for all of the 1.1-percent
decrease in the PPI for Finished Goods other than
foods and energy; the core PPI would have risen
slightly from July to August if not for the siz-

Chart 2. Changes in the tobacco component of the Producer Price Index (PPI) and the Consumer Price
Index (CPI) for All Urban Consumers, 1989-93

index change Index change
(percent) (percent)
40 40

30 4 1 1 1 4 1 1 1 1 i 1 L 4 L
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

30

Monthly Labor Review December 1994 5



Pricing of Tobacco Products

Chart 1. Producer Price Indexes (PPI) for Tobacco Products and Finished Goods and Consumer Price
Indexes (CPI) for All Urban Consumers for Tobacco and Smoking Products and All Items,
Index 1980 through first-half 1994

Index
(1982 ~ 100) PPI (1982 = 100)
350
300 - -| 300
Tobacco
250 + Products ~| 250
200 > 200
150 F = 150
100 Finished 4 400
ae Goods
te a = 50
0 ma 4 4 1 1 1 2 1 1 °
1980 1982 1984 1986 1988 1990 1982 1994
Index Index
(1982-84 = 100) CPI (1982-84 = 100)
240 240
220 ~| 220
i" Tobacco and
200 - ‘Smoking Products - 200
180 | 180
L
160 F > 160
140 F 7 140
120 F | 120
100 j- 4 100
80 - ~| 80
6 T | 60
9 1980 1982 1984 1986 1968 ~ 1990 * 1992 1994 0

4 Monthly Labor Review December 1994



Table A-1.

X-11 ARIMA/80 quality contro! statistics

Fatatistics

Item

Stable | Moving

Unusual events"

1991
Span: January 1983-December 1990

No prior adjustments (X-11 anima/80)

With prior adjustments {intervention Analysis
‘Seasonal Adjustments) . :

Intervention Analysis Seasonal Adjustment
model used: LO10011

1992
‘Span: January 1983-December 1991
No prior adjustments (X-11 aRmA/80)

(With prior adjustments (intervention Anatyols
Seasonal Adjustment) .

Intervention Analysis Seasonal Adjustment
model used: LO10111

1993
Span: January 1985-December 1992

No prior adjustments (X-11 anma/80) ......-

With prior agjusiments (Intervention Analysis
Seasonal Adjustment

Intervention Analysis Seasonal Adjustment
model used: L012011

1994
Span: January 1986~-December 1993
No prior adjustments (X-11 anima/80) ........

With prior adjustments (intervention Analysis
‘Seasonal Adjustment)

Ramps:? July 1993-August 1993

Intervention Analysis Seasonal Adjustment

model used: L012011

12.4 1.6 0.686 0.51

97.2 3 200 24

13.3 18 686 Bt

89.5 2 207 28

5.8 19 1.043 a7

34 Es) 2.250 1.16

11.2 16 725 61

6/84, 75/89, 5/90, 711/87, 11/90

6/84, 711/87, 6/89, 5/90, 710/90, 4/91, 5/91

41/87, 5/89, 5/90, 710/90, 5/91, 5/92, 8/92

711/87, *5/89, 5/90, 710/90, 5/91, 5/92, 8/92

‘Dates marked as unusual events are considered one-time occurrences that are not part of a recurring pattern,
? Seasonal shift, that is, a shift of an existing pattern from month to month.
3.4 ramp denotes a one-time “level shift” that occurs for one or several months.

tern, the change could not be adequately reflected
in seasonally adjusted data through conventional
X-11 methodology. As a result, the initially pub-
lished seasonally adjusted indexes for Decem-
ber and June would show increases that were too
large, followed by equally unrealistic seasonally
adjusted decreases in January and July.
Intervention Analysis Seasonal Adjustment
methods, based on the X-11 ARIMA/80, were first
introduced in the calculation of the January 1991
Pp’s for tobacco products and cigarettes. By this
time, price increases had shifted from occurring
solely in January to occurring primarily in De-

cember for 4 consecutive years; the shift from
July to June had been in place for 2 years. Gen-
erally, a pattern shift such as this must be ob-
served for 2 consecutive years before it can be
modeled as a seasonal shift in BLS Intervention
Analysis Seasonal Adjustment methodology. Us-
ing intervention analysis with indexes from Janu-
ary 1983 through December 1990, BLS analysts
determined that seasonal shifts occurred in De-
cember 1987 and again in June 1989. Increases
that were recorded in 3 months—June 1984, May
1990, and November 1990—were judged anoma-
lous, one-time events that were not part of a re-

Monthly Labor Review December 1994

—