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Table of Contents
1. Introduction and overview

1.1 Coverage
1.1 Health consequences of tobacco consumption
2. The impact of price on the demand for tobacco products
2.1 Conventional studies of cigarette demand
2.1.1 Analysis of aggregate data
2.1.2 Analysis of individual level data
2.2 Addiction models and cigarette demand
2.2.1 Imperfectly rational addiction models
2.2.2 Myopic addiction models
2.2.3 Rational addiction models
2.2.4 Critiques of the rational addiction model
2.3 Behavioral economic analyses of cigarette demand
2.4 Econometric studies of the demand for other tobacco products
3. Cigarette and other tobacco taxation
3.1 Comparative standards and the effects of tax on price
3.1.1 Purposes and methods of taxation
3.1.2 Effects of taxes on retail price
3.1.3 Variations in cigarette tax across countries and states
and the issue of smuggling
3.2 Fairness standards
3.2.1 Horizontal and vertical equity
3.2.2 The benefit principle
3.3 Public health standards
3.3.1 The social cost of smoking
3.3.2 The health benefits of increasing cigarette taxes
3.4 Economic efficiency and the pursuit of an optimal cigarette tax
3.4.1 Negative externalities associated with smoking
3.4.2 Other efficiency considerations
4. Advertising, promotion, and the demand for tobacco products

4.1 Theoretical and conceptual issues
4.2 Econometric evidence
4.3 Findings from the non-economic literature
5. Other tobacco control policies and demand

5.1 Health information and counter-advertising
5.2 Restrictions on cigarette smoking
5.3 Limits on youth access to tobacco products
6. Agricultural policy and the macroeconomic implications of tobacco

6.1 Size and nature of the tobacco industry
6.1.1 The global industry
6.1.2 The U.S. tobacco industry
6.2 The impact of the U.S. tobacco agriculture regulatory system
6.2.1 Nature of the system and its impact on tobacco farming
6.2.2 Relevance of the tobacco program to smoking and health
6.3 The contribution of the tobacco industry to the economy
6.3.1 States and nations
6.3.2 Tobacco farm communities
7. Conclusion
References
Economics of Smoking - p. 1
1. Introduction and overview

Historically one of the oldest and most important crops in the United States,
tobacco has become embroiled in the second half of the twentieth century in a struggle
pitting American economic against public health interests. While the tobacco industry
ranks among the most substantial and successful economic enterprises in the U.S., tobacco
products are associated with more deaths than any other product (U.S. Department of Health
and Human Services, 1989, 1998). Tobacco products, and particularly cigarettes, which
account for 95% of U.S. tobacco product sales, are credited with approximately one-fifth
of the nation's annual death toll. Cigarettes cause fully a third of deaths during middle
age. The leading cause of lung cancer and chronic obstructive pulmonary disease
mortality, as well as a major cause of cardiovascular death, cigarette smoking leads all
other causes of death in virtually all industrialized nations. According to an
epidemiological analysis sponsored by the World Health Organization, tobacco will become
the leading cause of death in developing countries during the first third of the 21st
century. By 2030, tobacco will be responsible for 10 million deaths annually worldwide
(Peto et al., forthcoming), a toll that will exceed by far that associated with any other
cause of disease (Murray and Lopez, 1996).
Formal economic analysis of tobacco dates back at least half a century (Tennant,
1950). At that time, most tobacco industry economic analysis was motivated by the factors
that prompted market analysis of any other product or service, such as a desire on the
part of an industry to understand the degree of price elasticity of demand for its
product, or the interest of government and academic economists in the causes and
implications of market concentration. Beginning in the late 1960s, however, following
publication of seminal British and American reports on smoking and health (Royal College
of Physicians, 1962; U.S. Department of Health, Education, and Welfare, 1964), the focus
of economic research shifted from a general industrial organization orientation toward
analysis self-consciously relevant to the public health damage wrought by tobacco. The
subsequent economic analysis has been motivated by a desire to determine how economic
forces influence tobacco consumption, with continuing emphasis on refining the scientific
rigor of the work; but the objective of much of the research is now to determine how to
harness economic forces and logic, how to use economic tools, to decrease smoking, with
the ultimate goal being to reduce the toll of tobacco.1
Certainly the most important example of this phenomenon has been the rapidly
expanding and increasingly sophisticated body of research on the effects of price
increases on cigarette consumption. Because excise tax comprises an important component
of price, the resultant literature has played a prominent role in legislative debates
about using taxation as a principal tool to discourage smoking in individual states, in
the U.S. as a whole, and in numerous other countries as well. In the United States in the
late 1990s, the findings of this literature have been showcased in the intense
congressional debate over whether to adopt comprehensive tobacco control legislation, with
a major price increase lying at the heart of all proposals (Chaloupka, 1998).
1.1 Coverage
This chapter examines in detail economic analysis of the relationships among
taxation, price, consumption, and disease outcomes, as well as considering how analysis
has enlightened other debates about the economics of tobacco. The relationship between
price and cigarette consumption has been the focal point of economic research on smoking,
and the locus of increasingly sophisticated and interesting development of theory and
methodology. For these reasons, and because the resultant literature constitutes the most
important contribution of economics to understanding tobacco policy, this chapter's
principal emphasis is on this body of research. The chapter devotes special consideration
to recent attempts to model nicotine addiction in the context of rational economic
behavior. Borne of a generic interest in the role of addiction in economic behavior, new
theoretical models have received their best empirical testing through the use of data on
cigarette smoking.2
1
Not all of the research is motivated by a desire to decrease smoking. Some authors
express the opinion that more respect should be accorded consumer sovereignty, despite the
issues of addiction and youthful initiation of smoking that have led many economists to
perceive the market for cigarettes as suffering from important market imperfections
(Warner et al., 1995). See, for example, Viscusi (1992) and Tollison and Wagner (1992).
2
As is discussed below, numerous variables other than price influence the demand for
The chapter also considers a variety of equity and efficiency concerns that
invariably accompany debates about cigarette taxation, including the validity of the
externality or social cost argument frequently invoked by the public health community in
calls for higher taxes; whether there are other legitimate grounds in economic theory to
support increased excise taxation; whether cigarette tax increases are regressive, and if
so how much; and whether large tax hikes produce substantial cross-border smuggling of
cigarettes. Recent economic studies have explored subtle impacts of cigarette taxation
that receive attention here as well; for example, cross-price elasticity issues include
how cigarette taxation may shift demand toward other tobacco products, such as smokeless
tobacco, or, within the cigarette family, from lower to higher tar and nicotine
cigarettes.
Coverage in this chapter also includes attention to economic analysis of the role of
advertising in the demand for cigarettes, as well as the role of restrictions or bans on
advertising. The effects of advertising and of advertising and other marketing
restrictions are of special interest due to their prominence in debates about tobacco
control at all levels of government, from municipalities, which have restricted cigarette
advertising on public transit and on billboards, to international bodies, which have
called for complete bans (Roemer, 1993). Although its value is constrained by obvious
limitations, econometric analysis offers insights into the role of advertising, and of
advertising restrictions, on the demand for cigarettes.
The chapter also examines what is known about the influence of other tobacco control
policies on the demand for cigarettes, including the development and dissemination of
information on the health consequences of smoking; media advocacy by means of "counter-
advertising;" the adoption and implementation of laws or policies that limit smoking in
public places; and legal restrictions on youth access to tobacco products.
Given tobacco's role in employment, tax revenues, and, in selected countries, trade
balances, governments have a legitimate interest in the "health" of their tobacco
industries. Tobacco companies tout the industry's economic contribution in attempts to
combat tobacco control policy measures. In recent years, independent economists have
countered the industry's economic argument by carrying out macroeconomic analyses that
examine the net contributions of tobacco to economies, rather than the gross contributions
featured by the industry. This literature, and its role in the debate over tobacco
control policy, are examined toward the end of the chapter. Also considered briefly is
the influence of tobacco agriculture support policies so prominent in the agricultural
policies of the United States and the European Union.
Despite its wide scope of coverage, this chapter does not examine all of the
economic contributions relating to smoking and health. To illustrate with two examples,
the chapter does not consider the growing literature on the cost-effectiveness of smoking
cessation interventions (Cromwell et al., 1997; Warner, 1997) and it omits the newly
emerging and potentially quite important analysis of the economics of the market for
nicotine replacement products (Oster et al., 1996; Hu et al., 1998). Another limitation
on coverage is that we consider almost exclusively English language publications, believed
to comprise a very sizable majority of the peer-reviewed literature. Further, reflecting
the authors' knowledge of this field and familiarity with data, examples draw heavily,
although not exclusively, on the U.S. experience. In particular, there is little coverage
of the economics of smoking in developing countries, the result primarily of the dearth of
studies on the subject. Although specific empirical conclusions from a given country may
not apply precisely to other nations, the general phenomena described and findings
presented should apply qualitatively to all countries, unless otherwise indicated.
Before turning to the economics literature, the remainder of this introductory
section presents a brief "primer" on the health consequences of tobacco use. We deem this
important background for understanding the nature and social significance of the economic
issues.
1.2 Health consequences of tobacco consumption
cigarettes, including consumers' knowledge of the hazards of smoking, parental and sibling
smoking behavior, smoking by peers, role modeling, income, and education (U.S. Department
of Health and Human Services, 1994). The near-exclusive focus of this chapter on price
and taxation reflects the facts that tax is the most policy-tractable variable influencing
the demand for cigarettes and that the economics literature has focused on price,
taxation, and addiction.
The health implications of tobacco have been contemplated for at least the past
millenium. During the first half of that period, the predominant view held that tobacco
afforded users a wide variety of health benefits. The Amerindians employed tobacco as an
analgesic and as a treatment for such diverse ailments as intestinal problems, asthma,
rheumatism, headaches, toothaches, boils, worms, fevers, and the pains of childbirth
(Goodman, 1993).
Serious medical and scientific attention to the health consequences of smoking is a
phenomenon of the present century, primarily of its second half.3 This is a reflection of
the development of the science of epidemiology during this period and of the relatively
modest number of victims claimed by tobacco prior to the 20th century. Before this
century, relatively few people reached the ages at which tobacco takes its greatest toll
(average life expectancy in the U.S. was 47 in 1900; currently it is 75). More
importantly, widespread intensive use of the most dangerous form of tobacco consumption,
cigarette smoking, began only in the very late 1800s. Lung cancer, today the source of
30% of all cancer deaths in the U.S. (U.S. Department of Health and Human Services, 1989),
was a rarity until earlier cigarette smoking spawned the epidemic first widely observed
during the 1930s.
Although a few scientific studies associated smoking with disease prior to mid-
century (Broders, 1920; Lombard and Doering, 1928; Pearl, 1938), the first evidence that
strongly implicated smoking in disease (specifically, lung cancer) was published in the
1950s (Wynder and Graham, 1950; Doll and Hill, 1954, 1956; Hammond and Horn, 1958a,
1958b). Since then, some 70,000 scientific articles have implicated smoking in a wide
variety of ailments, constituting the largest and best documented literature linking any
behavior to disease in humans (U.S. Department of Health and Human Services, 1994).
Today, cigarette smoking is established as the leading cause of lung cancer
(responsible for approximately 90% of lung cancer deaths in the U.S.), the leading cause
of chronic bronchitis and emphysema (responsible for over 80% of chronic obstructive
pulmonary disease deaths), and a major cause of heart disease and stroke. Smoking also
causes aneurysms, atherosclerotic peripheral vascular disease, oral cavity and laryngeal
cancer, intrauterine growth retardation and neonatal death, including SIDS (Sudden Infant
Death Syndrome). It is associated with additional cancers (bladder, pancreatic, renal,
gastric, and cervical) (U.S. Department of Health and Human Services, 1989), as well as a
host of other conditions affecting a wide variety of organ systems and disease processes,
including, for example, vision and hearing problems, slowed healing from injuries, and
increased susceptibility to certain infections (Napier, 1996). Chronic inhalation of
environmental tobacco smoke (ETS) causes lung cancer in nonsmokers and an assortment of
diseases and functional limitations in the children of smokers (Environmental Protection
Agency, 1994). ETS may be responsible for tens of thousands of heart disease deaths
annually (Glantz and Parmley, 1995).
All told, smoking is far and away the leading cause of premature death and of
avoidable morbidity and disability in the United States and in most industrialized
nations. As indicated above, the intensification of smoking in the world's less affluent
nations will soon bring the same distinction to smoking in the developing countries.
Barring substantial and unexpected decreases in tobacco use worldwide, a few decades hence
the global death toll from tobacco will dwarf all other causes, with the majority of
deaths occurring in the developing nations. The World Health Organization estimates that
fully 500 million of the 5 billion people alive at the beginning of this decade will die
as a result of consumption of tobacco products (Peto et al., forthcoming).
The mortality toll of tobacco reflects not only the lethality of tobacco products
but also the prevalence of their consumption. In the United States, approximately 45
3
Concern about the health consequences of smoking predates the "modern era" by nearly
four centuries. In 1604, for example, King James I of England lambasted smoking as "a
custome lothsome to the eye, hatefull to the Nose, harmefull to the braine, dangerous to
the Lungs, and in the blacke stinking fume thereof, neerest resembling the horrible
Stigian smoke of the pit that is bottomlesse" (as quoted in Sullum, 1998, p. 18). King
James subsequently raised the tax on tobacco by 1000%, deriving significant revenues for
his coffers. This illustrates the profound dilemma that has confronted policy decision
makers ever since: whatever its health consequences, tobacco has long been truly a
"golden leaf" for farmers and politicians alike. Its role in the very earliest commerce
between England and the American colonies is legendary, as is its role in contemporary
politics (Taylor, 1984; Fritschler and Hoefler, 1996).
million adults, almost a quarter of the adult population, smoke cigarettes (down from a
high of 42% in 1965 (U.S. Department of Health and Human Services, 1989)). Worldwide,
tobacco products are used by approximately one billion people. The large numbers of
tobacco consumers, combined with their frequent use of tobacco products, account not only
for the disease toll of tobacco, but also for the substantial size of the tobacco
industry. Important features of the structure and economic importance of the industry are
reviewed in section 6 below.
2. The impact of price on the demand for tobacco products

Many researchers once viewed cigarette smoking and other addictive behaviors as
irrational and therefore not suitable for conventional economic analysis (Elster, 1979;
Winston, 1980; Schelling, 1984b). They believed that the demand for cigarettes (and other
addictive substances) did not follow the basic laws of economics, including perhaps the
most fundamental law, that embodied in the downward-sloping demand curve. As the now-
substantial body of economic research demonstrates, however, the demand for cigarettes
clearly responds to changes in prices and other factors, as found in applications of both
traditional models of demand and more recent studies that explicitly account for the
addictive nature of smoking.
Conceptually, economists use a relatively broad definition of price that includes
not only the monetary price of purchasing a product, but also the time and other costs
associated with using the product. Restrictions on smoking in public places and private
work sites, for example, impose additional costs on smokers by forcing them outdoors to
smoke, raising the time and discomfort associated with smoking, or by imposing fines for
smoking in restricted areas. Similarly, limits on youth access to tobacco may raise the
time and potential legal costs associated with smoking by minors, while new information on
the health consequences of tobacco use can raise the perceived long-term costs of smoking.
This section focuses on the effects of monetary price on demand, while section 5 below
considers the effects of other aspects of full price.
In addition to price, a variety of other factors can affect the demands for
cigarettes and other tobacco products, including income, advertising and other promotional
activities, and tastes. In the industrialized nations, the relationship between income
and cigarette consumption has reversed. Early demand studies (for example, Ippolito, et
al., 1979; Fujii, 1980) concluded that cigarette smoking was a normal good, with cigarette
consumption rising as income rose. More recent studies, however, have found that
cigarettes have become an inferior good, in that the likelihood of smoking declines as
income rises (Wasserman, et al., 1991; Townsend et al., 1994). The effects of advertising
and promotion on the demand for cigarettes have been the subject of numerous studies;
these are reviewed in detail in section 4 below. Finally, nearly all econometric studies
of cigarette demand use a variety of factors to control for tastes, including gender,
race, education, marital status, employment status, and religiosity. Given the focus of
this book on economics, the impact of these socio-demographic determinants of demand will
not be reviewed.4
This section begins with a review of conventional studies of the impact of money
price on cigarette demand. This is followed by a discussion of economic models of
addiction and their applications to cigarette demand. Implications for the effects of
price on cigarette demand from the relatively new field of behavioral economics are then
reviewed. The section closes with a short consideration of the relatively limited
research on the effects of price on the demand for other tobacco products.
2.1 Conventional studies of cigarette demand

Numerous investigators have estimated the effects of price on cigarette demand using
conventional models of demand that do not account for the addictive nature of cigarette
smoking. Their studies have used diverse econometric and other statistical methods on
4
The importance of these variables should not be downplayed, however. In many
instances, these and other variables, such as parental and peer smoking behavior and
societal norms, are as important or more important than the variables which economists
have studied (U.S. Department of Health and Human Services, 1994). Variations in these
and other variables help to explain why large variations in prices across countries are
often not associated with comparably large variations in smoking prevalence. Economists'
interests focus on the marginal impact of price, advertising, and other economic variables
on the demand for cigarettes.
data from numerous countries. Many used aggregate time-series data for a single
geographical unit, while others employed pooled cross-sectional time series data; still
others used individual level data taken from surveys. The price elasticity estimates for
overall cigarette demand from recent studies fall within the relatively wide range from -
0.14 to -1.23, but most fall in the narrower range from -0.3 to -0.5.
2.1.1 Analysis of aggregate data

Many recent studies use aggregate data and appropriate econometric methods to
examine the effects of price on cigarette demand, controlling for income, tobacco control
policies, and a variety of socioeconomic and demographic factors. The exceptions ( Baltagi
and Goel, 1987; Peterson et al., 1992) compared changes in cigarette consumption in states
that had raised cigarette taxes to consumption in states where taxes had not changed. The
estimated price elasticities from these quasi-experimental studies, in the range from -
0.17 to -0.56, are consistent with those obtained from the econometric studies.
Although there are numerous studies of the price-demand relationship in
industrialized nations, until recently there were almost no estimates for developing
countries. Warner (1990) argued that price responsiveness in less developed countries is
likely to be greater than in more affluent countries, given the relatively low incomes and
relatively low levels of cigarette consumption by smokers in the poorer countries.
Findings from studies using data from Papua New Guinea (Chapman and Richardson, 1990),
China (Mao, 1996; Xu, Hu and Keeler, 1998) South Africa (van der Merwe, 1998a), Zimbabwe
(Maranvanyika, 1998), and Taiwan (Hsieh and Hu, 1997) are consistent with this argument.
Several difficulties are encountered in studies using time-series data.
Particularly troubling are the high correlations among many of the key independent
variables and price. Consequently, estimates of the impact of price and other factors on
demand can be sensitive to the inclusion and exclusion of other variables. Including
highly correlated variables can result in multicollinearity and unstable estimates for the
parameters of interest. Excluding potentially important variables, however, can produce
biased estimates of the impact of price on demand. Recent studies using state-of-the-art
econometric methods have addressed many of these difficulties (Seldon and Boyd, 1991;
Simonich, 1991; Flewelling et al., 1992; Sung et al., 1994; Barnett et al, 1995; Keeler et
al., 1996). Nearly all of the estimates from these studies have produced estimates for
the price elasticity of demand in a relatively narrow range, centered on -0.4.
Other problems are encountered when using pooled cross-sectional time-series data.
The measure of cigarette smoking employed in these studies is typically annual state-level
tax-paid cigarette sales. Interstate differences in cigarette prices, resulting from wide
variation in state cigarette taxes (Tobacco Institute, 1998), can lead to casual and
organized smuggling of cigarettes from low-tax to high-tax states, however (Advisory
Commission on Intergovernmental Relations (ACIR), 1977, 1985). As such, tax-paid sales
data are likely to overstate cigarette consumption in states with low cigarette taxes and
underestimate it in high tax states.5 Failing to account for this will produce upward-
biased estimates of the impact of price on cigarette demand. Many of the more recent
studies employing pooled time-series cross-sectional state data have controlled for the
potential for smuggling (ACIR, 1977, 1985; Baltagi and Levin, 1986; Chaloupka and Saffer,
1992; Keeler et al., 1996). These studies have also produced estimates of the price
elasticity of cigarette demand generally falling in a relatively narrow range centered on
-0.4.
The fact that cigarette prices, sales, and consumption are simultaneously determined
creates an additional complication in the analysis of cigarette demand and supply.
Failing to account for this simultaneity would lead to biased estimates of the price
elasticity of demand. Again, many of the recent studies employing aggregate time-series
data for a single country or other geographical unit, as well as many of those using
pooled cross-sectional time-series data, have avoided this problem by theoretically and
empirically modeling cigarette demand and supply (Bishop and Yoo, 1985; Porter, 1986;
Showalter, 1991; Sung et al., 1994; Barnett et al., 1995; Tremblay and Tremblay, 1995; and
Keeler et al., 1996). Other studies have taken advantage of natural experiments, most
notably 25-cent increases in the California and Massachusetts cigarette excise taxes, to
5
The same problem exists in time-series studies using aggregate country-level data
for countries with relatively high taxes and prices compared to neighboring countries.
See Joossens (1998) for a discussion of factors other than price that influence smuggling
across country borders.
look at the impact of price on demand (Keeler et al., 1993; Hu et al., 1994, 1995b; Sung
et al., 1994; Harris et al., 1996). After accounting for the potential simultaneity or
taking advantage of natural experiments, most of these studies produce estimates of the
price elasticity of demand that fall into the same narrow range found in other studies.
Finally, studies employing aggregate data are generally limited to examining the
impact of cigarette prices and other factors on aggregate or per capita measures of
cigarette consumption. Consequently, these studies are typically unable to evaluate the
differential impact of prices on smoking by various population subgroups of particular
interest, especially youth and young adults. Nor can they differentiate between the
impact of price on smoking prevalence and quantity, or smoking initiation and cessation.
A few recent analyses have attempted to address these limitations. For example,
Harris (1994) used annual time-series data on U.S. smoking prevalence taken from the
National Health Interview Surveys, coupled with aggregate measures of cigarette
consumption, to estimate the effects of price on smoking prevalence and average cigarette
consumption by smokers for the period from 1964 through 1993. His estimate of the
unconditional price elasticity of demand fell into the same narrow range generally found
in other studies. He estimated that approximately half of the impact of price was on
smoking prevalence, with the price elasticity of smoking participation being -0.238, while
the unconditional price elasticity of demand was -0.47. Townsend et al. (1994) looked at
the differential effects of price on cigarette smoking for various population subgroups
defined by age, gender, and socioeconomic status, using data aggregated from the 1972
through 1990 British General Household Surveys. They concluded that women were more
responsive to price than men, that both men and women in lower socioeconomic groups were
more sensitive to price than those that were better off, and that youth (16-19 years) and
young adults (20-24 years) were less responsive to price than adults.6
2.1.2 Analysis of individual level data

A relatively small but growing number of cigarette demand studies have used data on
individuals taken from large-scale surveys. In general, their estimated price elasticities
of demand are comparable to those estimated using aggregate data. The use of individual-
level data helps avoid some of the problems inherent in using aggregate data. For
example, because an individual's smoking decisions are too small to affect the market
price of cigarettes, potential simultaneity biases are less likely. Similarly,
individual-level income data and measures of socio-demographic determinants of demand are
less correlated with price and policy variables than comparable aggregate measures.
Other problems persist but can be addressed somewhat more easily using individual-
level data. For example, failing to account for interstate differences in cigarette
prices will again produce a biased estimate of the price elasticity of demand (biased
towards 0 in this case). Thus, given information on where an individual resides, studies
using individual-level data have employed a variety of approaches to control for potential
cross-border shopping in response to interstate price differentials. Some have limited
their samples to individuals who do not live near lower-price localities (Lewit and Coate,
1982; Wasserman et al., 1991; Chaloupka and Grossman, 1996; Chaloupka and Wechsler, 1997).
Others have included a measure of the price differential (Lewit et al., 1981; Chaloupka
and Pacula, 1998a, 1998b). Still others have used a weighted average price based on the
price in the own-locality and other nearby localities (Chaloupka, 1991).
As with the state tax-paid sales data, self-reported data on cigarette smoking yield
inaccurate measures of true consumption, given potential reporting biases. Based on a
comparison of self-reported consumption with aggregate sales data, Warner (1978)
demonstrated that survey-based self-reported consumption significantly and substantially
understated actual sales. Studies using individual-level survey data have implicitly
treated underreporting as proportional to true consumption across groups of interest
(e.g., age, gender, or socioeconomic groups). If the assumption is true, estimates of the
price elasticity of demand will not be systematically biased. The assumption has yet to
be demonstrated, however.
Finally, as Wasserman et al. (1991) observed, studies using individual-level data
may be subject to a substantial ecological bias in that omitted variables affecting
6
As we discuss below, other studies have derived the opposite conclusions concerning
the relative price responsiveness by gender (e.g., Lewit and Coate, 1982; Mullahy, 1985;
Chaloupka, 1990) and different age groups (e.g. Lewit, et al., 1981; Chaloupka and
Grossman, 1996).
tobacco use may be correlated with the included determinants of demand. Failing to
account for this can produce biased estimates for the included variables. For example,
unobserved sentiment against smoking may affect both cigarette sales and the strength of
tobacco control policies (including taxes and, consequently, prices). Ohsfeldt et al.
(1998) considered this possibility in their analysis of cigarette smoking and other
tobacco use that employed data from the 1992/93 Current Population Survey Tobacco Use
Supplements. Surprisingly, after modeling cigarette taxes and other tobacco control
policies as a function of cigarette smoking, various other indicators of sentiment against
smoking, and other factors, they found that taxes have a larger impact on demand.
Using individual-level data allows researchers to examine issues that generally
cannot be addressed with aggregate data. For example, most studies using individual-level
data separately consider the effects of price on the probability of smoking and on average
cigarette consumption by smokers. In addition, several consider the differential effects
of price on demand for various population subgroups (defined by age or gender, for
example). Finally, some have taken advantage of retrospective or longitudinal data to
examine the effects of prices and other factors on smoking initiation and cessation
decisions.
The earliest of the cigarette demand studies employing individual-level data were
conducted by Lewit and his colleagues (Lewit et al., 1981; Lewit and Coate, 1982). Lewit
and Coate used data from the 1976 National Health Interview Survey to examine the effects
of price on cigarette smoking, estimating an overall price elasticity of demand of -0.42
and an elasticity of smoking participation of -0.26. In addition, they found an inverse
relationship between (the absolute value of) price elasticity and age, estimating a total
price elasticity of demand for 20 through 25 year-olds more than double that of persons 26
and older. The researchers found that most of the effect of price for young adults was on
the decision to smoke (participation elasticity of -0.74 and conditional demand elasticity
of -0.20), but was about evenly split for those over 35 years of age (participation and
conditional demand elasticities of -0.15). Finally, they also looked at differences in
price responsiveness by gender, concluding that men, particularly young men, were very
responsive to price, while women were generally insensitive to price.
Lewit et al. (1981) and Grossman et al. (1983) confirmed the Lewit and Coate (1982)
conclusion concerning the inverse relationship between price elasticity of cigarette
demand and age. Using data from Cycle III of the Health Examination Survey, Lewit et al.
estimated that the price elasticity of smoking participation for 12-17 year-olds was -
1.20, while the conditional demand elasticity was -0.25. Their estimated total price
elasticity of youth cigarette demand of -1.44 was more than three times Lewit and Coate's
(1982) estimate for adults. These conclusions were generally supported by Grossman et
al.'s (1983) analysis of data from the National Household Surveys on Drug Use conducted
during the 1970s.
Lewit et al. (1981) offered two reasons why youth should be more price sensitive
than adults, at least in the short run. First, given the addictive nature of smoking,
long-term adult smokers are likely to adjust less quickly to changes in price than youth
who have been smoking for a relatively short time, if at all. In addition, peer behavior
is likely to be much more influential for youth, multiplying the effects of price on youth
smoking. That is, an increase in cigarette price directly reduces youth smoking and then
again indirectly reduces it through its impact on peer smoking. Grossman and Chaloupka
(1997) offered two additional reasons. First, the fraction of disposable income a young
smoker spends on cigarettes is likely to exceed that spent by an adult smoker. Second,
compared to adults, youth are more likely to be present-oriented. In the context of an
economic model of addictive behavior (discussed below), Becker et al. (1991) predicted
that changes in money price will have a greater impact on individuals with higher discount
rates since they give less weight to the future consequences of addictive consumption.
The conclusion that youth cigarette demand is more price elastic than adult demand
was widely accepted until an influential 1991 Rand study by Wasserman and colleagues
(1991). These researchers evaluated adults' cigarette demand using data from several of
the National Health Interview Surveys from the 1970s and 1980s and youth demand with data
from the Second National Health and Nutrition Examination Survey of the late-1970s. Using
a generalized linear model, the authors concluded that adult demand in the earlier years
of their data was relatively unresponsive to price, but that demand had become more price
elastic over time. Based on the trends in price elasticity, they predicted an overall
price elasticity of adult cigarette demand of -0.283 for 1988. Estimates from a two-part
model of adult cigarette demand implied that the effects of price on the decision to smoke
were almost double the impact of price on conditional demand. However, the authors did
not find a statistically significant impact of price on youth smoking. They attributed
their relatively low estimates of price elasticity, particularly those for youth, to the
inclusion in their models of an index of restrictions on smoking. These restrictions,
which they note are positively correlated with price, had not been included in most
previous studies of cigarette demand. Indeed, they obtained very similar estimates to
Lewit and Coate (1982) when leaving the restriction index out of models estimated using
the 1976 survey data.
Several more recent studies of youth and young adult smoking have supported the
earlier conclusions reached by Lewit and his colleagues (Lewit et al., 1981; Lewit and
Coate, 1982; Grossman et al., 1983) that the price sensitivity of cigarette demand is
inversely related to age. Chaloupka and Grossman (1996) examined the impact of price,
numerous tobacco control policies (including smoking restrictions and limits on youth
access to tobacco), and a variety of other socioeconomic and demographic factors on youth
smoking, using data from the 1992, 1993, and 1994 Monitoring the Future Surveys of eighth,
tenth, and twelfth grade students. They estimated a total price elasticity of youth
cigarette demand of -1.31, strikingly similar to the estimates obtained by Lewit et al.
(1981) 15 years earlier. In contrast to Lewit and his colleagues, however, Chaloupka and
Grossman found that the effects of price on smoking participation and conditional demand
were similar (-0.68 for smoking participation and -0.64 for conditional demand). Chaloupka
and Pacula (1998b) used the same data to look at the differential response by gender and
race, concluding that young men and young blacks are more responsive to price than young
women and young whites.
Chaloupka and Wechsler (1997) reached similar conclusions using data on young adult
smoking taken from the 1993 College Alcohol Survey. Also controlling for numerous other
determinants of cigarette demand, including a variety of restrictions on smoking, they
estimated a price elasticity of smoking participation of -0.53 and an unconditional price
elasticity of demand of -1.11 for college students. Noting that their sample was not a
random sample of all young adults, Chaloupka and Wechsler suggested that the price
elasticity of cigarette demand by young adults may be even higher, given the evidence that
cigarette demand is relatively less elastic for more educated or higher-income individuals
(Townsend, 1987; Chaloupka, 1991; Townsend et al., 1994; Farrelly et al., 1998).
Farrelly and his colleagues (1998) found similar evidence for young adults and
adults, based on 13 waves of the National Health Interview Survey conducted between 1976
and 1992. They estimated that demand was more than twice as elastic for their sample of
young adults, ages 18 to 24 years (total elasticity of -0.58), as for their full sample
(total elasticity of -0.25). Similarly, they estimated that blacks were about twice as
responsive as whites to cigarette prices, while Hispanics were even more price sensitive.
In addition, they found that men were more price sensitive than women. Finally, they
estimated that individuals with family incomes below the sample median were about 70
percent more responsive to price than those with higher family incomes.
Additional support for the inverse relationship between price sensitivity and age is
provided by recent studies by Lewit and his colleagues (1997), Evans and Huang (1998), and
Tauras and Chaloupka (1998). Lewit and his colleagues used data for ninth grade students
in 1990 and 1992 collected in the 22 North American communities involved in the National
Cancer Institute's Community Intervention Trial for Smoking Cessation (COMMIT). They
found that both youth smoking participation and intentions to smoke among young non-
smokers were inversely related to price, with estimated price elasticities of -0.87 and -
0.95, respectively. Evans and Huang used state level aggregated data on smoking
prevalence constructed from the 1977 through 1992 Monitoring the Future surveys to
estimate a price elasticity of youth smoking participation of -0.20. Unlike other studies
on youth smoking that largely rely on the cross-sectional variation in state cigarette
taxes and prices, Evans and Huang took advantage of the long time period covered by their
data and used the time series variation in state cigarette taxes to identify the impact of
cigarette taxes on smoking participation. While their estimated elasticity for the 1977
through 1992 period is relatively low, Evans and Huang concluded that youth smoking has
become more price sensitive over time, estimating an elasticity of -0.50 for youth smoking
participation in the period from 1985 through 1992. Most recently, Tauras and Chaloupka
(1998) used the longitudinal data from the Monitoring the Future surveys of high school
seniors conducted from 1976 through 1993 to estimate the price elasticity of smoking for
young adults; respondents in their sample ranged in age from 17 to 35 years. In models
controlling for unobserved state and individual factors affecting demand, they estimated
an overall price elasticity of demand centered on -0.79.
In general, researchers examining the effects of price on smoking participation
using individual-level data from cross-sectional surveys have assumed that much of the
price effect estimated for youth reflects the impact of price on smoking initiation, while
the estimate for adults is largely capturing the effects of price on smoking cessation. A
few recent studies have attempted to directly examine the impact of cigarette prices on
smoking initiation. With retrospective data from the smoking supplements to the 1978 and
1979 National Health Interview Surveys, Douglas and Hariharan (1994) studied the ages at
which survey respondents reported that they began smoking. Based on current state of
residence, they matched data on cigarette prices to the survey data to estimate the impact
of price on smoking initiation. They estimated a hazard model in which "failure" was
defined as a never smoker taking up smoking and used a relatively general variation on
standard duration methods: the split population duration model developed by Schmidt and
Witte (1989). This model allows for a large part of their sample to never begin smoking.
Finally, Douglas and Hariharan's theoretical and empirical framework was based on the
Becker and Murphy (1988) rational addiction model (described below). As anticipated,
Douglas and Hariharan found that a number of socioeconomic and demographic factors had a
significant effect on smoking initiation. However, their estimates for cigarette prices
were insignificant. Given the errors-in-variables problem associated with both the
retrospective data on smoking initiation and the cigarette price data, they noted that
price effects will be biased towards zero. Nevertheless, they found no evidence that
higher cigarette prices reduced smoking initiation.
Douglas (1998) extended this work by estimating a time-varying covariate model that
allows the hazard of smoking initiation to respond dynamically to changes in prices and
other factors. In addition to initiation, Douglas also estimated the hazard of smoking
cessation in a similar empirical framework, as well as estimating the impact of smoking
regulations and information on initiation and cessation (these findings are discussed
later). Using data from the cancer risk factor supplement to the 1987 National Health
Interview Survey, Douglas again concluded that cigarette price has little impact on
smoking initiation. As with the earlier analysis, however, there are likely to be errors-
in-variables problems that could account for this finding.
DeCicca et al. (1998a) employed data from the National Education Longitudinal Survey
of 1988 to examine the impact of price on initiation of daily smoking. This data set
contains data on youth smoking at several points in time (eighth, tenth, and twelfth
grades). Treating the three waves as independent cross-sections, they obtained estimates
of the price elasticity of youth smoking participation comparable to other recent
estimates. In an effort to examine the impact of price on smoking initiation, they
attempted to exploit the longitudinal aspect of their data by looking at the probability
of smoking in twelfth grade for a sample that excluded those who were smokers in eighth
grade. Their estimates for the effect of cigarette taxes on the probability of starting
to smoke between the eighth and twelfth grade are not statistically significantly
different from zero, supporting the findings of Douglas and Hariharan (1994) and Douglas
(1998) that raised doubts about the hypothesis that higher cigarette prices lead to
significant reductions in youth smoking. DeCicca et al. attributed the inconsistency in
their two sets of results to the possibility that cigarette tax rates are a proxy for
unobserved sentiment against cigarette smoking. If true, then estimates based on cross-
sectional studies are likely to significantly overstate the impact of price on smoking.
Dee and Evans (1998) reexamined the longitudinal data used by DeCicca et al.,
arguing that their finding that price has no impact on smoking initiation was largely the
result of the way in which their sample was constructed. In particular, rather than
following DeCicca et al. in deleting the large number of observations with missing values
for key independent variables (including income, parental education, and number of
siblings), Dee and Evans included these along with dummy variables indicating observations
for which the data are missing. In addition, they included a variety of binary indicators
for categorically collected data, rather than constructing "continuous" measures from
these data as did DeCicca et al. (e.g. parental and family attributes). After making
these changes but otherwise following the same basic approach, Dee and Evans estimated a
negative and significant impact of cigarette taxes on smoking initiation. Their estimated
price elasticity of smoking onset is -0.63, consistent with several other recent studies
of youth smoking employing cross-sectional data.
In response to Dee and Evans (1998), DeCicca and his colleagues (1998b) conducted a
reanalysis of the NELS data that used an alternative approach for dealing with the missing
data problem. Where possible, they used information from the longitudinal sample to fill
in missing values; when this could not be done, they used a conditional mean imputation
approach. Their reanalysis produced somewhat more significant estimates for the effect of
cigarette taxes on the onset of daily smoking, with implied price elasticities from
alternative specifications ranging from -0.025 to -0.505; somewhat smaller, less
significant estimates were obtained from models using price rather than tax. In addition,
their estimates for samples based on race/ethnicity implied that higher cigarette taxes
significantly reduced smoking onset among Hispanics, but had little impact on whites and
blacks.
Clearly, the use of longitudinal data to examine the impact of cigarette tax and
price changes on smoking initiation and cessation is an important advance. The findings
from studies using relatively longer panels that control for unobserved state and/or
individual factors affecting demand (i.e. Evans and Huang, 1998; Tauras and Chaloupka,
1998) are consistent with the findings that price sensitivity is inversely related to age,
as found in several earlier studies based on cross-sectional data. The inconsistent
findings from a few recent studies (DeCicca et al., 1998a, 1998b; Dee and Evans, 1998)
directly addressing the effects of price on smoking initiation with a relatively short
panel should be viewed with caution.
Hu et al. (1995a) introduced an innovation in cigarette demand estimation, using
data from California's Behavioral Risk Factor Surveys for 1985 through 1991 to examine the
possible effects on adult smoking of the interdependence of cigarette smoking with other
risk factors, including alcohol use and obesity. Estimates of the smoking participation
elasticity from models that included other behavioral risk factors were significantly
lower than when these factors were ignored, while conditional demand elasticities were
generally unaffected. Using two-part methods, Hu et al. estimated an overall price
elasticity of -0.46 from the models that included other risks, with the effects of price
about equally divided between smoking participation and conditional demand. The authors
noted, however, that their estimate of the price elasticity might be relatively high given
that they did not control for other tobacco control efforts.
Evans and Farrelly (forthcoming) recently examined a phenomenon not previously
studied by economists. Using data from the 1979 Smoking Supplement and the 1987 Cancer
Control Supplement to the National Health Interview Surveys, the authors investigated the
compensating behavior by smokers in response to tax and price changes. The supplements
contain unique information on smokers' choices of types of cigarettes, which Evans and
Farrelly combined with data from the Federal Trade Commission on the tar and nicotine
content of cigarette brands to construct a variety of measures of daily smoking intensity
(including cigarette consumption, total length of cigarettes consumed, tar intake, and
nicotine intake). They also constructed comparable aggregate measures for 1964-1993 from
the data used by Harris (1994) on aggregate smoking prevalence and cigarette consumption.
They found consistent evidence that, although smokers reduced daily cigarette consumption
in response to higher taxes, they also compensated in several ways. In particular,
smokers in high-tax states consumed longer cigarettes and those that are higher in tar and
nicotine, with young adults smokers also most likely to engage in this compensating
behavior. As a result, they argued that the perceived health benefits associated with
higher cigarette taxes are likely to be somewhat overstated. Given this compensating
behavior, Evans and Farrelly suggest that if cigarette taxes are to be used to reduce the
health consequences of smoking, then taxes based on tar and nicotine content would be
appropriate, an idea first suggested by Harris (1980).
2.2 Addiction models and cigarette demand

The first discussion by an economist of the effects of addiction on demand can be
found in Marshall's (1920) Principles of Economics , where he observed that
Whether a commodity conforms to the law of diminishing or increasing return, the
increase in consumption arising from a fall in price is gradual; and, further,
habits which have once grown up around the use of a commodity while its price is low
are not so quickly abandoned when its price rises again. (Appendix H, section 3,
page 807)
As Phlips (1983) noted, Marshall's statement clearly introduced the three basic dimensions
of addiction (U.S. Department of Health and Human Services, 1988) of gradual adaptation
(tolerance), irreversibility (withdrawal), and positive effects of habits (reinforcement)
that are used in many of the more recent formal models of addictive behavior. Until
recently, however, economists have either ignored the addictive nature of goods such as
cigarettes when estimating demand or have assumed that behaviors such as smoking were
irrational and could not be analyzed in the rational, constrained utility maximizing
framework of economics.
Many of the most recent studies of cigarette demand explicitly address the addictive
nature of cigarette smoking. Economic models of addiction can be divided into three basic
groups: imperfectly rational models of addictive behavior, models of myopic addictive
behavior, and models of rational addictive behavior.
2.2.1 Imperfectly rational addiction models

Elster (1979), McKenzie (1979), Winston (1980), and Schelling (1978, 1980, 1984a,
1984b) best exemplify the economic models of imperfectly rational addictive behavior.
These models generally assume stable but inconsistent short-run and long-run preferences.
This is seen, for example, in Schelling's (1978) description of a smoker trying to "kick
the habit":
Everybody behaves like two people, one who wants clean lungs and long life and
another who adores tobacco.... The two are in a continual contest for control; the
"straight" one often in command most of the time, but the wayward one needing only
to get occasional control to spoil the other's best laid plan. (p. 290)
Thus, the farsighted personality may enroll in a smoking cessation program, only to be
undone by the shortsighted personality's relapse in a weak moment. Winston (1980)
formally modeled this behavior and described how this contest between personalities leads
to the evolution of what he called "anti-markets," which he defined as firms or
institutions that individuals will pay to help them stop consuming.
Strotz (1956) was the first to develop a formal model of such behavior, describing
the constrained utility maximization process as one in which an individual chooses a
future consumption path that maximizes current utility, but later in life changes this
plan "even though his original expectations of future desires and means of consumption are
verified" (p. 165). This inconsistency between current and future preferences only arises
when a non-exponential discount function is used.7 Strotz went on to suggest that
rational persons will recognize this inconsistency and plan accordingly, by pre-committing
their future behavior or by modifying consumption plans to be consistent with future
preferences when unable to pre-commit. Pollak (1968) went one step further, arguing that
an individual may behave naively even when using an exponential discount function. Thaler
and Shefrin (1981) described the problem similarly, referring to an individual at any
point in time as both a "farsighted planner and a myopic doer" (p. 392), with the two in
continual conflict. While these models present interesting discussions of some aspects of
addictive behavior, they have not been applied empirically to cigarette smoking or other
addictions.
2.2.2 Myopic addiction models

The naive behavior described in some of the imperfectly rational models of addiction
is the basis for many of the myopic models of addictive behavior. As Pollak (1975)
observed, behavior is naive in the sense that an individual recognizes the dependence of
current addictive consumption decisions on past consumption, but then ignores the impact
of current and past choices on future consumption decisions when making current choices.
Many of these models treat preferences as endogenous, allowing tastes to change over time
in response to past consumption (Gorman, 1967; Pollak, 1970, 1976, 1978; von Weizsacker,
1971; Hammond, 1976a, 1976b; El-Safty, 1976a, 1976b).
These models are similar in spirit to those in which tastes change in response to
factors other than past consumption, including advertising (Dixit and Norman, 1978;
Galbraith, 1958, 1972) and prices (Pollak, 1977). Others allow past consumption to affect
current consumption through an accumulated stock of past consumption (e.g., Houthakker and
Taylor, 1966, 1970). These models are comparable to those of the demand for durable
consumer goods that use a stock adjustment process (e.g, Chow's (1960) model of the demand
for automobiles, and Garcia dos Santos' (1972) analysis of the demands for household
durables). As Phlips (1983) noted, however, the distinction between models with
endogenous tastes and those with stable preferences within a household production
framework is purely semantic, since the underlying mathematics of the two are the same.
The earliest theoretical models of demand in the context of myopic addiction can be
traced to the irreversible demand models (Haavelmo, 1944; Duesenberry, 1949; Modigliani,
1949; Farrell, 1952). Farrell, for example, described an irreversible demand function as
one in which current demand depends on all past price and income combinations. As a
result, price and income elasticities are constant, but may differ for increases and
decreases in price and income. Farrell tested this model empirically, using U.K. data on
7
Vuchinich and Simpson (1998) provided an interesting application of this idea to the
demand for alcoholic beverages, comparing behavior under hyperbolic versus exponential
discounting.
the demands for tobacco and beer from 1870 through 1938, in a model that included not only
current price and income, but also price, income, and consumption in the prior year. In
general, his estimates were inconclusive, although he did find limited evidence of habit
formation for tobacco use.
The notion of asymmetric responses to price and income reappeared in Scitovsky
(1976) and was applied to cigarette demand by Young (1983) and Pekurinen (1989), using
data from the U.S. and Finland, respectively. Both found that smoking was almost twice as
responsive to price reductions as it was to price increases, which they interpreted as
evidence of addiction.
Most empirical applications of myopic models of addiction are based on the
pioneering work by Houthakker and Taylor (1966, 1970) that formally introduced the
dependence of current consumption on past consumption by modeling current demand as a
function of a "stock of habits" representing the depreciated sum of all past consumption.
Houthakker and Taylor estimated demand functions for a variety of goods, including
cigarettes, using annual aggregates for the U.S. and several Western European countries.
Their estimates provided considerable support for their hypothesis of habit formation in
demand for almost all of the non-durable consumer goods they examined, including
cigarettes.
Mullahy (1985) took a similar approach in his empirical examination of cigarette
demand using individual level data from the 1979 National Health Interview Survey. In his
model, the stock of past cigarette consumption has a negative impact on the production of
commodities such as health and the satisfaction received from current smoking. Mullahy
used a two-part model to estimate cigarette demand, as well as instrumental variables
methods to account for the unobserved individual heterogeneity likely to be correlated
with the stock of past consumption. Mullahy found strong support for the hypothesis that
cigarette smoking is an addictive behavior, as shown by the positive and significant
estimates he obtained for the addictive stock in both the smoking participation and
conditional demand equations. His estimates for price are quite similar to those obtained
by Lewit and Coate (1982), with the overall price elasticity of demand centered on -0.47.
In addition, Mullahy estimated that men were more price responsive than women (total
price elasticities of -0.56 and -0.39, respectively). Finally, using an interaction
between the addictive stock and price, Mullahy concluded that more-addicted smokers
(defined as those with a larger addictive stock) were less responsive to price than their
less-addicted counterparts. Other approaches to estimating myopic demand models have
similarly concluded that cigarette smoking is an addictive behavior and that price has a
significant impact on cigarette demand (e.g. Jones, 1989; Baltagi and Levin, 1986).
2.2.3 Rational addiction models

Several researchers have modeled addiction as a rational behavior. In this context,
rationality simply implies that individuals incorporate the interdependence between past,
current, and future consumption into their utility maximization process. This is in
contrast to the assumption, implicit in myopic models of addictive behavior, that future
implications are ignored when making current decisions. In other words, myopic behavior
implies an infinite discounting of the future, while rational behavior implies that future
implications are considered, while not ruling out a relatively high discount rate.
Several of the rational addiction models, including those of Lluch (1974), Spinnewyn
(1981), and Boyer (1983), assume that tastes are endogenous. These models build on the
significant contributions of Ryder and Heal (1973), Boyer (1978), and others in the
optimal growth literature who have developed endogenous taste models with rational
behavior. Spinnewyn (1981) and Phlips and Spinnewyn (1982) argued that incorporating
rational decision making into models of habit formation results in models that are
"formally equivalent to models without habit formation" (Spinnewyn, 1981, p. 92). Thus,
they argue, assuming rationality only leads to unnecessary complications.
This assertion was challenged by Pashardes (1986) who derived demand equations for a
rational consumer in which current consumption is determined by past consumption and
current preferences with full knowledge about the impact of current decisions on the
future costs of consumption. Pashardes found considerable empirical evidence to support
the hypothesis of rational behavior in general, as well as evidence that cigarette smoking
is an addictive behavior. Finally, he noted that expectations concerning the future price
and other costs of consumption played an important role in consumer behavior.
Becker and Murphy (1988) similarly rejected the notion that myopic behavior is
empirically indistinguishable from rational behavior in their theory of rational
addiction. They assumed that individuals consistently maximize utility over their life
cycle, taking into account the future consequences of their choices. In their model,
utility at any point in time depends on current addictive consumption, current non-
addictive consumption, and the stock of past addictive consumption. Tolerance is
incorporated by assuming that the marginal utility of the addictive stock is negative.
Reinforcement is modeled by assuming that an increase in the addictive stock raises the
marginal utility of current addictive consumption. Finally withdrawal is captured since
total utility falls with the cessation of addictive consumption.
Becker and Murphy (1988) and Becker et al. (1991) developed several hypotheses from
this basic model. First, addictive consumption displays "adjacent complementarity"; that
is, due to reinforcement, the quantities of the addictive good consumed in different time
periods are complements. As a result, current consumption of an addictive good is
inversely related to not only the current price of the good, but also to all past and
future prices. Consequently, the long-run effect of a permanent change in price will
exceed the short-run effect.8 Moreover, in the Becker and Murphy model, the ratio of the
long-run to short-run price effect rises as the degree of addiction rises. In addition,
they predict that the effect of an anticipated price change will be greater than the
impact of a comparable unanticipated price change, while a permanent price change will
have a larger impact on demand than a temporary price change. Finally, price
responsiveness varies with time preference: addicts with higher discount rates will be
relatively more responsive to changes in money price than those with lower discount rates.
The opposite will be true with respect to the effects of information concerning the
future consequences of addictive consumption. Thus, the model suggests that younger, less
educated, and lower income persons will be relatively more responsive to changes in the
money price of cigarettes, while older, more educated, and higher income persons will be
relatively more responsive to new information on the health consequences of cigarette
smoking.9
Strong adjacent complementarity, reflecting strong addiction, can lead to unstable
steady states in the Becker and Murphy model. This is a key feature of their rational
addiction theory, helping to explain the binge behavior and "cold turkey" quit behavior
observed among addicts. Furthermore, these unstable steady states imply that there will
be a bimodal distribution of consumption, again something that is observed for many
addictive goods. In addition, Becker and Murphy's model implies that temporary events,
including price reductions, peer pressure, or stressful events, can lead to permanent
addictions.
Chaloupka (1988, 1990, 1991, 1992) used data from the Second National Health and
Nutrition Examination Survey conducted in the late 1970s in the first empirical
application of the rational addiction model. He found consistent evidence that cigarette
smoking was an addictive behavior and that smokers did not behave myopically. Chaloupka's
(1991) estimates of the long-run price elasticity of demand fell in the range from -0.27
to -0.48, larger than the elasticities obtained from conventional demand equations using
the same data. In addition to estimating the rational addiction demand equations for the
full sample, Chaloupka also explored the implications of the Becker and Murphy model with
respect to the rate of time preference by estimating comparable demand equations for
subsamples based on age and educational attainment. Chaloupka's (1991) estimates were
generally consistent with the hypothesis that less educated or younger persons behave more
myopically than their more educated or older counterparts. In addition, less educated
persons were more price responsive, with long-run price elasticities ranging from -0.57 to
-0.62, than were more educated persons, who were generally unresponsive to price.
Chaloupka (1990) also estimated separate demand equations for subsamples based on gender,
concluding that men behaved more myopically and were relatively responsive to price (long-
run price elasticity centered on -0.60) than women (statistically insignificant effect of
price on demand).
Similar findings were obtained by Becker et al. (1994) using aggregate, state-level
sales data for the U.S. over the period from 1955 through 1985. They found clear evidence
that smoking was addictive, as well as evidence of non-myopic, although not fully
rational, behavior.10 Estimates from other studies employing U.S. data (Keeler et al.,
8
Myopic addiction models also predict that the long run price elasticity of demand
will be larger than the short run elasticity.
9
See Chaloupka (1988, 1990, 1992) or Becker et al. (1994) for a more formal
discussion of these price effects.
10
The authors concluded that there was insufficient information in the data to
1993; Sung et al., 1994) and data from other countries, including Finland (Pekurinen,
1991) and Australia (Bardsley and Olekalns, 1998), are generally consistent with the
hypothesis of rational addiction. In contrast, Duffy (1996a), Cameron (1997), and
Conniffe (1995), using annual time-series data for the U.K., Greece, and Ireland,
respectively, found little support for the rational addiction model. These latter studies,
however, are generally limited by the relatively small number of observations available
for their analyses, and by the use of several highly correlated regressors.
As noted above, Douglas (1998) used hazard models to examine the determinants of
smoking initiation and cessation in the context of the Becker and Murphy (1988) rational
addiction model. In contrast to his finding that price does not significantly affect the
hazard of smoking initiation, Douglas concluded that increases in price significantly
increase the likelihood (hazard) of smoking cessation. He estimated a price elasticity
for the duration of the smoking habit of -1.07 with respect to future price, consistent
with the hypothesis of rational addiction; paradoxically, past and current prices were not
found to have a statistically significant effect on cessation. Similarly, his parametric
and non-parametric results imply that the hazard of smoking cessation has a positive
duration dependence, a finding Douglas suggested is consistent with rational addiction in
that the rational smoker will discount future health costs less as they become more
imminent.
2.2.4 Critiques of the rational addiction model

While the rational addiction model has gained acceptance among some economists, many
object to several assumptions of the model. Perhaps the most criticized aspect of the
model is the assumption of perfect foresight. As Winston (1980) explained, in the context
of the Stigler and Becker (1977) model:
[T]he addict looks strange because he sits down at period j=0, surveys future
income, production technologies, investment/addiction functions, and consumption
preferences over his lifetime to period T, maximizes the discounted value of his
expected utility, and decides to be an alcoholic. That's the way he will get the
greatest satisfaction out of life. Alcoholics are alcoholics because they want to
be alcoholics, ex ante , with full knowledge of its consequences. (page 302)
Similarly, Akerlof (1991) noted that individuals who become addicted in the rational
addiction model do not regret their past decisions, given that they are assumed to have
been fully aware of the consequences of their consumption of a potentially addictive good
when making those decisions.
A recent theoretical paper by Orphanides and Zervos (1995) addressed this and other
perceived inconsistencies of the rational addiction model that arise largely from the
assumption of perfect foresight. In particular, the authors introduced uncertainty into
the model by assuming that inexperienced users are not fully aware of the potential harm
associated with consuming an addictive substance. Instead, in their model, an
individual's knowledge comes from the observed effects of the addictive good on others as
well as through his or her own experimentation with that good. More specifically, they
assume that the harmful effects (including addiction) of consuming a potentially addictive
good are not the same for all individuals, that each individual possesses a subjective
understanding of his or her potential to become addicted, and that this subjective belief
is updated via a Bayesian learning process as the individual consumes the addictive good.
Thus, an individual who underestimates his or her potential for addiction and experiments
with an addictive substance can end up becoming addicted. Rather than the "happy addicts"
implied by the rational addiction model (Winston, 1980), these addicts will regret
becoming addicted. As Orphanides and Zervos noted, the incorporation of subjective
beliefs into the rational addiction model helps explain youthful experimentation, the
importance of peer influences, and other commonly observed facets of addiction.
More recently, in a model focusing on cigarette smoking, Suranovic et
al.(forthcoming) also reconsidered the Becker and Murphy (1988) model of rational
addiction. As described above, adjacent complementarity is a key feature of the rational
addiction model. Suranovic et al. noted, however, that one implication of adjacent
complementarity is that efforts to reduce current consumption will lead to reductions in
utility. These "quitting costs" are an important feature of their model and help explain
accurately estimate the discount rate, but that their estimates were clearly inconsistent
with myopic behavior.
the seeming inconsistency between smokers' stated wishes to quit smoking and their
continued cigarette consumption. In addition, they help explain why smokers engage in
various behavior modification treatments, such as the use of the nicotine patch, which
help make quitting easier.
A second point of departure from the Becker and Murphy model concerns the timing of
the consequences of smoking, which Suranovic et al. assume are concentrated at the end of
a smoker's life. In addition, rather than assuming that individuals choose a lifetime
consumption path that maximizes the present value of their lifetime utility, Suranovic et
al. assume "boundedly rational" behavior, implying that individuals choose current
consumption only. As a result, their model suggests that aging is enough to induce
cessation among some smokers. As in the Becker and Murphy model, their model implies that
quitting "cold-turkey" is likely in the case of a strong addiction (one where quitting
costs rise rapidly for small reductions in consumption). However, in contrast to Becker
and Murphy, Suranovic et al. predicted gradual reductions in consumption progressing to
quitting in the case of relatively weak addictions. Interestingly, some newly emerging
epidemiologic evidence supports this prediction (Farkas, 1998).
In addition, as Becker and Mulligan (1997) describe, addiction and time preference
may be related. As discussed above, the Becker and Murphy (1988) model of rational
addiction implied that people who discount the future more heavily were more likely to
become addicted. In their theoretical discussion on the determination of time preference,
Becker and Mulligan suggest that addictive consumption, by raising current utility at the
expense of future utility, can make even rational persons behave more myopically.
Finally, Showalter (1998), in his analysis of the behavior of firms producing an
addictive good, suggests an alternative interpretation for the finding in most empirical
applications of the rational addiction model that future consumption has a significant
impact on current consumption. Rather than resulting from rational behavior on the part of
consumers, Showalter shows that the same finding could result from myopic behavior by
consumers coupled with rational behavior by firms. In his empirical applications of this
model, Showalter finds that the rational and myopic demand models produce similar
predictions, but that neither does well in predicting actual behavior, a finding he
attributes to the difficulties of accurately forecasting prices.
2.3 Behavioral economic analyses of cigarette demand

Behavioral economics involves the application of the principles of consumer demand
theory to experimental psychology (Hursh and Bauman, 1987). Over the past decade, there
have been numerous behavioral economic analyses of a variety of addictive behaviors,
including cigarette smoking (Bickel and DeGrandpre, 1996). These studies examine the
impact of price and other factors on the self-administration of a number of addictive
substances by humans as well as a variety of non-human species in a laboratory setting.
Price, in this context, is defined as the response or effort required to receive one dose
of a drug (Bickel et al., 1993). As in standard economic analyses, an increase in price
is expected to lead to a reduction in the quantity of drug demanded. One advantage of
this experimental approach for the analysis of cigarette demand, both in general and as it
relates to policy debates specifically, is that it allows researchers to study the effects
on demand of changes in cigarette prices that are many times larger than the price
differences that are observed in the cross-sectional or time-series data that have been
used in the econometric studies of demand. One limitation of the approach, however, is
that these methods are generally applicable only to dependent individuals. For example,
for ethical reasons (and others), they cannot be used to address issues related to the
effect of price on smoking initiation.
The behavioral economics of cigarette smoking is the most extensively researched
area in the behavioral economics of drug abuse (Bickel and Madden, 1998). In a series of
papers, Bickel, DeGrandpre, and their colleagues have reported the results of research on
cigarette smoking conducted in their behavioral economics laboratory (Bickel et al., 1991;
DeGrandpre et al., 1992; DeGranpre et al., 1994; Bickel et al., 1995; DeGrandpre and
Bickel, 1995; Bickel and DeGrandpre, 1996; Bickel and Madden, 1998). These experiments
typically involve individuals ages 18 and older who smoke a pack or more of cigarettes per
11
day who participate in between two and five three-hour experimental sessions per week.
Price, in these experiments, is defined as the number of complete pulls and resets of a
11
For a discussion of a number of other requirements for the participants and more
detail on the features of these experiments, see Bickel and Madden (1998).
plunger required to receive a preset number of puffs on a cigarette. For example, 50

pulls on the plunger may be required to obtain two puffs on a cigarette. Puffs are
monitored by a puff-volume sensor so that each subject receives essentially the same dose
per puff (Bickel and Madden, 1998).
A wide range of prices is used in these experiments. In some of the experiments,
respondents were also presented with an opportunity to earn money for pulls on the plunger
that could then be spent on cigarettes. As in the econometric studies described above,
the behavioral economic analyses have consistently found an inverse relationship between
cigarette smoking and price. Estimates of the price elasticity of demand obtained from
these studies are surprisingly consistent with those obtained from econometric studies.
For example, Bickel et al. (1995) estimated a mean price elasticity of demand of -0.56 for
five subjects in an experiment in which price ranged from 12 to 1600 pulls per puff. A
particularly interesting finding from the behavioral economics research is that the price
elasticity of demand rises as price rises. For example, DeGrandpre and Bickel (1995)
estimated a mean price elasticity of -1.58 for prices ranging from 400 to 4500 pulls per
puff. These findings appear to be generalizable not only across drugs but also across
species (Bickel et al., 1990).
2.4 Econometric studies of the demand for other tobacco products

In contrast to the relatively large literature examining the impact of cigarette
prices on cigarette smoking, few studies look at the effects of price on the use of other
tobacco products, and fewer still consider cross-price effects for cigarettes and other
tobacco products. Much of this research has been conducted by Ohsfeldt and his colleagues
(Ohsfeldt and Boyle, 1994; Ohsfeldt et al., 1997, 1998). Using state-level aggregates
constructed from the September 1985 tobacco use supplement to the Current Population
Survey, Ohsfeldt and Boyle (1994) examined the impact of state smokeless tobacco taxes and
cigarette excise taxes on the prevalence of smokeless tobacco use by males ages 16 years
and older. The authors concluded that higher smokeless tobacco taxes would significantly
reduce the prevalence of smokeless tobacco use. In addition, Ohsfeldt and Boyle found
evidence of substitution among tobacco products, in that higher cigarette excise taxes
have a positive and significant effect on the prevalence of smokeless tobacco use. Given
this finding, they suggested that the increase in smokeless tobacco use observed among
young males in the 1980s was at least in part due to the increases in state cigarette
taxes which were rising more rapidly during this time than state taxes on other tobacco
products.
Similarly, Thompson and McLeod (1976) and Pekurinen (1989, 1991) concluded that some
Canadian and Finnish cigarette smokers, respectively, would switch from manufactured
cigarettes to less expensive hand-rolled cigarettes in response to increases in the prices
of manufactured cigarettes. Pekurinen also found a negative and significant relationship
between the demands for pipe tobacco and cigars and their own-prices. Leu (1984),
however, found little evidence of substitution among tobacco products by Swiss tobacco
users in response to changes in their relative prices.
The findings obtained by Ohsfeldt and Boyle based on aggregate data are confirmed by
their subsequent analyses using individual-level data from the September 1985 CPS
(Ohsfeldt et al., 1997) and the September 1992, January 1993, and May 1993 CPS (Ohsfeldt
et al., 1998). In the more recent analysis, the authors estimated an own-tax elasticity
for smokeless tobacco use of -0.10 for their sample of males ages 16 and older and again
concluded that smokeless tobacco products are substitutes for cigarettes. In addition, as
seen for cigarette demand, they estimated an inverse relationship between the elasticity
of demand for smokeless tobacco products and age.
This finding was confirmed by Chaloupka et al.'s (1997) recent analysis of smokeless
tobacco use among young males using data from the 1992, 1993, and 1994 Monitoring the
Future surveys of eighth, tenth, and twelfth grade students. The researchers estimated an
overall price elasticity of young males' smokeless tobacco use of -0.746, and a
participation elasticity of -0.523.
12
3. Cigarette and other tobacco taxation
12
As most of the evidence and concern pertaining to tobacco taxation relates to
cigarette excise taxation, we refer specifically to cigarette taxation in most of the
discussion in this section. However, we do present the evidence pertaining to the
taxation of other tobacco products where it applies.
With retail price an important determinant of the demand for cigarettes, and excise
tax often a significant component of retail cigarette price, the issue of whether to
increase cigarette excise taxes has been highly visible in legislative debates on both
governmental revenue raising and tobacco control for decades. Cigarette excise taxation
offers an unusual attraction for legislators: given the evidence on demand elasticities,
increases in cigarette taxes of politically plausible magnitude will produce a public
health benefit, by discouraging smoking, particularly among children. At the same time,
they will generate additional revenues for the governmental unit in question, typically at
a fairly low administrative cost. Further, polls often find support for cigarette excise
increases among American voters, frequently even including smokers.
Still, the prospect of increased taxation raises a myriad of complicated
philosophical and practical questions. Among the former are the following: What is the
"right" level of cigarette taxation, if any? What is the basis for determining that it is
"right"? Are cigarette taxes fair, given their distributional burdens in terms of both
vertical and horizontal equity? In particular, since more low-income than high-income
people smoke (in developed countries), will increased cigarette taxes impose an unfair
regressive burden on low-income taxpayers? What are the proper trade-offs between the
interests of individuals (liberty interests, tax burden) and the societal interest in the
public's health? Practical questions include the following: Given the oligopolistic
nature of the cigarette industry, as well as estimated supply and demand elasticities, how
will taxation affect cigarette price? With differences in tax rates by jurisdiction
defining much of the difference in prices across borders of states and nations, will a
given increase in excise tax in a relatively high-tax jurisdiction result in a significant
amount of smuggling from a neighboring low-tax jurisdiction? What are the revenue
implications of a tax increase of given magnitude? How will a given tax-induced price
increase influence smoking, and consequently, what impacts will it have on the public's
health?
Economists have made numerous important conceptual and empirical contributions to
the policy debate on cigarette taxation, primarily, although not exclusively, through
their evaluation of the relationship between cigarette price and consumption, reviewed in
the preceding section. In this section, we review economists' contributions to better
understanding the rationale for (or against), and additional effects of, cigarette excise
taxation.
3.1 Comparative standards and the effects of tax on price

3.1.1 Purposes and methods of taxation
Cigarettes and other tobacco products have been taxed for centuries, primarily
because the relatively inelastic demand for these products makes them an easy source of
revenues. In the U.S., for example, tobacco has been taxed since colonial times, rising
with revenue needs and declining during more prosperous times. Since the Civil War,
tobacco taxes have remained a part of the U.S. federal tax system, often increasing during
wartime and falling again in peacetime. Similar historical patterns are observed in many
other developed countries. However, the importance of tobacco taxes as a share of total
revenues has generally declined over time in most countries. In the U.S. for example,
tobacco taxes currently account for less than one-half of one percent of total federal
revenues, down from 3.36 percent of revenues in 1950.
In recent decades, the increased taxation of cigarettes and other tobacco products
has been motivated not only by the revenue generating potential of these taxes, but also
as a means to reduce cigarette consumption. Warner (1981b) concluded that the information
on the health consequences of cigarette smoking that began appearing in the 1950s and
early 1960s led a number of states to increase cigarette taxes as a way of discouraging
cigarette demand. More recently, a number of countries have adopted or considered large
tax increases on cigarettes and other tobacco products as a way to reduce consumption. In
Canada, for example, steady federal and provincial tobacco tax increases throughout the
1980s and early-1990s were motivated in part by concerns over the health consequences of
smoking. Similar concerns were behind the recent large increases in cigarette taxes in
California, Massachusetts, Arizona, Oregon, and other U.S. states.
Large tax increases can generate both significant declines in cigarette smoking as
well as considerable increases in cigarette tax revenues. In Canada, for example, the
over 500 percent increase in taxes between 1982 and 1992 led to an increase in real
cigarette prices of 170 percent, reducing total cigarette smoking by 38 percent (Sweanor
and Martial, 1994). Total federal and provincial cigarette tax revenues rose by 240
percent during this period, even with the development of a significant black market in
cigarettes.
Cigarettes and other tobacco products are taxed in a variety of ways. The most
commonly used methods of taxation include excise taxes, value added and other ad-valorem
taxes, and import duties. Most cigarette excise taxes are specified as an amount per x
number of cigarettes (e.g., the U.S., Canada, and many others), while others are based on
the weight of tobacco contained in the cigarette (e.g., Australia and Malaysia).
Similarly, there are a variety of ad-valorem taxes, including the value added taxes
imposed by most European and many other countries, as well as the sales taxes applied in
most U.S. states and elsewhere. There are comparable differences in the types of import
duties applied by nearly all countries to tobacco products. Some of the distinctive
features of these taxes include: earmarking for tobacco-related education, counter-
advertising, and other health related activities (e.g., Finland, Denmark, Peru, Romania,
Nepal, and several U.S. states); the use of tax revenues to create the state-run Health
Promotion Foundations in several Australian states and the Health Sponsorship Council in
New Zealand, to fund sporting and artistic events previously backed by the tobacco
industry; and the differential taxes on cigarettes with high tar and nicotine content used
in previous years in the U.K. (WHO, 1997; Roemer, 1993).
3.1.2 Effects of taxes on retail price

Increases in cigarette and other tobacco taxes result in higher prices for these
products. When excise taxation is the primary form of tobacco taxation, however, the real
value of the tax will fall over time, unless regularly increased to account for inflation.
Given that taxes are an important component of price, one consequence of an excise tax
system for tobacco products with relatively infrequent tax increases is that the real
price of these products will fall over time as the prices of other goods and services
increase more rapidly. In the U.S., for example, due to the relative stability of federal
and state cigarette excise taxes throughout the 1970s, real cigarette prices fell by
nearly 40 percent. Between 1981 and 1996, however, real cigarette prices in the U.S. rose
by over 65 percent, due in part to the tripling of the federal cigarette excise tax and
numerous state tax increases.13 In contrast, the real value of an ad-valorem tax on
tobacco products is maintained when the prices of these products rise with the prices of
other goods and services.
The oligopolistic nature of the cigarette industry and the addictive nature of
cigarette demand have important implications for the effects of cigarette tax increases on
cigarette prices. In a perfectly competitive market with constant long-run costs of
production, any tax increase would be fully passed on to consumers. At the other extreme,
a monopolist would share the burden of the tax increase with consumers, with consumers
bearing relatively more of the burden when demand is relatively inelastic. In most
developed countries, the cigarette industry, however, is clearly at neither extreme, but
is instead an oligopoly. In the U.S., for example, the five leading cigarette producers
accounted for virtually the entire cigarette market, with the top three (Philip Morris,
R.J. Reynolds, and Brown & Williamson) controlling over 90 percent of the market (Federal
Trade Commission, 1997). In some countries, however, particularly developing countries, a
domestic monopoly controls most of the market.
Most of the empirical analyses of the relationship between cigarette taxes and
prices are based on data from the U.S. Early studies produced generally inconsistent
findings (Barzel, 1976; Johnson, 1978; Sumner, 1981; Sumner and Ward, 1981; Bulow and
Pfleiderer, 1983; Bishop and Yoo, 1985; Sullivan, 1985; Sumner and Wohlgenant, 1985;
Ashenfelter and Sullivan, 1987). One general weakness of these studies is that they
failed to account for the dynamic interaction of firms in an oligopolistic industry.
Instead, they generally assumed that the rules for firm behavior were established and then
worked backwards to estimate the degree of competition in the industry (Harris, 1987).
More recent studies have attempted to model the dynamic nature of an oligopolistic
industry when estimating the impact of cigarette taxes on cigarette prices. Harris (1987)
used data on wholesale and retail cigarette prices as well as manufacturing costs to
estimate the change in cigarette prices that resulted from the doubling of the U.S.
federal cigarette tax in 1983. He concluded that the eight-cent tax increase led to a 17-
cent price increase that was not explained by increased manufacturing costs. Instead,
Harris argued that the scheduled tax increase served as a mechanism for a coordinated,
13
Increases in the non-tax component of price, however, account for most of the rise
in U.S. cigarette prices between 1981 and 1996. During this period, cigarette taxes as a
percentage of price fell from just over one-third to under one-quarter.
oligopolistic price increase.

Barnett and his colleagues (1995) noted that Harris' analysis did not fully account
for underlying trends in cigarette prices. Consequently, they argued that Harris
attributed too much of the increase in price to the increase in the tax since the upward
trend in cigarette prices predated the debate over the federal tax increase. Instead,
they argued that the introduction of generic cigarettes in 1981 allowed cigarette
producers to engage in coordinated increases in the prices of premium cigarettes since the
generic cigarettes would keep more price-sensitive smokers in the market.
Keeler and his colleagues (Keeler et al., 1996; Barnett et al., 1995; Sung et al.,
1994) used national and state level data in empirical analyses of the effects of tax
increases on price. Their models account for the interaction of supply and demand, the
oligopolistic nature of the cigarette industry, and, in some, the addictive nature of
cigarette demand. Using annual state-level data for the period from 1960 through 1990,
Keeler et al. (1996) estimated that a one-cent increase in a state's cigarette tax would
raise retail prices in that state by 1.11 cents. In addition, they estimated that
increases in federal cigarette taxes would generate larger increases in cigarette prices
than those resulting from state tax hikes (Barnett et al., 1995). They attributed this
finding to the potential of cross-border shopping for cigarettes in response to a state
tax increase. Finally, Keeler et al. (1996) concluded that cigarette producers price
discriminate by state, in that stronger state and local anti-smoking laws are offset by
lower prices. However, they noted that the effect of price discrimination is not large
relative to retail cigarette prices.
Based on the Becker and Murphy (1988) rational addiction model, Becker et al. (1994)
suggested an alternative explanation for the finding that cigarette prices increase by
more than cigarette taxes when taxes are raised. They argued that when taxes are raised,
cigarette companies will raise price by more to obtain maximum profit from current,
addicted smokers. These increased current profits help offset the future losses from the
reduced smoking initiation resulting from the price increase. Becker and his colleagues
explained this apparent paradox as follows: "If smokers are addicted and if the industry
is oligopolistic, an expected rise in future taxes and hence in future prices induces a
rise in current prices even though current demand falls when future prices are expected to
increase" (page 413). They went on to explain that because of the addictive nature of
smoking, cigarette producers set prices below their short-run profit maximizing level in
order to "hook" consumers on their addictive product, thus raising the future demand for
this product. Showalter (1998) makes a similar argument with respect to advertising,
suggesting that cigarette producers might engage in apparently excessive advertising in
order to attract a few new customers.
3.1.3 Variations in cigarette tax across countries and states and the issue of smuggling
The share of cigarette taxes in cigarette prices varies widely among countries. In
Denmark, Ireland, and the U.K., for example, over 80 percent of cigarette prices are
accounted for by cigarette taxes (Sweanor, 1997), while taxes in most others were between
65 and 80 percent.14 In contrast, among developed countries, cigarette taxes are less
than half of price only in the U.S., where they account for 35 percent of price, on
average (21 percent in the lowest taxing state and 47 percent in the highest). The large
difference in cigarette taxes leads to a five-fold difference in cigarette prices among
these countries. As the WHO (1997) has observed, inter-country differences in wages and
prices can understate the difference in price when expressed in a single currency. When
expressed in terms of minutes of labor required to earn the price of a pack of cigarettes,
the differences are even larger.
One consequence of the differences in cigarette taxes and prices, both across
countries as well as among different taxing jurisdictions within countries, is the
potential for casual and organized cigarette smuggling and other forms of tax evasion.
The cigarette industry, for example, frequently argues that cigarette tax increases will
actually lead to reductions in tax revenues due to smuggling and other tax evasion
(British American Tobacco, 1994). The smuggling problem is exacerbated by the relative
ease with which tobacco products can be transported, the potential profits from this
illegal activity, the presence of an informal distribution network in many countries, the
availability of tax-free and duty-free cigarettes, and nonexistent or relatively weak
policies concerning cigarette smuggling and their lack of enforcement (Joossens and van
14
Based on prices and taxes as of December 31, 1996.
der Merwe, 1997; Joossens and Raw, 1995, 1998; Advisory Commission on Intergovernmental
Relations (ACIR), 1977 and 1985). Joosens and Raw (1995, 1998) argued that many of these
other factors can be as important as price differences in spawning cigarette smuggling.
For example, they noted that there is little evidence of cigarette smuggling in some of
the highest priced European countries, including France, Norway, Sweden and the U.K.,
while there is extensive evidence of smuggling in those with relatively low prices, such
as Spain and Italy. Moreover, they concluded that much of the cigarette smuggling that
does occur in Europe and elsewhere is actually encouraged by the large, multinational
tobacco companies. Thursby and Thursby (1994) provided empirical support for this
argument, based on their analysis of data from the U.S. from which they concluded that
increases in federal cigarette excise taxes lead to increased commercial cigarette
smuggling.
There have been relatively few econometric analyses of the impact of price
differentials on organized and casual cigarette smuggling. All of these studies are based
on annual state-level cigarette sales data from the U.S. and all have concluded that the
casual and organized smuggling of cigarettes from major tobacco producing states, as well
as other states with relatively low cigarette prices compared to neighboring states,
accounts for a significant share of sales in these states (Saba et al., 1995; Becker et
al., 1994; Chaloupka and Saffer, 1992; Baltagi and Levin, 1986; ACIR, 1977, 1985;
Manchester, 1976).
Perhaps the most widely cited example of the link between cigarette tax increases
and smuggling is the Canadian experience during the late-1980s and early-1990s. In 1980,
when Canada adopted an ad-valorem approach to cigarette taxation, Canadian cigarette
prices were somewhat higher than prices in the U.S. By 1984, the gap had widened as
Canadian cigarette taxes doubled and real cigarette prices rose by 25 percent. In 1984,
in response to industry pressure, the ad-valorem tax was replaced by an excise tax. Over
the next few years, growth in Canadian cigarette taxes slowed, with most tax increases
taking place at the provincial level. In 1988, however, the federal government mounted an
aggressive anti-smoking campaign that included significant tax increases. In 1989, the
federal tax was raised by two cents per cigarette, followed by a three cents per cigarette
increase in 1991; provincial taxes continued to increase as well. By early 1994, the
average Canadian tax per pack was $2.96 (in U.S. dollars), more than five times the U.S.
average (Sweanor and Martial, 1994).
The large tax and price disparities between the U.S. and Canada led to substantial
cigarette smuggling from the U.S. Smuggling was a relatively minor problem prior to 1992;
however, beginning in 1992, smuggling rapidly increased after the repeal of a Canadian tax
on cigarette exports. In addition, the smuggling problem was exacerbated by the long
undefended border between the U.S. and Canada, relatively weak border controls, and the
high concentration of the Canadian population near U.S. borders (Sweanor and Martial,
1994). Much of the black market trade was in cigarettes originally produced in Canada,
exported to the U.S. tax-free, and then smuggled back into Canada; relatively little
involved U.S. produced cigarettes given their use of a blend of tobacco different from
that preferred by Canadian smokers.
In response to an aggressive industry-sponsored campaign, the Canadian federal
cigarette tax was reduced by $5.00 per carton on February 9, 1994, with an agreement to
match provincial tax reductions of up to another $10.00 per carton. Quebec quickly
lowered its provincial tax by $11.00 per carton, for a total tax cut of $26.00 per carton,
cutting cigarette prices in half. Several other provinces followed and by the end of
1996, the average tax per pack was less than $2.00. Canadian tax revenues fell and rates
of smoking increased, particularly among youth.
The variations in taxes across countries and within countries over time reflect a
myriad of practical and political considerations, with smuggling but one of them. In
contrast to the legislators who must set taxes based on such considerations, academic
economists approach the issue of the desirable level of cigarette taxation by
contemplating the application of a number of economic principles relating to both equity
and efficiency. The remainder of section 3 examines these principles and their relevance
to the determination of a theoretically optimal cigarette excise tax. The discussion also
compares and contrasts the perspective of the economist with that of the public health
professional, for whom different criteria define "optimality" in cigarette taxation.
3.2 Fairness standards

The search for an optimal tax encompasses considerations of efficiency and equity.
Each of these domains has featured prominently in policy debates on increasing cigarette
taxes as well. From an efficiency point of view, the principal economic theory argument
favoring imposition of a product-specific (excise) tax relates to the creation of negative

externalities through production or consumption of the product. The nature and extent of
such externalities with regard to smoking have been the subject of considerable debate
among economists, as is discussed later in this section.1516
First, however, we examine a central issue in cigarette taxation, namely whether it
violates widely accepted standards of fairness, with an emphasis on vertical equity. In
developed countries such as the U.S., proportionately more lower-income people smoke than
do those with high incomes. As a consequence, the burden of a tax on cigarettes is
experienced disproportionately by the poor. The tax is criticized as being highly
regressive.
3.2.1 Horizontal and vertical equity

In terms of tax policy, the principle of horizontal equity is that equals should be
treated equally. Clearly, cigarette taxation violates this principle, if one accepts that
people who are identical except for their smoking behavior should be deemed "equals."
Arguments in favor of cigarette taxation thus ignore this principle, while opponents of
taxation appeal directly to it (although rarely in the language of economists). Violation
of the horizontal equity principle has never been the focal point of critics' concern,
however. Rather, they have focused on questions of vertical equity, specifically the
apparent regressivity of cigarette taxes. Cigarette taxes would be regressive with
respect to income if poorer and more affluent consumers smoked at the same rate. The
potential problem of regressivity is exacerbated, in many developed countries at least, by
the above-mentioned tendency for smoking prevalence to be inversely related to income.
Recent empirical analysis has muted this concern somewhat, concluding that the
degree of regressivity is substantially less than appears at face value. Using data from
the 1984-85 Consumer Expenditure Survey, analysts at the Congressional Budget Office
(1990) found that expenditures on tobacco products increased with income, except for those
in the highest income quintile. In part this reflects an increasing intensity of smoking
(numbers of cigarettes) among smokers as income rises, and a propensity for higher-income
smokers to buy products that are more expensive per unit. As a percentage of post-tax
income, however, tobacco spending varied inversely with income level, with the lowest
quintile spending 4% on tobacco.
When the CBO analysts examined tobacco spending as a percentage of expenditures on
all good and services, however, they found that the share of tobacco expenditures fell
gradually over the first four income quintiles (from 1.6 to 1.1%) and dropped sharply in
the top quintile (to 0.7%). Consequently, CBO concluded, if annual family expenditures
are more reflective of lifetime income than annual family income, then tobacco
15
Less frequently debated is a pragmatic consideration: whether cigarette taxation
violates the Ramsey Rule, namely that when dealing with consumption taxes, tax rates
should vary inversely with the elasticity of demand for products (holding supply
elasticity constant). The purpose is to ensure that revenue-raising occurs in a manner
that will minimize distortions in consumers' choices among goods and services and in their
decisions of how much to spend and how much to save. Until recently, the empirical
evidence has suggested that cigarettes are an excellent target for taxation, consistent
with the Ramsey Rule, given the consensus view on their relatively low demand
elasticities, discussed in the preceding section. Jones and Posnett (1988) estimated that
a 1% increase in the cigarette tax rate would generate about a 0.9% increase in revenue.
As noted in the preceding section, however, long-run demand elasticities may be as much as
twice short-run elasticities, as reflected in the findings associated with application of
the rational addiction model to cigarette smoking (Becker et al., 1994). Use of these
greater long-run elasticities would suggest a lower level of tax efficiency.
16
The issues raised in this discussion would apply also to many other behaviors and
consumption goods, such as consuming large quantities of fat (a risk factor for heart
disease and cancer) or driving motorcycles (a risk factor for serious injury). Despite
the logical parallels, few economists or public health professionals have advocated a fat
tax or a special injury-related tax on motorcycles. Cigarettes (and alcohol; see the
chapter by Cook and Moore) have been identified as unique in terms of the magnitude of the
health damage and negative externalities they create. The "slippery slope" argument --
once negative externalities are used to justify taxing tobacco and alcohol, cars will be
next, then fat, then salt, etc. -- is not addressed in this chapter.
expenditures are only slightly regressive over income classes. CBO also noted that
younger families spend a higher proportion of their income on tobacco and that their share
of tobacco spending as a percentage of total expenditures was higher as well.
To examine the distributional impact of a cigarette excise tax increase, CBO
simulated the effects of doubling the then (1990) 16-cent federal per pack excise tax.
When income tax brackets and transfer payments were indexed to account for the price
increases associated with the excise tax increase, the apparent regressivity was reversed;
the adjustments had the effect of lowering individual income taxes and raising transfer
payments. Relative to expenditures, CBO found the burden of the increased tax to be
closer to proportional than regressive. The largest share of the simulated tax increase
was paid for by families in the third and fourth income quintiles, with the smallest share
borne by families in the two lowest quintiles (first and second).
To control for the intertemporal nature of cigarette smoking, Lyon and Schwab (1995)
examined the distributional effects of cigarette (and other "sin") taxes across measures
of permanent or lifetime income. The authors did not find important differences in
regressivity patterns compared to studies based on current income.
Recent research on differences in the price elasticity of demand for cigarettes by
various measures of socioeconomic status has produced findings that suggest that the
degree of regressivity normally attributed to cigarette taxation is considerably
overstated. Townsend and colleagues (1994) found that (the absolute value) of price
elasticity was inversely related to social class in Great Britain, with members of the
highest social class exhibiting little price responsiveness and those in the lowest social
class having an elasticity close to unity. In the U.S., Chaloupka (1991) concluded that
less-educated persons were more price responsive than the more-educated, while Farrelly
and his colleagues (1998) found that cigarette demand by lower income persons was more
elastic than that by higher income persons. Given the high correlation between income and
both social class in Great Britain and education in the U.S., these studies indicate that
increased cigarette taxes would reduce observed differences in smoking among socioeconomic
groups. This mitigates conclusions about regressivity that derive from analyses that have
failed to consider the inverse relationship between elasticity and income. The latter has
characterized all studies to date.
Regardless of whether regressivity proves to be a serious concern or not with regard
to cigarette taxation per se, analysts have pointed out that the goal of tax policy is for
the overall impact of a tax and expenditure system to be progressive or proportional,
rather than regressive (Congressional Budget Office, 1990; Warner et al., 1995). Related
to this notion, various proposals to increase cigarette taxes have earmarked a portion of
revenues to expenditures designed to aid the poorer members of society. These have ranged
from smoking-specific expenditures (e.g., provision of smoking cessation services for the
poor) to proposals to fund health care for the poor in part with cigarette tax revenues.
3.2.2 The benefit principle

Another perspective on fairness is that smokers should bear the costs of smoking
that they impose on other members of the society. This consists of two categories of
costs: those associated with diseases experienced by nonsmokers due to exposure to
environmental tobacco smoke; and smokers' own publicly-funded medical costs subsidized by
nonsmoking taxpayers. Related to the latter, excise taxation might be partially justified
on the basis of the benefit principle, the notion that people who derive benefits from
government activities should be taxed to cover their costs of production.
In the most direct application of this "user fee" concept, proponents argue that
smokers should pay, through cigarette taxes, for the publicly-funded health care that
smoking necessitates, primarily in the U.S. through the Medicaid program for the indigent
and the Medicare program for the elderly. Although appealing at first blush, the logic
underlying this argument can be challenged. First, the tax is a blunt instrument: many
smokers who incur smoking-related health care expenditures will pay for them themselves,
either out of pocket or through private health insurance. Why should they subsidize the
health care costs of other smokers more than do nonsmokers? Similarly, many of today's
smokers, who pay the excise taxes, will cease smoking in time to avoid smoking-related
illnesses. Further, the costs that today's generation of smokers will experience in the
future are not easily predicted; perhaps some currently expensive smoking-related disease
conditions will be readily and inexpensively treatable in the future. Even if these costs
were knowable, they would need to be discounted to reflect the fact that they will not
occur, on average, for two or more decades. As it has been advanced to date, the "user
fee" argument has today's smokers paying for today's smoking-related health care costs
(Warner et al., 1995).
In the case of smoking, the benefit principle is inextricably linked to the broader
issue of the negative externalities associated with smoking. We consider the evidence
pertaining to externalities below. First, however, we turn to fairness arguments in favor
of increasing cigarette taxes that emanate from the public health community. Economists'
analyses of the external costs of smoking are highly relevant to informing the public
health community's sense of the social costs of smoking.
3.3 Public health standards

The public health community has advocated large increases in tobacco taxes for two
reasons. One is the notion that smokers should cover the social costs of smoking, with
the public health conception of social costs including both private costs to smokers and
their families, as well as negative externalities (Cook, 1991). The second is based on a
pragmatic realization: through its effects on prices, taxation will discourage many people
from smoking, particularly young people. As a consequence, literally hundreds of
thousands of premature deaths could be avoided by large increases in cigarette taxes. In
this context, cigarette taxation is viewed as a powerful policy tool with which to foster
improvements in the public's health.
3.3.1 The social cost of smoking

The public health community has long argued that smoking imposes large costs on
society and that smokers should bear the burden of these costs. Cost-of-smoking analyses
include three categories of costs: (i) the direct medical costs of preventing,
diagnosing, and treating smoking-related diseases; (ii) the indirect morbidity costs
associated with lost earnings from work attributable to smoking;17 and (iii) the indirect
mortality costs related to the loss of future earnings due to premature smoking-produced
deaths. Combined, these total well over $100 billion in the U.S.18 Although most of the
cost-of-smoking analysis has employed American data, estimates have also been prepared for
Canada (Forbes and Thompson, 1983; Collishaw and Myers, 1984), Great Britain [ref], China
(Jin et al., 1995), and other countries. In addition, numerous state-specific analyses
have been performed in the U.S., most based on the SAMMEC model (Smoking-Attributable
Morbidity, Mortality, and Economic Costs) (Shultz et al., 1991).
The cost-of-smoking studies have employed a variety of methods of estimating the
different cost components, with attributable-risk methodology common in estimating
smoking-related disease incidence or prevalence and the human capital approach employed in
placing a value on lost years of life (Hodgson and Meiners, 1982; Warner et al., 1998).
Following a trend in cost-of-illness estimation in general, more recent studies have
adopted an incidence approach (Manning et al., 1989, 1991; Hay, 1991; Hodgson, 1988, 1992;
Oster et al., 1984), in contrast with the prevalence approach predominant in the earlier
studies (e.g., Rice et al., 1986). The prevalence approach values the present costs
associated with all existing cases of smoking-produced illness (including future lost
earnings attributable to current deaths). In contrast, the incidence approach values all
of the future costs associated with new cases of smoking-produced disease during the
reference year. The former provides an estimate of the current economic burden of
smoking, while the latter is more useful for analyses of interventions that might
interrupt the development of smoking-related illness.
The cost-of-smoking studies can be faulted on numerous grounds. For one, they have
tended to omit certain categories of smoking-related health care, such as treatment of
burn victims from smoking-ignited fires19 and perinatal care for low-birth-weight babies
of smoking mothers (U.S. Department of Health and Human Services, 1998). Few studies have
considered the costs of treatment of diseases caused by environmental tobacco smoking. No
17
A significant amount of work loss is associated with smoking (U.S. Department of
Health and Human Services, 1989). In addition, smoking may decrease productivity while
smokers are on the job, due primarily to the number and length of smoking breaks they
take. The latter is rarely included in studies of the social costs of smoking, although
it has been raised during debates on indoor smoking restriction legislation.
18
Authors' calculations, updating estimates in Bartlett et al. (1994) and Miller et
al. (1998) to contemporary dollars.
19
Cigarette smoking is the leading cause of home fires and the leading cause of burn
deaths (Napier, 1996).
study has yet attempted to value intangible costs, such as the pain and suffering of
smoking-related disease victims and their families. Ironically, these intangible costs
may well dominate all of those that are more readily quantified (Abt, 1975).
Hodgson (1998) and his colleagues (Warner et al., 1998) have argued that, as it is
being applied in this literature, the conventional attributable risk methodology
considerably underestimates smoking's burden on the health care system by virtue of its
failure to consider how smoking complicates the course of many illnesses not themselves
directly associated with smoking. For example, diabetics who smoke often have more
complications of their diabetes than diabetics who do not smoke. Smokers recover more
slowly from surgeries of all types than do nonsmokers, thus extending post-surgical
hospital stays. HIV-infected smokers may be more likely to develop near-term AIDS than
are HIV-infected nonsmokers (Napier, 1996). Inclusion of such costs in cost-of-smoking
analysis might lead to an increase in estimates of 50% or more.
The cost-of-smoking studies also fail to take account of a wide variety of direct
costs in addition to medical costs, including such items as the time and transportation
costs associated with getting patients to and through health care services, the direct
costs of home modifications to accommodate smoking-related disabilities, damage to
buildings due to smoking-produced fires, smoking-related maintenance costs in industrial
settings and homes, and the increased frequency of laundering necessitated by smoking.
Omission of these nonmedical costs is standard practice in nearly all of the broader cost-
of-illness literature. Occasionally, such omissions are acknowledged, with the
researchers stating that they did not view such costs as large enough to warrant the
additional research.
The indirect morbidity and mortality costs have been criticized frequently as
representing an inadequate means of valuing the avoidable premature loss of life. By
relying exclusively on the human capital approach, they place no value on life per se,
clearly contrary to the behavior of virtually all civilized societies which invest in
preserving the health of senior citizens after they retire. Many analysts concur that use
of willingness-to-pay measures would be preferable, but they bemoan the lack of suitable
instruments for assessing such values.
The cost-of-smoking analytical community includes individuals who have calculated
some of the economic "benefits" of smoking, including the reduction in Social Security
payments for smokers who die prematurely (Shoven et al., 1989) and medical expenditures
avoided as a result of smokers' premature demise. The latter, in particular, has set off
a "battle of the studies" to ascertain whether the net medical expenditures associated
with smoking are positive or negative (Leu and Schaub, 1983; Manning et al., 1989;
Hodgson, 1992; Barendregt et al., 1997; Warner et al., 1998). The entire question of
whether such "negative costs," or cost offsets, should be included in the calculation of
smoking's social costs has become a major front in the academic battle over definition of
the social costs of smoking. Viscusi (1995), for example, recently concluded that
consideration of medical and pension offsets makes the net social costs of smoking small,
if positive at all. Harris countered that in no other area of social policy analysis is
death treated as an economic benefit (Coalition on Smoking or Health, 1994; Harris, 1993).
The import of this intellectual debate is potentially substantial. At the center of
the public health community's advocacy of higher cigarette taxes is the social cost
argument that smokers (or the industry that feeds their addiction) are imposing a huge
economic burden on the society and ought to pay for it through higher excise taxes. Using
the public health construction of social cost, some analysts have concluded that in the
U.S., the cigarette excise tax needs to be on the order of $3-4 or more to cover these
costs (e.g., Hay, 1991).
Economists of many political stripes have countered that, for purposes of estimating
an optimal cigarette excise tax, the correct notion of social cost is the traditional
economist's measure of externalities, i.e., costs imposed by smokers on others, excluding
their own family members. Economists' contributions to this debate are considered below,
following a brief discussion of the true heart of the public health case for higher taxes:
the health benefits that would result.
3.3.2 The health benefits of increasing cigarette taxes

Through a variety of channels, the economics literature on tax, price, and demand
has reached the public health community (Scott and Dickert, 1993; Coalition on Smoking or
Health, 1994). Given the strength of the evidence linking price increases to demand
decreases, with the consensus that price elasticity is inversely related to age, the
public health community has become convinced that cigarette tax increases are one of the
most effective policy tools for decreasing smoking, especially among children. As a
consequence, increasing price, generally through a tax hike, is featured in nearly every
comprehensive tobacco control policy proposal.
The raison d'etre underlying the public health community's desire to see smoking
decline is to reduce the morbidity and disability and premature mortality associated with
smoking. Economists have taken the demand elasticity evidence and combined it with data
on the health consequences of quitting smoking (primarily adults) and not starting
(primarily children) to project the health gains that would be achieved with tax increases
of various magnitudes. For example, in the mid-1980s, the U.S. Congress had to decide
whether to permit a scheduled "sun-setting" of 8 cents of the then 16-cent cigarette
excise tax (increased from 8 cents in 1983). Warner (1986b) used the price elasticity
estimates of Lewit et al. (1981) for children and Lewit and Coate (1982) for adults to
estimate the consumption implications of permitting the sun-setting to occur or, instead,
increasing the tax by 8 or 16 cents per pack. He concluded that if the tax were doubled
to 32 cents, and the real value of the tax maintained thereafter, 800,000 youths would be
deterred from starting to smoke and 2.7 million adults encouraged to quit. Applying the
conservative assumption that one of every four lifetime smokers dies prematurely of a
smoking-related illness (the proportion is now believed to be about half), the analysis
estimated that this tax increase would eventually reduce premature deaths in persons then
12 years and older by 860,000.
Harris (1987) also evaluated the consumption and health implications of the 1983
doubling of the federal excise tax, considering the implications of various elasticity
estimates. He concluded that the tax increase had likely deterred 600,000 youths from
smoking and that, as a consequence of their avoidance of cigarettes and adults quitting,
54,000 of the youths and an additional 100,000 adults would survive to at least 65 years
of age.
The General Accounting Office (1989) employed the same elasticity estimates used by
Warner (1986b) and the same assumptions about premature mortality avoided to evaluate the
likely health benefits from a sustained real 21-cent federal tax increase in 1989, which
they estimated would increase retail price by 15%. They predicted a further reduction in
youth smoking of 500,000, with a subsequent reduction in premature mortality among these
youths of 125,000.
Recently, Moore (1996) developed a more sophisticated econometric model that,
incorporating state-level data on death rates from smoking-related diseases from 1954
through 1988, could be used to evaluate the impact of higher taxes on mortality. He
determined that a 10% increase in cigarette excise taxes would save approximately 5,200
lives each year. Similarly, Evans and Ringel (forthcoming) examined whether or not higher
state cigarette taxes can be used to improve birth outcomes. Using data on approximately
10.5 million births in the U.S. over the period from 1989 through 1992, the authors
estimated a smoking prevalence elasticity of -0.5 for pregnant women and found that
increased cigarette taxes would significantly raise birth weight.
With the help of economic consultants, the Coalition on Smoking or Health (1994)
used relatively conservative estimates of price elasticity and of the mortality
consequences of smoking to estimate the health implications of alternative tax hikes
advocated by the Coalition's member organizations. The Coalition determined that a 75-
cent tax increase in 1992 would reduce premature deaths due to smoking by 900,000. A $2
per pack increase was estimated to save 1 million more lives than the 75-cent increase.
Chaloupka (1998) did the same for the price increases included in many of the recent
proposals for national tobacco legislation in the US. Based on Chaloupka and Grossman's
(1996) estimates, Chaloupka estimated that a $1.50 increase in cigarette taxes and prices,
phased in quickly and maintained in real terms, would reduce overall cigarette consumption
by about 30 percent while cutting youth smoking prevalence almost in half. Based on the
CDC's (1996) estimates for the number of youth in the 1995 US cohort of 0 through 17 year
olds who would eventually die prematurely from a smoking related illness, Chaloupka
estimated that this tax increase would prevent approximately 2.5 million deaths in this
cohort.
To most members of the public health community, the health benefits of a tax
increase justify its imposition. However, public health professionals appeal to the
social cost argument to garner public and, especially, legislative support. Given the
conceptual as well as empirical problems with the public health community's construction
of the social cost of smoking, discussed above, the question remains as to whether
economists would find theoretical justification for increasing the cigarette tax in the
analyses of external costs that have been performed to date, or for that matter in other
considerations. The next section addresses the economic efficiency issues and evidence.
3.4 Economic efficiency and the pursuit of an optimal cigarette tax

Most economists would concur that an economically optimal tax on cigarettes would
equate the revenues generated with the net external costs produced by smoking.20 Here we
review the evidence pertinent to determining such a tax and evaluate additional
considerations that relate to the notion of optimality when considering taxation of an
addictive substance such as cigarettes.
3.4.1 Negative externalities associated with smoking

As discussed above, the public health community's definition of social costs
incorporates both negative externalities and private costs. While economists agree that
the latter should not be considered as social costs in contemplating a corrective tax on
cigarettes, there is no complete consensus on precisely what consequences warrant
inclusion, and even for those for which there is consensus, estimates of the magnitude of
the true social externalities vary widely. Moreover, other tobacco control policies,
particularly restrictions on smoking in public places and private worksites, may be more
efficient approaches to dealing with some of these externalities.
One author found that including the costs of the long-term intellectual and physical
consequences of smoking-related low-birth-weight disabilities implied a tax of $4.80 per
pack (Hay, 1991). In contrast, other studies have found much smaller per-pack negative
externalities, often less than existing excise tax rates. For example, evaluating data
from the RAND Health Insurance Experiment and the 1983 National Health Interview Survey in
an incidence-based cost analysis, Manning et al. (1989) concluded that, for their mid-
range estimates, the negative externalities of smoking totaled the equivalent of 43 cents
per pack (in 1986 dollars). Partially offsetting these negative externalities, however,
were an estimated 27 cents in "external savings" resulting from smoking-related premature
deaths, meaning that the net negative externalities equaled 16 cents. The researchers
thus concluded that the empirical evidence did not justify raising the cigarette tax on
grounds of covering negative externalities.21 In a later analysis that drew on the
Manning et al. study, Viscusi (1995) came to the same conclusion.
The Manning et al. study and Viscusi’s reanalysis hasbeen cited frequently by
opponents of a cigarette tax increase. Representing the Tobacco Institute at a Senate
hearing, Tollison (1994) identified the work by Manning and his colleagues, as well as
that of other prominent health economists, as rejecting the propriety of an economically-
motivated tax increase. The Congressional Research Service (Gravelle and Zimmerman, 1994)
cited the same study in the CRS's evaluation of the grounds for a tax increase (which the
authors found wanting). Updating the figures to 1995 dollars, the CRS estimated the net
negative externalities at 33 cents per pack of cigarettes, two-thirds of the average 50
cents in federal and state taxes imposed on cigarettes in late 1993.
20
Pigou (1962) suggested that, for goods with market prices less than their social
costs, taxes could be used to raise the marginal cost of consuming the good to the social
marginal cost. For some goods, taxes could generate revenues that exceed total external
costs, reflecting the fact that the taxes are based on marginal rather than average
external costs (Cook and Moore, 1993).
21
Early analysis of the offsetting savings associated with smokers' premature deaths
is found in the work of Leu and Schaub (1983). These authors estimated the lifetime
medical expenditures of a cohort of Swiss males, which included both smokers and
nonsmokers, and compared them with the simulated expenditures of a hypothetical cohort
assumed to include only nonsmokers. The authors concluded that the lifetime expenditures
would be very similar for both cohorts, with the higher annual costs of smokers in the
"real" cohort offset by the additional years of medical expenditures in the longer-lived
hypothetical no-smoker cohort. In estimating the medical costs of nonsmokers in the
hypothetical cohort, Leu and Schaub recognized that those who would have been smokers in
the "real" cohort would differ in ways other than just smoking from those who would be
nonsmokers in both cohorts. They introduced the notion of the "non-smoker smoker type" as
the conceptually correct entity to evaluate in the hypothetical cohort, for those members
who would have been smokers in the "real" cohort. This useful distinction has been
incorporated in the work of several economists since then, including Manning et al.
(1989). Implicitly, it is embodied in all attempts to evaluate smoking-related health
care costs in which smokers' other risk-taking behaviors are controlled (e.g., Bartlett et
al., 1994; Miller et al., 1998).
Although the Manning et al. study has dominated attention within the economics
debate about the marginal social costs of smoking, the study reveals several problems of
both omission and commission, many of which the authors have acknowledged (Manning et al.,
1991). Adjustments reflecting these issues often lead to qualitatively different
conclusions about the desirability of increasing the cigarette excise tax. In terms of
omission, most notably the study excluded a variety of costs associated with environmental
tobacco smoke (ETS) that, if included, would significantly increase the social cost
estimate. Many of the health consequences of ETS were not well appreciated when Manning
et al. undertook their research in the mid-1980s (e.g., the consequences of ETS for heart
disease). However, the authors made the decision to consider then-known ETS costs as
internal, based on the traditional economic assumption that the family is the appropriate
economic unit for consumption decisions, including the decision to smoke. Further, the
authors reasoned, the adverse health consequences of smoking were largely confined to the
nonsmoking spouses of smokers.22
Although few economists would challenge the sanctity of the family as the basic
economic unit, the assertion about the internal nature of ETS costs is less clear.
Certainly, some ETS costs are external to the family (e.g., airline attendants' ETS-
induced lung disease prior to the banning of smoking on flights). Others likely represent
a mix of internal and external costs. For example, disease and developmental problems
associated with low birth-weight caused by mothers' smoking during pregnancy often have
support costs that spill over into the broader society, as social institutions are
required to pick up some of the medical, institutional, and other costs related to these
conditions. Thus, regardless of one's philosophical approach to the issue of intra-family
health problems caused by ETS, determining the appropriate distribution of costs between
family and the rest of society is a distinct challenge.
The potential role of ETS costs in reevaluating the net negative externalities
associated with smoking is seen by considering the following figures. Manning et al.
(1991) noted that inclusion of the costs of 2,400 lung cancers from ETS (a fairly
conservative estimate of this toll (Environmental Protection Agency, 1992)) as external
costs would add approximately 19 cents per pack in external costs (updated to 1994
dollars). In addition, inclusion of the costs of neonatal care for smoking-related low-
birth-weight babies would add 3 cents to the total, while including fetal deaths
attributable to smoking would add yet another 19 cents. Deaths from smoking-related fires
would add a further 9 cents. The ETS costs would sky-rocket if one included the estimated
30,000-60,000 heart disease deaths recently associated with ETS (Glantz and Parmley,
1995), adding perhaps 70 cents to the total social costs per pack. Similarly, inclusion
of the smoking-induced respiratory tract infections and cases of aggravated asthma in
children (Environmental Protection Agency, 1992) would boost the total further, as would
inclusion of the long-term developmental disabilities in smoking-related low-birth-weight
babies (Hay, 1991). All told, the social costs per pack could easily mount toward several
dollars if all of the health hazards associated with ETS are real, many are treated as
external to the basic consuming unit, and if all or even a significant fraction of the
associated costs are included.
ETS cost estimation is also influenced substantially by whether one employs the
human capital approach or willingness-to-pay to value the lives of persons who die
prematurely due to ETS exposure. Manning et al. used a conservative estimate of $1.66
million per premature death based on the range of estimates in the literature.23 Using
willingness-to-pay, the Environmental Protection Agency (1994) obtained a $4.8 million
figure. In its analysis (which included the adverse effects of ETS on heart disease and
children's health, but not on fetal and perinatal health), the EPA estimated that the
22
At the time this analysis was undertaken, virtually all of the medical literature
indicting ETS as a cause of disease related to the experience of nonsmoking wives of
smoking husbands (U.S. Department of Health and Human Services, 1986; Environmental
Protection Agency, 1992); there was no significant evidence of ETS exposure or disease
effects outside of the home.
23
As discussed above, the authors' estimates of external costs attributable to ETS
were negligible, making the choice of the cost of a premature death of little consequence
to their calculations (Manning et al., 1989). However, had they included the full range
of health consequences now attributed to ETS, the choice of a value-of-life measure would
have been of much greater importance.
benefits that would result from a ban on smoking in all worksites would total between $39
billion and $71 billion annually, the equivalent of from $2.45 to $4.45 per pack of
cigarettes. The EPA used fairly conservative assumptions concerning the effects of a
worksite smoking ban on smoking and exposure to ETS. They assumed a ban would reduce the
number of current smokers by 3-6%, the number of future smokers by 5-10%, and daily
consumption among continuing smokers by 10-15%, for a total long-run reduction in
cigarette consumption of 14-22%. The EPA estimated that these consumption reductions
would reduce out-of-home ETS exposure by 90% and in-home exposure by 6.4%. An earlier EPA
report (1992) had concluded that an estimated 73% of ETS exposure occurs outside the home.
The EPA thus predicted that a worksite ban would reduce total ETS exposure by 66.4%.
Quite independent of the treatment of the effects of ETS, the Manning et al. (1989)
study and "spin-offs", such as Gravelle and Zimmerman's (1994) review of the evidence and
Viscusi’s (1995) reanalysis, raise the issue of which types of costs ought to be included
in calculations of external costs. Manning and colleagues' finding that current taxes
covered external costs would have been reversed had the authors not included the value of
pensions and Social Security benefits not realized by smokers by virtue of their premature
demise. As demonstrated by Shoven et al. (1989), smokers subsidize nonsmokers' Social
Security benefits by virtue of the smokers' early average ages of death; the same
relationship should hold for defined benefit pensions as well. Some analysts have
considered this a transfer, not subject to consideration as an externality, rather than a
compensating external benefit of smoking, as Manning et al. treated it. However, Manning
et al. did not consider it a transfer because they viewed the length of life of smokers as
endogenous. As the literature on the costs of smoking demonstrates repeatedly, inclusion
or exclusion of such costs can play a significant role in calculating net external
costs.24
The importance and complexity of the handling of such matters is illustrated by
their differential effects in different societies and at different times. For example, as
just noted, in the U.S. analysts have concluded that, by dying early, smokers subsidize
nonsmokers' Social Security payments (Shoven et al., 1989; Viscusi, 1995). In the United
Kingdom, by contrast, research indicated that sickness benefits paid to smokers and
pensions paid to their dependents compensated for the lower direct pension benefits paid
to smokers as a consequence of their earlier average age of death (Atkinson and Townsend,
1977). In developing countries in which old-age expenses are largely a private matter,
the social "benefit" of smokers' dying early would not exist, and hence would not offset
any negative externalities of smoking. Of course, this could change over time if and as
such societies developed social security plans. Similarly, the magnitude of the offsets
in the developed countries could change if and as benefit programs in those countries were
altered (Warner et al., 1995).
As this discussion has demonstrated, calculation of the "true" net negative
externalities associated with smoking is an exceedingly difficult challenge, one that
involves conceptual questions, epidemiologic and other data considerations, and "moving
targets" in terms of both knowledge and institutional structures. The relevance of the
task to understanding optimal cigarette taxation recommends further research, despite its
difficulty.25
24
Other candidates for inclusion are the reduction in income taxes and insurance
premiums paid by smokers due to reduced earnings associated with smoking-related
illnesses; smoking-related health care costs paid by public insurance plans (and
conceivably private, depending on how these are treated); and increased sick pay and
disability benefits paid during smoking-related illnesses. If such items are included,
care must be taken to consider both reduced payments by smokers into public revenues and
altered patterns of consumption of government-financed goods and services.
25
An interesting example of the problems created by institutional structures in
trying to assess the relevance of ETS to determining an optimal tax lies in the effects of
workplace smoking bans on the development of ETS-related diseases: the more pervasive are
workplace bans, the less ETS exposure nonsmokers will experience, and hence the amount of
ETS-related disease will decline. This, in turn, would decrease the conceptually optimal
tax.
3.4.2 Other efficiency considerations

Several factors related to smoking complicate the task of defining an
optimalcigarette tax. Two essential realities about smoking -- namely, that it is a
behavior initiated almost exclusively during childhood (U.S. Department of Health and
Human Services, 1994) and that it is addictive (U.S. Department of Health and Human
Services, 1988) -- give pause in treating cigarette consumption just like any other
rational economic behavior. A third reality -- that many smokers are not truly well
informed about the hazards of smoking (U.S. Department of Health and Human Services, 1989;
Schoenbaum, 1997)26 -- also challenges a basic proposition of rational behavior. For
smoking as for other consumption, rational economic behavior presumes both the existence
of adequate knowledge on which to base consumption decisions and rational use of the
knowledge. In the absence of adequate knowledge, higher taxes might be justified ( Cordes
et al., 1990). One may be particularly interested in applying this concept to teenagers,
although increasing taxes is a decidedly blunt instrument if its purpose is solely to
better "inform" youths about the risks of smoking (Warner et al., 1995).
As discussed in an earlier section, the empirical applications of the rational
addiction model suggest that addicted adult smokers do not behave myopically in
contemplating the relationship between cigarette consumption and past, present, and
expected future prices. However, as the evidence reviewed above indicated, youth exhibit
much more myopic cigarette consumption behavior than do adults, consistent with studies
that have found young smokers greatly underestimating the probability that they would
still be smoking five years later (U.S. Department of Health and Human Services, 1994).
Moreover, as illustrated by the Orphanides and Zervos (1995) model, the role of
information (more specifically the lack of information on the potential for addiction) is
particularly important in the initiation process, and results in later regret.
A group of health economists who have studied the economics of smoking recently
concluded that protecting children from a future of nicotine addiction, with its
associated health risks, was the most compelling reason favoring increased taxation of
cigarettes (Warner et al., 1995). They perceived high taxes as appropriate to balance an
environment in which children face numerous inducements to smoke, including multi-billion
dollar advertising and marketing campaigns by the cigarette companies, many designed to
attract children to smoking (US Department of Health and Human Services, 1994). To
address this imbalance, these economists supported such measures as increased public
education and increased enforcement of restrictions on youth access to tobacco products,
although the limited effectiveness of such measures is well documented. (See section 5
below.) The economists observed, however, that these measures do not address children's
tendency to discount the future heavily, in a manner that, as rational adults, they might
come to regret. Taxation, they felt, is the best available policy instrument to address
this problem, both conceptually and empirically. As observed above, two recent analyses
(Orphanides and Zervos, 1995; Suranovic et al., in press) examining the initiation of
smoking, continuation over time, and eventual consideration of quitting (and difficulty in
doing so) lend new insight into this issue of regret.
4. Advertising, promotion, and the demand for tobacco products

Cigarettes are one of the most heavily advertised and promoted products in the
world. In the United States, for example, the cigarette industry spent $5.1 billion on
advertising and promotion activities in 1996 (Federal Trade Commission, 1998); as a
percentage of sales, these expenditures have increased dramatically since 1980. Cigarette
advertising includes the more traditional advertising on television, radio, and
billboards, in newspapers, magazines, and transit facilities, and, most recently, on the
internet. Spending on promotion includes a wide variety of activities, including
promotional allowances to retailers, point-of-purchase promotional materials, direct mail
advertising, the distribution of free samples, coupons, and specialty items, multiple pack
promotions, and retail value-added offers, as well as endorsements, sponsorship of
cultural, sporting, and other entertainment events, and sponsorship of community and other
organizations. Nearly 87% of all cigarette advertising and promotional expenditures in
the U.S. in 1974 were devoted to traditional advertising; by 1996, in striking contrast,
this had fallen to just over 10%, with the balance going to the less-traditional
promotional activities. Promotional allowances ($2.15 billion in 1996) and coupons and
retail value added ($1.31 billion in 1996) have been the largest spending categories in
26
For a contrary view, see Viscusi (1992).
recent years.
This section begins with a brief discussion of the arguments related to cigarette
advertising and demand, as well as a review of some of the economic issues related to
cigarette advertising. We then examine the econometric literature on the impact of
cigarette advertising on smoking, consider the limitations of the econometric approach,
and review the growing literature on the impact of restrictions and bans on cigarette
advertising and promotion. The section closes with a short description of the findings on
cigarette advertising and demand from the non-economics literature.
4.1 Theoretical and conceptual issues

The impact of cigarette advertising on cigarette smoking, particularly youth
smoking, has been the subject of extensive debate over the past several decades. The
public health community takes it as given that advertising encourages smoking and is a
particularly significant influence on smoking initiation among youth. The industry, on
the other hand, contends that cigarette advertising is a form of competition that has no
impact on overall cigarette smoking, but instead simply affects market share. In
addition, the industry argues that advertising provides useful information to smokers
about their products, including information on tar and nicotine content.
Warner (1986a) suggested several mechanisms through which cigarette advertising and
promotion could affect cigarette consumption. He identified four direct mechanisms: (1)
advertising can entice children and young adults to experiment with smoking and to
initiate regular smoking; (2) it can reduce current smokers' willingness to quit smoking;
(3) it can serve as a cue or stimulus that leads to increased daily cigarette consumption
by smokers; and (4) it can induce former smokers to resume their habit by reinforcing the
attractions of smoking. Two indirect mechanisms were: (1) discouraging a full discussion
of the health consequences of cigarette smoking in media dependent on tobacco advertising;
and (2) contributing to a social environment in which smoking is perceived to be socially
acceptable. The U.S. Surgeon General (U.S. Department of Health and Human Services, 1989)
added a third indirect mechanism, namely that institutions dependent on tobacco industry
promotional and other support may create political opposition to strong tobacco control
policies.
Warner and his colleagues (Warner, 1985; Warner and Goldenhar, 1989; Warner et al.,
1992) have examined the first indirect mechanism empirically, concluding that there is
strong evidence that magazines' coverage of the hazards of smoking was significantly
diminished as the magazines' share of advertising revenues from cigarette advertising
rises. Warner et al. (1992) found that magazines that did not carry cigarette advertising
were more than 40% more likely to cover the health consequences of smoking than those with
cigarette advertising. The difference was more pronounced for women's magazines, with
those that did not advertise cigarettes more than 230 percent more likely to cover the
hazards of smoking.
4.2 Econometric evidence

Other than this work by Warner and colleagues, research by economists has not
addressed the hypothesized individual mechanisms by which advertising can influence
cigarette consumption. However, beginning with Schmalensee's 1972 study, there have been
numerous econometric studies of the impact of cigarette advertising on cigarette demand,
mostly for the U.S. and the U.K, but also for several other countries as well. No
consensus concerning the effects of advertising on smoking has emerged from this research,
however. Several recent reviews of this literature, drawing on many of the same studies,
reached opposite conclusions. Based on their review of 24 studies with estimates of the
advertising elasticity of cigarette demand, Andrews and Franke (1991) concluded "that
there is a significant relationship between advertising and cigarette consumption across
studies, independent of study design factors. However, the estimated magnitude of this
relationship varies depending on several study design factors" (page 96). Moreover, they
concluded that the positive impact of advertising on cigarette demand has declined over
time, a factor they attributed to the maturation of cigarette markets in most of the
countries studied. Duffy (1996b), on the other hand, concluded that econometric studies
of the relationship between cigarette advertising and demand generally have found that
advertising has little or no impact on aggregate cigarette consumption.
In his now classic volume, The Economics of Advertising , Schmalensee (1972)
introduced several concepts that reemerge repeatedly in subsequent studies of cigarette
advertising and demand. In particular, he examined cigarette demand at both the industry
and firm levels, allowed for the possibility that a firm's cigarette advertising
expenditures might be based on current sales, and modeled not only the effects of current
advertising expenditures on demand but also the impact of lagged expenditures. As

Schmalensee observed, failing to account for the potential endogeneity of cigarette
advertising expenditures would lead to biased estimates of the impact of advertising on
demand. Similarly, failing to account for the cumulative or "stock" effects of
advertising could lead to an omitted variables problem, although the evidence is mixed
concerning the durability of cigarette advertising (Boyd and Seldon, 1990). Schneider et
al. (1981) extended the use of the "stock" of advertising to allow the marginal
productivity of advertising expenditures in the U.S. to fall after the 1971 ban on
broadcast cigarette advertising.
An additional issue raised by Schmalensee relates to the measurement of advertising
expenditures. In half of his industry-level models, he used the absolute level of
cigarette advertising, while in the other half, he used the ratio of cigarette advertising
to total advertising, providing an intuitive argument favoring the latter analogous to the
use of relative rather than absolute price. Subsequent theoretical models of consumer
behavior have made this argument more formally (Theil, 1980; Duffy, 1987).
The numerous econometric studies on the impact of aggregate cigarette advertising
expenditures on aggregate cigarette consumption differ with respect to many of the issues
raised by Schmalensee, as well as in several other respects. Almost none follows
Schmalensee and treats advertising expenditures as endogenous. A few estimate firm-
specific demand (e.g., Roberts and Samuelson, 1988), while most examine industry demand.
Several introduce measures of past advertising expenditures; some do so directly (e.g.,
Goel and Morey, 1995), while others construct a cumulative "stock" of advertising (e.g.,
Schneider et al., 1981). Most look at absolute or per capita measures of cigarette
advertising expenditures, while a few employ measures of expenditures on cigarette
advertising relative to overall advertising expenditures (e.g., Duffy, 1996a). Many
estimate single equation models of cigarette demand; several, however, estimate
simultaneous equations models of supply and demand (e.g., Porter, 1986). Most estimate
conventional demand models, while some estimate myopic demand models that include a
measure of past cigarette consumption (e.g., Baltagi and Levin, 1986) or an alternative
approach (Fujii, 1980); one estimates demand in the context of the rational addiction
model (Duffy, 1996a).
Schmalensee (1972) and many subsequent econometric studies based on aggregate data
from the U.S., U.K., and a few other countries found no statistically significant effect
of aggregate cigarette advertising expenditures on cigarette consumption (Hamilton, 1972;
Lambin, 1976; Grabowski, 1976, 1978; Metra Consulting Group, 1979; Schneider et al., 1981;
Johnson, 1986; Baltagi and Levin, 1986; Stavrinos, 1987; Tegene, 1991; Duffy, 1991, 1996a;
Wilcox and Vacker, 1992; U.K. Department of Health, 1992; Wilcox et al., 1994; Franke,
1994; Goel and Morey, 1995). A few of these studies, however, did find some evidence that
lagged cigarette advertising had a significant positive impact on current cigarette
consumption, providing some support for the durability of advertising (Schmalensee, 1972;
U.K. Department of Health, 1992; Goel and Morey, 1995). Several other studies have found
that cigarette advertising has a positive and significant impact on aggregate cigarette
demand (McGuiness and Cowling, 1975, 1980; Fujii, 1980; Witt and Pass, 1981; Reuijl, 1982;
Radfar, 1985; Bishop and Yoo, 1985; Leeflang and Reuijl, 1985; Abernethy and Teel, 1986;
Porter, 1986; Roberts and Samuelson, 1988; Chetwynd et al., 1988; McAuliffe, 1988; Kao and
Tremblay, 1988; Seldon and Doroodian, 1989; Seldon and Boyd, 1991; Valdes, 1993; Tremblay
and Tremblay, 1995). However, the magnitude of the estimated effect is generally small.
Differences in the design, data, and empirical methods account for the inconsistent
findings.
Based on the mixed evidence from the studies using aggregate data, aggregate
cigarette advertising appears to have a small or negligible impact on aggregate cigarette
sales. However, as a number of researchers have observed, the nature of competition in
the cigarette industry and the limitation of econometric analysis to estimating marginal
effects imply that there should be at most a small impact of aggregate cigarette
advertising expenditures on aggregate cigarette consumption (Cox, 1984; Warner, 1986a;
Warner et al., 1986; U.S. Department of Health and Human Services, 1989; Saffer, 1995,
1998; Pollay, 1996).
As Saffer (1995, 1998) has noted, advertising expenditures will have diminishing
marginal productivity. Drawing on the "advertising response functions" used to
characterize brand-level advertising in the empirical marketing literature, which clearly
imply diminishing returns to advertising at the brand level (Rao and Miller, 1975; Ackoff
and Ernshoff, 1975), Saffer concluded that an "industry advertising response function"
will also show diminishing returns to increasing expenditures and marginal effects could
be well below average effects. Moveover, in a highly concentrated market with a virtual
absence of price competition, where the "personality" of the product is very important to
consumers, total advertising expenditures will almost certainly exceed the "rational"
level associated with joint profit maximization that would be expected to show a
significant positive impact on overall demand. Instead, in an effort to increase or
protect market share, firms will advertise beyond the level where one would expect to find
a sizable positive marginal effect of total advertising on total demand, assuming that the
firms do not collude in deciding upon the amount of advertising. A number of econometric
studies have looked at the impact of advertising on demand at the firm or brand level.
These generally have found that increases in advertising expenditures have a positive and
significant effect on market share (Telser, 1962; Peles, 1971; Schnabel, 1972; Grabowski,
1978; Holak and Reddy 1986; Pollay 1996). Pollay (1996), for example, estimated that
"share of voice" (brand share of advertising expenditures) has a significant impact on
market shares, and that brand choice among teenagers is about three times more sensitive
to advertising than it is for adults (a result surprisingly similar to the estimates for
youth and adult price sensitivity).
In short, given that the econometric analyses of aggregate expenditures and
consumption are designed to assess the impact of a marginal change in advertising
expenditures on total cigarette sales, it is not surprising that most of these analyses
estimate small or insignificant effects of advertising on demand. In addition, critics of
these analyses suggest several methodological shortcomings, including: the lack of
appropriate measures of advertising exposure and other problems with the measures of
advertising employed; the failure to distinguish between the impact of advertising and
promotional activities; problems with the simultaneity between advertising expenditures
and sales; the omission of other key variables, such as concurrent counteradvertising; and
more (Cox, 1984; Warner, 1986a; Warner et al., 1986; U.S. Department of Health and Human
Services, 1989; Chapman, 1989; U.K. Department of Health, 1992; Luik, 1994; Saffer, 1995,
1998; Duffy, 1996b; Pollay, 1996). These and other critics have suggested that more
appropriate approaches include the examination of more disaggregated data and the analysis
of non-marginal changes in advertising expenditures, such as those that result from
significant restrictions or complete bans on cigarette advertising and promotion.
To date, only one econometric study has examined the impact of cigarette advertising
employing individual level data and more appropriate measures of advertising exposure.
Lewit et al. (1981) used data on about 6,700 youth ages 12-17 years taken from Cycle III
of the U.S. Health Examination Survey conducted from 1966 through 1970. Based on measures
of televised cigarette advertising and counter-advertising, and self-reported information
on time spent watching television, Lewit and his colleagues estimated the number of pro-
and anti-smoking commercials each youth would have seen. Their estimates provide support
for the hypothesis that televised pro-smoking advertisements significantly increased youth
smoking.
There are a number of studies examining the impact of restrictions and bans on
cigarette advertising on smoking. Many of the older studies look at the impact of the
U.S. ban on broadcast cigarette advertising that began January 2, 1971 (Ippolito et al.,
1979; Schneider et al, 1981; Bishop and Yoo, 1985; Porter, 1986; Baltagi and Levin, 1986;
Kao and Tremblay, 1988; McAuliffe, 1988; Seldon and Dooroodian, 1989; Seldon and Boyd,
1991; Simonich, 1991; Franke, 1994; Goel and Morey, 1995; Tremblay and Tremblay, 1995).
In general, these studies produced mixed evidence on the impact of the ban on television
and radio advertising. Most concluded that the ban did not significantly reduce cigarette
smoking in the U.S. A few suggested that the marginal productivity of cigarette
advertising fell after the ban (for example, Tremblay and Tremblay, 1995). Several,
including Hamilton (1972) and Warner (1979), suggested that the net impact of the 1971 ban
was to raise cigarette consumption because it also led to the elimination of effective
anti-smoking commercials broadcast under the Fairness Doctrine (discussed below).
Schneider et al. (1981) supported this argument empirically, concluding that the
advertising ban led to a net increase of nearly 5% in per capita tobacco consumption, in
part due to a price reduction resulting from the reduced costs associated with less
advertising. In addition, they argued, the advertising ban limited the provision of
information to smokers concerning the tar and nicotine content of different brands and,
consequently, reduced the likelihood that smokers would switch to lower tar and nicotine
brands.
Others examined the impact of other country-specific restrictions, including: the
1965 U.K. ban on televised cigarette advertising (Atkinson and Skegg, 1973; Witt and Pass,
1984); the ban on advertising in electronic media in Australia (Johnson, 1986; McLeod,
1986); the Finnish extension of its television ad ban to other media (Pekurinen, 1989,
1991); and Spain's partial ban on broadcast advertising (Valdes, 1993). Hamilton (1977)
presented similar estimates from separate regressions for 11 countries over the period
1948-1973. These studies also produced mixed evidence on the effectiveness of these
partial bans. In general, they suggested that the bans led to a temporary reduction in
cigarette smoking, but that they had little impact in the long run. However, more
extensive restrictions coupled with anti-smoking publicity, strong health warnings, and
other activities appear to have led to more permanent reductions in demand (Pekurinen,
1989, 1991).
Still others have conducted cross-country analyses of the impact of restrictions and
bans on cigarette advertising and promotion (Hamilton, 1977; Cox and Smith, 1984; Laugesen
and Meads, 1991; and Stewart, 1993). These, too, have yielded mixed findings. In
addition to country-specific regressions, Hamilton (1977) included models pooling some of
the countries in his sample. As in the country-specific models, he found no evidence that
advertising restrictions reduced cigarette demand. Cox and Smith (1984) took an indirect
approach to estimating the impact of advertising bans on demand. Using data from 15 OECD
countries, they sorted countries by their use of legislative versus voluntary strategies
to reduce smoking, where limits on advertising reflected a more legislative strategy.
Based on a series of country-specific regression models, they concluded that smoking
declines more rapidly in countries that take a legislative approach to tobacco control,
suggesting that advertising restrictions are effective in reducing demand.
Laugesen and Meads (1991) pooled annual aggregate data from 22 OECD countries for
the period 1960-1986 in their examination of the impact of advertising and promotion
restrictions. Rather than focusing on a specific type of restriction (e.g., a broadcast
advertising ban), Laugesen and Meads constructed an advertising restriction index that
ranges from zero (no restrictions) to 10 (complete bans on advertising and sponsorships
coupled with multiple, strong warning labels on cigarette packaging). Estimates from this
model imply that cigarette consumption would be about 6% lower with the strongest
restrictions than it would be with no restrictions. In their preferred specification, to
account for the lagged effects of advertising, the coefficient on the advertising
restriction index was interacted with time. In this specification, Laugesen and Meads
found that advertising restrictions actually had a positive effect on cigarette demand
through the early 1970s, but then reduced consumption after 1973. Estimates for the final
year of their data implied that each additional point in the restriction index reduced
cigarette consumption by about 1.5 percent, well above their estimate for the
specification that does not allow the effect to vary over time. Laugesen and Meads
attributed the positive effects of the ban early in their sample to the industry's ability
to substitute other marketing activities for broadcasting advertising in response to early
restrictions. However, its ability to substitute other media for banned media diminished
over time as the restrictions became more comprehensive.
Stewart (1992) raised a number of concerns about the approach taken by Laugesen and
Meads. Specifically, Stewart argued that errors in variables for the dependent and
several independent variables will bias the estimates on the advertising restriction
coefficients. In addition, he argued that the Laugesen and Meads approach failed to
account for unmeasured, country-specific factors (i.e., culture, tastes, and attitudes)
that should be important determinants of cigarette consumption, and that the omission of
these factors leads to biased estimates of the advertising restriction coefficients.
Laugesen and Meads (1993) defended the estimates from their research, arguing that after
correcting for errors in the data, the estimates confirmed their earlier finding that bans
on advertising significantly reduce cigarette consumption. The authors did not present
these revised estimates in their response, however.
Using data on 22 OECD countries for the period 1964-1990, Stewart (1993) presented
his own empirical analysis of the impact of restrictions on cigarette advertising on
demand. He estimated fixed effects models to control for unmeasured country-specific
influences on demand. Rather than using a comprehensive measure of restrictions on
cigarette advertising, however, Stewart focused on bans on the televised advertising of
cigarettes. Also, in contrast to Laugesen and Meads, Stewart did not allow the impact of
the advertising restriction to change over time. He estimated that the ban on cigarette
advertising on television has had a positive but insignificant impact on cigarette demand,
consistent with the findings from several other studies on the effects of broadcast
advertising bans alone.
In late 1992 the United Kingdom's Department of Health reviewed the evidence on the
impact of cigarette advertising and restrictions on advertising on cigarette demand (U.K.
Department of Health, 1992). The "Smee Report," known by the name of the project
director, also contains two original econometric analyses on the impact of advertising
restrictions, one for Norway and the other for Canada. Estimates from these analyses
suggest that the countries' relatively comprehensive advertising and promotion bans did
lead to significant reductions in smoking. Given this evidence as well as that from the
numerous qualitative and quantitative studies reviewed, the Smee Report concluded that
cigarette advertising has a positive impact on smoking and that bans on advertising would
reduce demand.
In a subsequent edited volume, critics of the Smee Report argued that it was flawed
in several ways, including the following: the literature review omitted several
qualitative and quantitative studies that found no impact of advertising or ad
restrictions on cigarette demand; the findings from some of the literature reviewed are
misstated; the empirical analyses contained methodological and other errors (Luik, 1994).
Stewart (1994), for example, compared the estimates for the countries common to his 1993
econometric analysis with those presented in the Smee Report, concluding that advertising
bans in Norway, Finland and Canada have actually increased tobacco consumption.27
The Smee Report, Saffer (1998), Stewart (1993), and others have indicated several
factors that complicate the ability of econometric analysis to examine the impact on
cigarette demand of restrictions on cigarette advertising and promotion. The potential
endogeneity of advertising restrictions has not been carefully examined in any of the
econometric studies. Similarly, with the exception of Stewart (1993), social, cultural,
and other differences among countries have not been well controlled for in the econometric
research. However, efforts to control for these, using fixed effects modeling for
example, create severe multicollinearity problems that make it difficult to isolate the
impact of the advertising restrictions on demand from other key determinants. Similarly,
as Saffer noted, a majority of the studies to date have examined the impact of
restrictions on advertising in one or two media, leaving firms free to substitute towards
other media and to develop new marketing approaches. The findings from several studies,
which suggest at best a temporary negative effect of a relatively limited set of
advertising restrictions, are consistent with the argument that effective alternatives are
developed in response to the ban. So to are the findings from the few studies that have
found that relatively comprehensive restrictions significantly reduce demand.
4.3 Findings from the noneconomic literature

While econometric methods are powerful tools for examining the demand for cigarettes
and other tobacco products generally, they are relatively ill-suited for evaluating the
effects of cigarette advertising and promotion and related restrictions, as described
above. Evidence from a number of other disciplines, however, supports the argument that
cigarette advertising and promotion directly and indirectly increase cigarette demand
(Warner, 1986a; U.S. Department of Health and Human Services, 1989, 1994, 1996, 1998; U.K.
Department of Health, 1992).
A major source of noneconomic evidence is survey research and experiments that
assess reactions to and recall of cigarette advertising and smoking behavior, particularly
among children. These studies have concluded that cigarette advertising is effective in
getting children's attention and that the ads are recalled, with strength of interest
correlated with current or anticipated smoking behavior or smoking initiation (U.S.
Department of Health and Human Services, 1989, 1994; Food and Drug Administration, 1996;
Goldstein et al., 1987; DiFranza et al., 1991; Evans et al., 1995; Pierce et al., 1998).
However, these studies generally cannot assess the potential endogeneity between an
interest in smoking and behavior (U.S. Department of Health and Human Services, 1989,
1996).
Others have articulated logical arguments that conclude that cigarette advertising
and promotional activities are not consistent with the tobacco industry's claim that the
market for tobacco products is mature and that marketing activities are designed to
promote brand share rather than market expansion. For example, Tye et al. (1987)
calculated that cigarette firms' battling only for brand share did not make financial
sense in a U.S. market in which the top two firms now control 75% of cigarette sales (and
one company has 95% of smokeless tobacco sales) and in which brand loyalty is notoriously
strong. The authors argued that if the industry believed its own brand-share argument, it
would have welcomed the opportunity for a legislated ban on tobacco advertising, proposed
in the U.S. Congress in the mid-1980s. Instead, the industry fought the ban vigorously.
Similarly, Warner (1986a) noted that even if the industry is a mature or declining one,
27
The Smee Report's estimate for Finland is based on the work by Pekurinen (1989,
1991) rather than an original econometric analysis.
retaining existing consumers and recruiting new ones would be particularly important in
the cigarette market in which about 5% of consumers are lost annually to cessation and
death. Finally, while the overall market may be mature, there are segments of the market
that appear to be potential growth markets, such as youth in the U.S., for whom smoking
prevalence has risen throughout the 1990s (University of Michigan News and Information
Services, 1997), or specific minority groups, such as Hispanic females for whom smoking
rates are well below those of other groups of women (U.S. Department of Health and Human
Services, 1998). Substantial evidence, including recently released internal industry
documents (www.house.gov/commerce/TobaccoDocs/documents.html), indicates that increasing
shares of advertising and promotion activities have been directed towards these growth or
potential growth markets (U.S. Department of Health and Human Services, 1989, 1994, 1998;
U.K. Department of Health, 1992; King et al., 1998; industry documents - need refs.).
Clearly, there is no "smoking gun" that proves that advertising and promotion play a
significant role in expanding or maintaining the market for tobacco products, or that they
do not. Examining all of the evidence collectively, Warner (1986a) concluded that it is
more likely than not that advertising and promotion do stimulate cigarette consumption.
However, he also characterized the extent of the influence of advertising as unknown and
possibly unknowable.
To date, economists' contributions to the relevant body of knowledge about cigarette
advertising have been less numerous, and likely less consequential, than in other areas of
smoking and health, such as the highly productive work on the relationship between
cigarette price and demand, reviewed in section 2. Still, the econometric research in
this area has offered important insights into the challenge of evaluating the effects of
advertising. The door is open for creative new work to follow.
5. Other tobacco control policies and demand

This section focuses on the impact on cigarette demand of some of the more widely
used tobacco control policies in addition to taxation and advertising restrictions,
including the dissemination of information on the health consequences of smoking,
restrictions on smoking in public places and work places, and limits on youth access to
tobacco products. Other policies, such as the disclosure of tobacco product constituents
and the funding of school-based smoking prevention programs, have not been the subject of
economic analysis.
5.1 Health information and counter-advertising

In both the early 1950s and the mid-1960s, smoking-related "health scares" received
substantial public attention in the United States. The first was prompted by coverage in
the popular media of the then-new scientific evidence linking smoking to lung cancer
(Wynder and Graham, 1950; Doll and Hill, 1954). Illustrative was an article in the
December, 1952 Reader's Digest entitled "Cancer by the Carton" (Norr, 1952). The second
followed release of the first Surgeon General's report on smoking and health (U.S.
Department of Health, Education, and Welfare, 1964), the first official government
document to label smoking a cause of lung cancer and to call for "appropriate remedial
action." Media attention to the report ranked it as one of the year's most covered news
stories.
The impact of these "health scares" has been the subject of extensive econometric
analysis (Sumner, 1971; Hamilton, 1972; Schmalensee, 1972; Atkinson and Skegg, 1973;
McGuiness and Cowling, 1975; Thompson and McLeod, 1976; Warner, 1977, 1981a, 1989;
Ippolito et al., 1979; Fujii, 1980; Schneider et al., 1981; Leu, 1984; Porter, 1986;
Bishop and Yoo, 1985; Kao and Tremblay, 1988; Simonich, 1991; Pekurinen, 1989, 1991; Meier
and Licari, 1997). In general, these and other studies concluded that cigarette smoking
fell significantly in response to the new information on its health consequences. Warner
(1977, 1981a), for example, found that the public scares in the early 1950s significantly
reduced smoking in 1953 and 1954, but that their negative impact diminished through the
decade. He concluded that the 1964 Surgeon General's report led to an immediate 5%
decline in cigarette consumption. Schneider et al. (1981) estimated that U.S. per capita
tobacco consumption was about 39 percent lower in 1978 than it would have been in the
absence of the two health scares.
The evidence linking cigarette smoking to morbidity and premature mortality led to a
number of public policy efforts to disseminate information on the health consequences of
smoking. Numerous countries have adopted policies requiring health warning labels on
cigarette packaging and advertising; in general, these warnings have become stronger and
more prominent over time. Non-econometric evaluations of warning labels have concluded
that small, inconspicuous labels that provide little specific information about the
consequences of smoking are generally ineffective. However, multiple, strong, and direct
messages that are prominently displayed have been found to be effective (World Health
Organization, 1997). The limited econometric evidence also suggests that health warning
labels have led to small but significant reductions in cigarette smoking (Abernethy and
Teel, 1986; Tansel, 1993; Meier and Licari, 1997; Bardsley and Olekans, 1998).
Mass media "counter-advertising" campaigns have been widely used to discourage
cigarette smoking and other tobacco use. Econometric analyses of anti-smoking publicity
and paid counter-advertising generally, but not universally, have concluded that these
campaigns have significantly reduced cigarette smoking (Hamilton, 1972; Warner, 1977,
1981a, 1989; Ippolito et al., 1979; Metra Consulting Group, 1979; Fujii, 1980; Schneider
et al., 1981; Lewit et al., 1981; Porter, 1986; Abernethy and Teel, 1986; Baltagi and
Levin, 1986; Stavrinos, 1987; Kao and Tremblay, 1988; Pekurinen, 1989, 1991; Simonich,
1991; Tansel, 1993; Hu et al., 1994, 1995b, 1995c; Tremblay and Tremblay, 1995; Goel and
Morey, 1995; Hsieh et al., 1996). Much of the econometric evidence from the U.S. is based
on two major counter-advertising campaigns: the anti-smoking messages broadcast in the
late-1960s under the Federal Communications Commission's Fairness Doctrine (Hamilton,
1972; Warner, 1977, 1981a, 1989; Ippolito et al., 1979; Fujii, 1980; Schneider et al.,
1981; Lewit et al., 1981; Porter, 1986; Baltagi and Levin, 1986; Simonich, 1991; Tremblay
and Tremblay, 1995; Goel and Morey, 1995) and the anti-smoking media campaign in
California in the early 1990s, funded by an earmarked tax on cigarettes (Hu et al., 1994,
1995b, 1995c).
From 1967 until January 2, 1971, the date television and radio advertising of
cigarettes was banned, anti-smoking messsages were broadcast to "compensate" for pro-
smoking advertisements, initially at the rate of one anti-smoking message for every eight
cigarette ads and eventually at a 1:3 ratio. Television time for these counter-
advertisements was donated by broadcasters under the Fairness Doctrine which required
broadcasters to air both sides of a controversial issue if one side was being aired. Per
capita cigarette consumption dropped four years in a row, for the first time in history
(Warner, 1977, 1979). Schneider et al. (1981) concluded that the counter-advertising
reduced per capita consumption by approximately 5%. Using individual-level data on
smoking among youth ages 12-17, taken from Cycle III of the Health Examination Survey,
Lewit and his colleagues (1981) found that the anti-smoking messages significantly reduced
youth smoking prevalence.
In 1988, California voters passed Proposition 99, the California Tobacco Tax and
Health Promotion Act. The Act raised the state cigarette tax by 25 cents per pack and
earmarked 20 percent of new tax revenues for health education programs to reduce cigarette
smoking, including a statewide media campaign. Similar tax increases with funds earmarked
for counter-advertising campaigns have been adopted in Massachusetts, Arizona, Oregon, and
elsewhere. In addition, part of the funds received by several other American states that
have recently settled lawsuits with the tobacco industry are earmarked for counter-
advertising campaigns. Hu and his colleagues (1994, 1995b) concluded that California's
anti-smoking media campaign has significantly reduced smoking in California. They
estimated an elasticity of cigarette sales with respect to expenditures on the anti-
smoking media campaign of -0.05 (Hu et al., 1995c). Comparing the impact of the tax
increase with that of the media campaign, they estimated that the tax increase reduced per
capita cigarette sales by over 27 packs, while sales declined by just under eight packs
per person in response to the media campaign. Early evidence from Massachusetts suggests
a comparable decline in sales after that state's tax-funded anti-smoking campaign (Harris
et al., 1996). Chaloupka and Grossman (1996) concluded that similar counter-advertising
campaigns financed by earmarked cigarette taxes lead to significant reductions in both the
prevalence of youth smoking and average cigarette consumption by young smokers.
Econometric evidence from Greece (Stavrinos, 1987), Finland (Pekurinen, 1989, 1991),
Turkey (Tansel, 1993), Australia (Bardsley and Olekalns, 1998), and the U.K. (Townsend,
1998) indicates that the U.S. experience is not unique. In each of these studies, mass
media campaigns aimed at reducing cigarette smoking by providing information on the health
consequences of smoking were estimated to have led to significant reductions in smoking
prevalence and in cigarette consumption.
The evidence described above clearly indicates that cigarette demand has declined in
response to dissemination of new information on the health effects of cigarette smoking.
Viscusi (1990, 1991, 1992, 1995) and others have concluded that individuals have heard and
comprehended the health warnings and are making rational, well-informed choices when it
comes to smoking. Indeed, as noted above Viscusi (1992) believes that smokers
overestimate the risk of dying from lung cancer as a result of smoking. As such, he
suggested (Viscusi, 1992, 1995) that the scope for further government intervention to
reduce cigarette smoking is relatively limited. Kenkel (1991), however, concluded that
while knowledge about the health effects of smoking is relatively common and has
significantly reduced smoking, it is incomplete. Moreover, his estimates implied that
improved health knowledge would lead to significant changes in cigarette smoking, in
contrast to his findings for health knowledge concerning alcohol use and exercise. As was
noted earlier, a wealth of additional evidence further supports the view that, while
general knowledge concerning the health consequences of smoking is relatively widespread,
it is often superficial and does not extend to risks other than those associated with lung
cancer, heart disease, and chronic lung disease (U.S. Department of Health and Human
Services, 1989). Further, many smokers, particularly including heavy smokers, do not
personalize the health risks that they acknowledge as applying to smokers "in general"
(Schoenbaum, 1997). Warner et al. (1995), Brownson et al. (1992), Grossman et al.
(forthcoming), and others argue that some populations, particularly younger and less
educated/low-income groups, significantly understate the health consequences of smoking;
for example, children in particular may be prone to underestimate the risk of becoming
addicted.
5.2 Restrictions on cigarette smoking

As information on the health consequences of exposure to environmental tobacco smoke
(ETS) has become more widespread (U.S. Department of Health and Human Services, 1986; U.S.
Environmental Protection Agency 1992; Steenland, 1992; Steenland et al., 1996),
governments at all levels have adopted policies limiting smoking in public places and
private workplaces. Beginning with Arizona in 1973, states started adopting "clean indoor
air" laws with the explicit objective of limiting nonsmokers' exposure to ETS (U.S.
Department of Health and Human Services, 1986). In general, these laws prohibit smoking
in elevators, health care facilities, public transportation, indoor cultural and
recreational facilities, government buildings, public meeting rooms, schools, shopping
malls, and retail stores. The most extensive laws also include restaurants and private
workplaces. A recent World Health Organization (1997) survey of tobacco control policies
in 134 countries indicated that the vast majority of countries now have some form of
restriction on smoking in public places.
Although the restrictions are primarily intended to reduce nonsmokers' exposure to
ETS, they can also lead to significant reductions in cigarette smoking since they reduce
the smoker's opportunities to smoke or otherwise raise the "cost" of smoking. This is
particularly true for adult smokers restricted from smoking at the workplace. In
addition, restrictions on smoking may alter the perceived norms related to smoking by
changing attitudes concerning the social acceptability of smoking (U.S. Department of
Health and Human Services, 1994).
A number of recent econometric and other studies have examined the impact of smoking
restrictions on cigarette demand in the U.S. and elsewhere (Wasserman et al., 1991;
Chaloupka, 1992; Chaloupka and Saffer, 1992; Keeler et al., 1993; Chaloupka and
Grossman, 1996; Evans et al., 1996; Chaloupka and Wechsler, 1997; Chaloupka and Pacula,
1998a, 1998b; Ohsfeldt et al., 1998; Bardsley and Olekalns, 1998; Townsend, 1998). In
general, restrictions on smoking in public places and private workplaces have been found
to reduce both smoking prevalence and average daily cigarette consumption among smokers.
Wasserman et al. (1991) estimated that expanding smoking restrictions from those limiting
smoking in a small number of relatively minor public places (elevators, waiting rooms,
etc.) to more comprehensive restrictions, including restaurants and private workplaces,
would reduce overall per capita smoking by almost 6%. Similarly, Chaloupka and Grossman
(1996) and Chaloupka and Wechsler (1997) concluded that strong restrictions on smoking
significantly reduce both smoking prevalence and average daily cigarette consumption for
youth and young adults, respectively.
Using annual state-level data for 1975-1985, Chaloupka and Saffer (1992) examined
the possibility that smoking restrictions are endogenous. They found that states with the
strongest restrictions, those with limits on smoking in private workplaces, were also the
states in which anti-smoking sentiment was relatively high and smoking was relatively low.
After accounting for this, Chaloupka and Saffer concluded that the strongest restrictions
had no impact on cigarette demand. However, they did find that relatively comprehensive
restrictions on smoking in public places (those including restaurants in addition to a
number of other public places) significantly reduced smoking even after accounting for
their potential endogeneity. In a more recent analysis of this issue, using data from the
September 1992, January 1993, and May 1993 tobacco use supplements to the Current
Population Survey, Ohsfeldt et al. (1998) concluded that the strongest restrictions on
smoking lead to significant reductions in smoking prevalence, after accounting for their
potential endogeneity.
Evans and colleagues (1996) examined whether workplace restrictions led to self-
selection, with nonsmokers attracted to worksites at which smoking was not permitted and
smokers seeking out worksites permitting smoking. Using data from the 1991 and 1993
National Health Interview Surveys, the authors examined self-reported information on
whether or not workers were in firms that had policies restricting smoking. If the
respondent answered affirmatively, more detailed information on the policies was
collected. Evans et al. estimated the impact of the restrictions on cigarette demand in a
simultaneous equations model that allows for individuals to self-select worksites based on
their smoking status and smoking policies. The authors found that, after accounting for
workers' potential self-selection, smoking bans diminished the probability of adult
smoking by 5%, while reducing average daily cigarette consumption among smokers by 10%.
As such, the authors concluded that recent declines in smoking among workers relative to
non-workers in the U.S. can be attributed to the growing number of workplace bans on
smoking.
5.3 Limits on youth access to tobacco products

According to the World Health Organization (1997), 43 countries ban the sale of
cigarettes to minors, typically by establishing a minimum legal purchase age for
cigarettes and restricting the distribution of free samples of to underage youth. The
non-economics literature provides mixed evidence on the effectiveness of these youth
access limits. A few studies have found that raising retailer compliance with the minimum
age laws reduces the prevalence of youth smoking (Jason et al., 1996; Forster et al.,
1998). Others, however, have found little impact on youth smoking, even with high
compliance by retailers (Rigotti et al., 1998). A few recent econometric analyses have
examined the impact of these limits on youth tobacco use in the U.S., generally finding
little or no impact on youth cigarette smoking and other tobacco use (Wasserman et al.,
1991; Chaloupka and Grossman, 1996; Chaloupka et al., 1997; Chaloupka and Pacula, 1998a).
Chaloupka and Grossman (1996) attributed this to the relatively weak enforcement of these
laws.
Chaloupka and Pacula (1998a) examined the impact of enforcement of and compliance
with the limits on youth access on youth smoking using data collected in a special 1994
survey of state activities related to the Synar amendment (Downey and Gardiner, 1996).
This amendment requires states to establish minimum purchase ages for tobacco products and
to demonstrate that these laws are being enforced by conducting random, unannounced
compliance checks of retailers selling tobacco products. Failure to do so can lead to the
loss of state block grant funds for substance abuse prevention and treatment programs.
Chaloupka and Pacula's estimates suggest that when the limits on youth access are
comprehensively and aggressively enforced and highly complied with, they significantly
reduce the prevalence of youth smoking.
6. Agricultural policy and the macroeconomic implications of tobacco

Most of the policy-relevant economic research on tobacco has focused on the
arguments in the cigarette demand function, discussed in the preceding sections. With a
few exceptions, the literature cited has addressed how policy variables directly influence
smoking by individuals. There is another domain in which economic issues arise and
economic analysis has produced important understanding, however: how policy effects on
the economic welfare of the industry indirectly influence smoking and health. In this
section, we examine the literature pertaining to two such issues, each of which has been
raised in the course of the social debate on the economic and health consequences of
tobacco.
The first involves economic policy intended to benefit the agricultural sector of
the U.S. tobacco industry: how the unorthodox regulation of domestic tobacco growing in
the U.S. affects the price and quantity of tobacco grown, and through this channel
influences the price and consumption of cigarettes. The tobacco "subsidy" has been a
source of contention within the U.S. public health community for years, with most health
professionals believing that the "subsidy" encourages tobacco growing and thereby smoking.
As economists will appreciate immediately, the direct effect of a tobacco price support
system is the opposite: it discourages smoking by artificially inflating the price of
tobacco in cigarettes. Economic analysis has provided insight into the extent of this
effect, permitting policy analysts to consider it in the broader context of the overall
implications of the price support program.
The second issue addresses the broad question of how dependent nations' economies
are on preservation of a robust tobacco industry for employment, tax revenue, and a
positive contribution to the trade balance. A central thrust of the tobacco industry's
strategy to combat tobacco control policies has long been to argue that, regardless of the
health consequences of its products, the economic vitality of America (and other
countries) depends on a strong tobacco industry. In recent years, macroeconomic research
has been undertaken in several countries to challenge the premise with empirical evidence.
Prior to addressing these issues, this section opens with background on both the
global and U.S. tobacco industries.
6.1 Size and nature of the tobacco industry

6.1.1 The global industry
In 1983,28 an estimated 47 million people directly owed their livelihoods, in whole
or in part, to tobacco cultivation, product manufacture, distribution, and retailing
(representing 18.2 million full-time equivalent jobs), with 30 million of these in farming
(11 million FTEs), nearly half in China alone.29 In addition, over 10 million people (8
million FTEs) were employed in supplier industries, those providing materials and services
to the tobacco industry (e.g., harvesting tools and cigarette papers, insurance coverage
and transportation and shipping) (Agro-Economic Services, 1987).
In the 69 countries included in this evaluation of the global industry (covering 90%
of the world's population), an average of 0.3% of arable land was devoted to tobacco,
although tobacco accounted for 1.3% of full-time agricultural employment, reflecting the
labor intensity of tobacco growing. Tobacco constituted 1% of total agricultural output,
0.8% of total manufacturing output, and 3 percent of total retail sales (Agro-Economic
Services, 1987).
International trade in tobacco and tobacco products represented 0.5% of total
exports and 0.4% of imports, the difference reflecting a robust international contraband
trade (Agro-Economic Services, 1987) which appears to have grown considerably in recent
years (Joosens, 1998). For a handful of countries, tobacco exportation represents an
international economic lifeline. In Zimbabwe, for example, tobacco accounts for
approximately one-third of the country's export revenues (Chapman and Wong, 1990;
"Zimbabwe...", 1998).
Tobacco's economic importance worldwide derives also from its use as a source of
governmental revenues. Excise (and other) taxation generates many tens of billions of
dollars annually. Several countries derive 10% or more of total government revenues from
tobacco taxation (Chapman and Wong, 1990).
6.1.2 The U.S. tobacco industry

In 1995, Americans spent $48.7 billion on tobacco products, most of it on just under
490 billion cigarettes. In addition, U.S. farms and cigarette companies shipped abroad,
respectively, $1.4 billion worth of unmanufactured tobacco leaf and $5 billion in
manufactured product (Gale, 1997).
The five core sectors of the tobacco industry -- tobacco growing, auction
warehousing, product manufacturing, wholesale trade, and retail trade -- collectively
employ up to half a million Americans in tobacco-related activity (Gale, 1997). Industry
activity generates an additional 650,000 to 2 million spin-off jobs, representing
purchases from suppliers and spending by the recipients of incomes from tobacco product
sales.30 In 1992, the emotional and political heart of the U.S. industry, tobacco
28
We are not aware of any contemporary figures on the size of the global industry.
The data presented here, covering the year 1983, suggest a rough order-of-magnitude
estimate of the industry's importance, albeit one that likely underrepresents the
contemporary industry given that tobacco consumption has increased worldwide annually
since that year.
29
China is the world's largest producer and consumer of cigarettes.
30
Estimates of direct, indirect, and expenditure-induced employment are taken from
several sources, including Warner et al. (1996), Price Waterhouse (1992), Tobacco
Merchants Association (1995), and Gale (1997). The smallest total employment associated
with tobacco industry activity is Gale's estimate of 1.2 million, although Gale also
reported a high estimate of direct employment (500,000). The largest total employment
estimate is that of the WEFA Group at 3 million jobs, although we believe that this and
several other industry-commissioned estimates rely on improbably large multipliers in
estimating expenditure-induced employment. Reviewing the Price Waterhouse analysis,
farming, included 124,000 farms on which tobacco was grown in some 20 states. However,
just three states -- North Carolina, Kentucky, and Tennessee -- accounted for 82% of the
91,000 farms officially designated as tobacco farms (defined by the U.S. Department of
Agriculture as farms on which tobacco accounts for at least 50% of sales). A further
three states -- Georgia, South Carolina, and Virginia -- accounted for an additional 10%
of tobacco farms. Collectively, these six southeastern tobacco states were responsible
for a comparable percentage of tobacco production as well (Grise, 1995).
Estimating tobacco farm employment is difficult because so few farmers rely
exclusively on tobacco for their full-time economic activity. Employing the arbitrary
assumption that each job is half time (1000 hours), the USDA estimated the number of
tobacco farming jobs in 1995 at 156,000 (i.e., fewer than 80,000 FTE jobs). The largest
employment contribution associated with tobacco was in the retail sector, however, with an
estimated 257,000 jobs spread all over the country. The other politically "visible"
component of the industry -- workers employed in cigarette manufacturing -- numbered only
25,600. They were concentrated primarily in only three cities in which the vast majority
of U.S. cigarettes are manufactured: Richmond, VA, Winston-Salem, NC, and Louisville, KY
(Gale, 1997).
Although the tobacco farmer is the "heart" of the industry in emotional and
political terms, economically the farmer appears to be little more than a minor appendage.
Domestically-grown tobacco represented only about 2% of the domestic retail tobacco
dollar in 1995, with imported tobaccos constituting another 1-2%.31 Once one accounts for
leases of tobacco-growing quotas, farm supplies and equipment, overhead, and marketing
costs, farm workers actually took home only about 30% of tobacco farm gross receipts for
their labor, under 1% of the nearly $50 billion Americans spent on cigarettes and other
tobacco products. By comparison, the largest share of the tobacco dollar went to
manufacturing (38%), with additional major participants being wholesale and retail trade
(27%) and government, through excise taxation (26%) (Gale, 1997).
Although tobacco growing and cigarette manufacturing might seem like excellent
candidates for a highly competitive marketplace, they do not come close to conforming to
the economist's ideal of the smoothly functioning unregulated competitive market. The
manufacturing industry is characterized by a high degree of concentration, with two
companies, Philip Morris and R.J. Reynolds, selling three-quarters of all cigarettes
purchased in the U.S. and three others (Brown & Williamson, Lorillard, and Liggett)
accounting for the vast majority of the rest; Philip Morris alone captures half the market
(with one of its brand lines, Marlboro, accounting for more than half of the company's
sales) (Kluger, 1996). Four other companies round out this highly concentrated oligopoly.
Although one can readily imagine barriers to entry into the cigarette market (e.g.,
brand-name marketing advantages, distribution channels, etc.), tobacco farming seems a
less obvious domain for noncompetitive forces. Nonetheless, this purely agricultural
endeavor is not subject to the conventional laws of supply and demand in the U.S. Rather,
a convoluted system of price supports and allotments regulates who can grow tobacco, where
and how much they can grow, and what minimum prices they can expect at market. The
existence of this system, and the concentration of the industry in the six southeastern
states, has been credited with responsibility for the unusual political power wielded by
the six tobacco bloc states in Congress (Taylor, 1984; Warner, 1988; Gale 1997). We turn
now to a consideration of the nature of this system and its implications for both tobacco
agriculture and smoking and health.
Arthur Andersen Economic Consulting (1993) identified what they believed to be serious
methodological flaws and concluded that "employment and job loss figures are grossly
inflated."
Other analysts have suggested that the industry substantially underestimates
employment associated with tobacco, since they fail to include health care personnel who
care for the victims of tobacco-produced diseases, undertakers who bury them several years
earlier than nonsmokers, professional launderers who clean and repair smokers' clothing
more frequently, and so on (Schelling, 1986; Warner, 1987).
31
The tobacco crop value in 1995 was less than $2.6 billion, much of which was
exported as raw leaf or in manufactured cigarettes (Gale, 1997).
6.2 The impact of the U.S. tobacco agriculture regulatory system

32
6.2.1 Nature of the system and its impact on tobacco farming
Since the early 1930s, the U.S. federal government has implemented a variety of
tobacco farm programs designed to limit tobacco growing and prop up tobacco prices. Born
of Depression-era concerns about the traumatic effects on farmers of cyclical prices and
the vagaries of the weather, the programs have ensured stability but also limited
innovation in production techniques and farm size. Although the specifics of the programs
have varied over time, they have shared certain core elements in common: restriction of
the supply of tobacco, by restricting who can grow tobacco and how much they can grow, and
the assurance of minimum prices.
The tobacco farm programs began with the Agricultural Adjustment Act of 1933 through
which cash payments were made to tobacco farmers who agreed to limit production. The
Agricultural Act of 1938 established the principle of marketing quotas, with penalties for
growers who exceeded them. Price supports were originally set at 75% of base-period
prices and have varied up and down since then. The continued existence of the price
support system rested on a vote of tobacco farmers every three years. If two-thirds of
the farmers supported the system, as they have during each vote (with some minor
exceptions), legally enforceable marketing quotas are put in place.
The growers of tobacco, and the acreage they can farm, are limited through a system
of allotments, in essence a license to grow tobacco, allocated to farms existing at the
time the system was established. Under the first of the allotment programs, only farmers
possessing the allotments, or renting or purchasing land with allotments, could grow
tobacco. Since 1962, however, farmers have been permitted to rent or purchase allotments
without having to use the allotment holder's land, although subject to a number of
restrictions as to type of tobacco and how far the quota could be transported (e.g., some
quotas could be applied only within the county of the allotment holder). Supplies of
tobacco were thus limited through allotments and marketing quotas, as well as restrictions
on imported tobacco. Quotas are established based on the intended purchases by cigarette
manufacturers, anticipated exports and imports, and the amount of tobacco needed to
achieve a specified level of reserves. The Secretary of Agriculture can further adjust
the quotas by + 3% of the amount determined by formula.
The price support is based on a loan program through which farmers are guaranteed a
pre-specified minimum price. Farmers attempt to sell their tobacco at auction. If the
high bid does not at least match the loan price, a farmer-owned cooperative purchases the
tobacco at that guaranteed price, using money loaned by the USDA's Commodity Credit
Corporation (CCC). The cooperative stores the tobacco as collateral for the CCC loan.
When the cooperative later resells the tobacco, it forwards the proceeds to the CCC to
cover the loan principal and interest.
Until 1982, general tax revenues were used to cover CCC losses. Although the
amounts of money involved were modest by federal government program standards (Warner,
1988), the image of taxpayers' subsidizing the growing of a product that health officials
characterized as deadly became politically untenable. As a result, Congress passed the
No-Net-Cost Tobacco Program Act of 1982 which eliminated the taxpayer subsidy. Since
then, farmers and buyers have paid an assessment per pound of tobacco to cover any losses
in the loan program. The federal government continues to cover the cost of administering
the program, as well as providing a variety of other services to growers through the USDA.
In 1993, the total federal outlay on these activities was $26 million.
Over time, variations in the tobacco program have modified import policies and
imposed and then removed domestic-content requirements for U.S. cigarette manufacturers,
as well as tinkering with quota determination and allocation, price support, and so on.
For a discussion of specific revisions of the relevant laws, see Capehart (1997) and Grise
(1995).
The net effect of the program on tobacco agriculture has been multi-faceted. It has
brought the stability to the tobacco farm economy that it was designed to ensure. It has
restricted domestic tobacco supplies. The program has clearly restricted tobacco farm
size and limited the development of more capital-intensive methods of tobacco farming;
indeed, the growing of tobacco entails greater labor intensity than for nearly all other
U.S. crops. The program has increased the price of domestic tobaccos and, as a
consequence, the price of cigarettes (discussed below). As a result of boosting prices,
32
This section's description of the tobacco agriculture program is based on material
from Capehart (1997), Grise (1995), and Zhang and Husten (1998).
it has likely restrained the amount of raw leaf exportation from the U.S. It has created
an economically entrenched political constituency, the allotment holders, the principal
beneficiaries of the program (Babcock and Foster, 1992).
6.2.2 Relevance of the tobacco program to smoking and health

The tobacco program has had two effects directly germane to the issue of smoking and
health, one ostensibly favorable, the other not. By restricting the supply of tobacco and
increasing its price, the program has likely boosted the price of the finished product,
cigarettes, and thereby decreased the quantity demanded. The extent of this effect --
arguably the less important of the two (Warner, 1988; Zhang and Husten, 1998) -- has been
studied by economists and is the focal point of this section. In contrast, by allocating
the right to grow tobacco, or to earn money by leasing allotments, to a select group of
citizens in the tobacco southeast, and by ensuring stable and relatively high prices for
farmers, the tobacco program has created a highly concentrated economic and thus political
interest that has long wielded substantial power within the halls of Congress (Taylor,
1984; Babcock and Foster, 1992). Long-time observers of both Congress and tobacco concur
that the existence of the tobacco bloc has thwarted the development of effective tobacco-
and-health policies frequently over the past 35 years (Taylor, 1984; Fritschler and
Hoefler, 1996).
Whether the consumption-discouraging effects of the increased price of tobacco or
the consumption-encouraging effects of a lack of aggressive federal tobacco control policy
have dominated has been the subject of some informed speculation but no formal analysis.
Having reviewed the evidence, both Warner (1988) and Zhang and Husten (1998) concluded
that the latter was more important than the former, but in each case this conclusion
rested as much on the finding that the direct effect of the tobacco program on cigarette
price was very small. It is here that economic analysis has provided useful empirical
evidence.33
The economic effects of the tobacco price support program have been the subject of
formal economic analysis for at least three decades (Johnson, 1965). Since the mid-1980s,
four analyses have estimated the impact of abandonment of the tobacco price support
program on tobacco supplies and prices. Using a simultaneous equations model of the
supply of and demand for tobacco and cigarettes, which included the possibility of
substitution of foreign for domestic tobaccos, Sumner and Alston (1985) estimated that
eliminating the program in 1983 would have reduced the price of U.S. tobacco by 20-30%.
The authors estimated an increase in domestic tobacco output of 50-100% or more with
supply restrictions ended, with cigarette manufacturers likely to buy more domestic
tobacco and exports likely to double. Reflecting this expanded output, Sumner and Alston
estimated that tobacco growing revenues would have risen by 15-60% despite the price
decrease. Because domestic tobacco represented under 10% of the retail price of
cigarettes, the authors concluded that the price support program boosted the retail price
of cigarettes by no more than 3%.34 Employing a price elasticity of demand of -0.3, they
estimated that the direct effect of the price support program was to decrease the demand
for cigarettes by about 1%. A decade later, economists at the USDA produced a similar if
less detailed analysis that supported Sumner and Alston's findings. Grise (1995)
concluded that the price support program raised domestic tobacco prices by 30-40%. He
estimated that this tobacco price effect raised cigarette prices by 1-2%.
33
This analysis has been particularly useful simply to help correct the misimpression
of the lay public that the tobacco price support program, or the "tobacco subsidy," as it
is more commonly referred to, has directly encouraged smoking by encouraging tobacco
growing. The public has not generally appreciated that, to the contrary, the program has
limited the quantities of tobacco grown and brought to market.
34
Sumner and Alston (1985) assumed that tobacco price increases attributable to the
price support system would be fully passed on to retail consumers. This is a reasonable
assumption. Although the evidence is mixed, most previous research has characterized the
tobacco industry as a constant-cost industry. Research has also demonstrated that the
industry has exploited its oligopolistic character with a strong price-leadership model,
passing on more than 100% of federal excise tax increases (Harris, 1987). A recent study
concluded that the industry engages in a minor amount of price discrimination by state,
passing along slightly more than states' excise tax increases (Keeler et al., 1996).
Obviously, the permeability of state borders limits the extent of such price
discrimination.
Still more recently, researchers at the federal Office on Smoking and Health (OSH)
in the Centers for Disease Control and Prevention analyzed contemporary data and
determined that the price support program increased tobacco prices by 18-23% (Zhang et
al., 1997). In contrast with the early 1980s, domestic tobacco accounted for only 3% of
cigarette retail price in 1991. This decline in the domestic tobacco farm value share of
retail cigarette value reflected several developments pertaining to the amount and price
of domestic tobaccos. First, the amount of tobacco employed in manufacturing a given
number of cigarettes has declined significantly since the 1980s, as it has since well
before then (from the early 1950s to the present, the amount of tobacco per cigarette has
declined by over a third (Congressional Research Service, 1994)). This has resulted from
reduced wastage, in part as a consequence of new production technologies that allow
manufacturers to blend in parts of the tobacco plant previously discarded, such as tobacco
stems, and to expand the volume of tobacco per unit of weight (called "puffing"). It also
reflects a shift in demand from relatively large-barreled cigarettes, some unfiltered, to
filtered and small-diameter cigarettes.
A second reason for the decline in the domestic tobacco share of the cigarette
dollar is manufacturers' increasing reliance on less expensive imported tobaccos. At
various times, as much as a third or more of the tobacco in U.S. cigarettes has been
imported. From 1980 to 1991, for example, the imported tobacco share rose from 29% to
35%. More recently, the share of imported tobaccos quickly decreased and then
increased.35 The 1993 Omnibus Budget Reconciliation Act (OBRA) included a provision
requiring that 75% of the tobacco in U.S.-manufactured cigarettes be domestically grown.
Shortly after the domestic content provision was implemented, it was determined to be
inconsistent with the requirements of the General Agreement on Tariffs and Trade (GATT).
It was replaced in September 1995 by a complicated tariff-rate quota (TRQ) designed to
restrict imports but to conform to GATT requirements.36
A third factor in the declining share of cigarette expenditures attributable to
domestic tobacco has been the stability of tobacco prices compared to more rapidly
inflating prices for the manufactured product. From 1980 to 1991, the farm price of
tobacco rose only 18%. During the same period, cigarette price increased 187%.
Accounting for the reduced role of domestic tobacco in cigarette price, Zhang and
colleagues concluded that the tobacco price support program likely increased the retail
price of cigarettes by no more than 1%. To assess the impact on smoking, the researchers
employed a more recent estimate of the price elasticity of demand for cigarettes and then
allocated half of the price response to decisions of whether or not to smoke and the other
half to number of cigarettes per day per continuing smoker. Given these assumptions, they
estimated that the direct effect of the tobacco price support program was to decrease the
number of smokers by 0.14%. As such, they concluded that the beneficial effect of the
37
price support program, from a public health point of view, was very modest at best.
In the most recent attempt to evaluate the implications of the tobacco price support
system, Brown (1998) examined a mix of likely provisions in comprehensive federal tobacco
control legislation that would directly affect domestic tobacco growing. Combining the
35
Imported and domestic tobaccos are not perfect substitutes. Tobaccos come in
numerous varieties, each with its own characteristics, and soil and weather conditions
combine to alter those characteristics from one growing location to another. As a
consequence, the world price of tobacco does not necessarily reflect the marginal price.
Some American-grown tobaccos, prized by cigarette manufacturers, can command a higher-
than-average price on world markets.
36
The TRQ imposes quotas on imported tobaccos by exporting country, with imports
above quota levels subject to a 350% ad valorem duty. However, most of the duty is
refunded if the excess imported tobacco is included in cigarettes made in the U.S. for
export.
37
The authors' assumptions are subject to challenge. In particular, as indicated
earlier in this chapter, most of the research on cigarette price elasticities to date
suggests that the dominant effect of increasing prices on adult consumption is to lower
daily cigarette consumption for continuing smokers, rather than decrease smoking
prevalence. The OSH authors' estimate of the impact on numbers of smokers is so small,
however, that alternative assumptions will not alter the qualitative conclusion that the
impact on smoking is very small.
effects of eliminating the price support program with adoption of a $1.50 per pack federal
cigarette excise tax increase, he predicted a long-run decline in tobacco leaf price of
20-30%, not inconsistent with the OSH estimates, which did not incorporate an excise tax
increase.
The consistency of the findings from these studies provides strong support for the
conclusion that the direct effect of the U.S. tobacco price support program on
discouraging smoking, by virtue of raising cigarette prices, is very small.
6.3 The contribution of the tobacco industry to the economy

6.3.1 States and nations
Since the late 1970s, the U.S. tobacco industry has commissioned numerous prominent
economics consulting firms to produce estimates of the industry's contributions to
employment, incomes, and tax revenues for the country as a whole, the individual states,
and occasionally specific cities and counties (Wharton Applied Research Center, 1979;
Chase Econometrics, 1985; Price Waterhouse, 1990, 1992; Tobacco Merchants Association,
1995; American Economics Group, 1996b). When tobacco control policy measures have been
under consideration by legislative bodies, industry representatives have used the findings
from these analyses to try to convince legislators that adoption of the policy would
inflict economic damage on the state's or nation's citizens, in particular by causing
widespread loss of jobs (Warner, 1987). In a few instances, the industry's consultants
have observed in their formal written reports to their clients that alternative spending
patterns would generate compensating employment (Chase Econometrics, 1985; American
Economics Group, 1996a)38. When meeting with legislators, however, the industry's
representatives have never mentioned this.
That the decline or demise of one economic activity would be replaced by alternative
economic activity, each of which would eventually produce comparable national levels of
employment, is obvious to economists. The compensating benefits of replacement economic
activities are not generally contemplated by the lay public, however. As such,
legislators, journalists, and other members of the public are susceptible to the
industry's argument that reduced purchase of tobacco products will lead to substantial
economic dislocation, and that such dislocation exacts a high price from communities. The
industry has used its estimates in two ways: to indicate the overall significance of
tobacco in the economies of the states and the nation as a whole; and to make projections
of lost jobs and tax revenues that would result from the adoption of specific tobacco
control policy measures.
To respond to this argument, economists have performed macroeconomic analyses that
essentially complete the analysis initiated by the industry's consultants. Where the
industry-sponsored studies estimate the gross economic contribution of tobacco -- the
numbers of jobs, earnings, taxes paid -- the independent studies estimate the net
contribution, i.e., the benefit of tobacco-related economic activity after one considers
the implications of redistribution of the same resources to alternative uses. Researchers
at the University of Michigan employed the REMI Model (Regional Economic Models, Inc.)
(Treyz, 1993) to estimate how both declining tobacco consumption and the complete
elimination of tobacco consumption would affect employment in the state of Michigan
(Warner and Fulton, 1994) and in the principal regional economies of the U.S., as defined
by the U.S. Bureau of Economic Analysis (BEA) (Warner et al., 1996). The study of the
effects on Michigan was intended to demonstrate how declining tobacco consumption impacts
the economy of a nontobacco state, since nontobacco states comprise the large majority of
U.S. states and they have often been the targets of the industry's economic argument. The
study of the regional economies of the U.S. was intended to contrast effects within the
southeast tobacco-state region (consisting of half the 12 states in the BEA's southeast
region) with implications for the 8 nontobacco regions (one, "southeast nontobacco,"
consisting of the six nontobacco states in the BEA's southeast region).
38
In the most telling example of this, buried in chapter V of volume 1 of the
detailed technical report prepared by analysts at Chase Econometrics (1985) is the
acknowledgment that money not spent on tobacco products would be reallocated to other
spending, and that nationwide (combining tobacco and nontobacco states), the economic
results with and without tobacco "would be substantially the same." The report authors
explicitly observed that compensatory responses to the absence of tobacco spending "that
would occur automatically within the Chase Econometrics Macroeconomic Model...were
constrained from taking place within [the firm's] analysis."
To illustrate the procedure (the basics of which were conceptually identical for the
two studies), in the regional analysis the researchers first generated a baseline forecast
of the economies of each of the 9 regions for the years 1993 to 2000, assuming no changes
in the expected pattern of spending on tobacco (which included an expected annual decline
in consumption, based on the trend in the decade preceding the period of the simulation).
The eight-year period selected for the simulation was intended to permit analysis of
dynamic short- and medium-run impacts on the regional economies. To evaluate the gross
contribution of tobacco to employment, analogous to what the industry's consultants have
done, the researchers then generated an alternative forecast in which all of the expected
spending on tobacco was removed from the baseline forecast. Comparison of the two
forecasts, with and without tobacco spending, permitted assessment of the amount of
employment associated with tobacco spending, by region, economic sector, and year. To
estimate the net employment implications resulting from consumers devoting their former
tobacco expenditures to other goods and services, the analysts reallocated this amount
according to consumers' normal spending patterns, with tobacco excluded. Net employment
was estimated by comparing the employment projections in the baseline simulation with
those from the simulation in which tobacco spending is reallocated to other goods and
services.
To examine the implications of a more realistic scenario which might be expected if
effective tobacco control policy measures were adopted, namely an increasing rate of
decline in tobacco product consumption, the researchers assumed that the recent historical
rate of decline would double. The simulations were repeated with the appropriate amount
of tobacco spending removed (gross model) and reinjected into the alternative goods and
services (net model).
In the first study, Warner and Fulton (1994) demonstrated that in a nontobacco
state, declining spending on tobacco products would increase the state's employment, and
that this effect would persist over several years. The finding reflected the fact that
tobacco products represent imports for Michigan (and other nontobacco states). Since some
of the reallocated spending would be devoted to goods and services produced within the
state, more state spending would recycle within Michigan, thereby producing more Michigan-
based jobs. Although this is obvious to economists, it represented a revelation to many
noneconomists in the policy community.
In the second study (Warner et al., 1996), the researchers found that with either a
decline or the complete elimination of domestic tobacco spending, each of the eight
nontobacco regions would gain employment during the period studied, while the southeast
tobacco region would lose employment. The study further demonstrated that the losses
within the tobacco region would be considerably smaller than those suggested by the
industry's analyses, which again have never included the effects of alternative spending,
which would benefit the tobacco states as well as the nontobacco states. One of the
study's most important conclusions was that plausible declines in tobacco consumption
would have exceedingly small impacts on employment even in the southeast tobacco region.
Under the more realistic scenario, the estimated loss of 36,600 jobs in the region by the
year 2000 would amount to only 0.2% of regional employment.
Similar analyses have been performed in other countries. The idea was first
introduced by Allen (1993) in a qualitative consideration of the economic implications of
the tobacco industry in Canada. Subsequently, Buck and colleagues (1995) used an input-
output model to study the employment implications of tobacco in the United Kingdom. Most
recently, van der Merwe (1998b) evaluated the same issue in South Africa. Despite
variations in basic methods (e.g., input-output vs. dynamic models) and more specific
assumptions (most notably, the nature of the alternative spending pattern), all of these
studies have arrived at the same conclusion: spending on tobacco does not generate
greater employment for the country in question than would alternative spending patterns.
The tobacco industry's consultants report on other industry-related impacts in
addition to employment. The two most important are the tax revenues generated by spending
on tobacco and the positive contribution of tobacco to certain countries' trade balances.
No non-industry analysis has attempted to evaluate the net effects of reductions in
tobacco spending on these two variables. The results are obvious, however. For most
countries, reductions in tobacco spending would produce reductions in government revenues,
reflecting the fact that cigarettes, unlike most other products, are subject to excise
taxation. Thus, governments that succeed in reducing tobacco consumption through tobacco
control policies generally will need to seek alternative sources of revenue to replace
those lost due to declining tobacco product sales. The one exception, of course, is a
sales reduction occasioned by an increase in an excise tax. In this instance, as is
discussed earlier in the chapter, government revenues will rise at the same time that
consumption falls.
Reductions in spending on tobacco could adversely affect the balance of payments in
those countries in which exports of tobacco and tobacco products exceed imports. However,
tobacco exports play a truly central role in the balance of payments in only a handful of
countries; most notably, Zimbabwe relies on tobacco for approximately a third of its
foreign exchange earnings (Chapman and Wong, 1990; "Zimbabwe...", 1998). In contrast to
the net exporters, in countries in which tobacco product imports exceed exports,
decreasing consumption could improve the trade balance (Warner and Fulton, 1995).
6.3.2 Tobacco farm communities

As the regional analysis of the U.S. demonstrated, reductions in tobacco product
sales can harm the economies of specific areas of countries highly dependent on tobacco
economic activity. That analysis also demonstrated, however, that plausible policy-
induced decreases in tobacco consumption would have extremely modest effects on employment
within the United States' major tobacco region (Warner et al., 1996).
Less clear, however, and likely more important from both a political and
humanitarian point of view, is the impact of declining tobacco sales on the local
communities that are most heavily dependent on tobacco farming or product manufacture. In
the popular mind in the U.S., large numbers of counties in North Carolina, Kentucky, and
the four other tobacco states are virtually wholly dependent on tobacco farming.39
Substantial decreases in tobacco product sales would, it is widely believed, wreak havoc
with these communities' economies. Sympathy with this view has led to the inclusion of
significant benefits to tobacco farmers in all of the comprehensive tobacco control
legislative proposals under consideration by the U.S. Congress in 1998.
According to work by agricultural economists, however, the image distorts a more
benign reality. Relatively few tobacco counties in the U.S. are so dependent on tobacco
that plausible policy-induced decreases in tobacco consumption would inflict serious
economic hardship. Indeed, Gale (1998) stated recently that he expects merely a
continuation of the kinds of economic adjustments that tobacco farmers have been making
for decades; and, he observed, tobacco farm communities today have more diversified
economies upon which to draw in making those adjustments than in years gone by. He
summarized the essence of the situation by noting, "Tobacco has an important historical
role in many Southern communities. Today, however, tobacco plays a minor economic role in
most local economies where it is grown" (p. 43).
That the importance of tobacco farming within the tobacco belt states has diminished
substantially is made clear by data supplied by the Economic Research Service (ERS) of the
40
USDA. From 1964 to 1993, the number of tobacco farms declined from 330,000 to 124,000.
Domestic consumption of domestically-produced tobaccos has declined from 1.6 billion
pounds in 1952 to 900 million pounds in 1993. Adjusted for inflation, the value of
domestically grown tobacco has fallen.
For most tobacco farmers, tobacco growing represents only part-time, seasonal work.
Further, most tobacco farms are small, with over 70% having annual gross sales of less
than $20,000. Nearly two-thirds of farm operators work off of their farms, as well as on
them, with 42% working off-farm at full-time jobs (Gale, 1998). Also telling are data
indicating that the share of income from all farming, not just tobacco, in tobacco
counties fell from 5% in the early 1970s to well under 2% today. The ERS classifies
counties as "farm dependent" if earnings from all farming constitute at least a fifth of
the county's total earnings. By this definition, there were only 27 "farm dependent"
41
tobacco counties in the U.S. in the mid-1990s, out of 424 tobacco counties. And among
39
Because, compared with tobacco growing, cigarette manufacturing involves many
fewer, higher paid workers whose employment is concentrated in three economically
diversified cities, public sympathy resides more with the farmers. The remainder of this
section focuses exclusively on tobacco farming communities.
40
The decline in the number of farms is not matched by declining acreage devoted to
tobacco. During the most recent six years for which data are available, the number of
farms fell from 179,000 to 124,000, but acreage increased from 587,000 to 745,000 acres.
This trend toward larger farms, permitted by relaxation of some of the stricter
limitations of the quota system, would greatly accelerate were the price support program
ended.
41
A tobacco county is a county in which tobacco is grown for commercial purposes.
these farm dependent tobacco counties, only one derives a majority of its farm receipts
from tobacco. The next four most tobacco-dependent derive 25-35% of their farm earnings
from tobacco, while the remaining 22 counties each receives less than 5% of its farm
earnings from tobacco sales. Most tobacco counties are not classified as "farm
dependent." Across all tobacco counties, the USDA estimates that tobacco sales account
for approximately a fifth of total farm receipts. However, there are a number of counties
on the North Carolina-Virginia border and in eastern Kentucky in which tobacco's share of
farm sales exceeds 70%.
To put the role of tobacco into perspective, USDA calculates the ratio of tobacco
gross receipts to total proprietor and labor income within a county. By this measure,
almost half of tobacco counties (199) have a tobacco-income ratio of less than 0.01. Only
33 counties have a ratio exceeding 0.1 (Gale, 1998). USDA also calculates an index of a
tobacco county's ability to replace tobacco income through economic growth in other
sectors. The index measures the ratio of annual growth in inflation-adjusted local
personal income from all sources to tobacco gross receipts. USDA interprets an index
value exceeding 1.0 as meaning that the county is creating sufficient new economic
opportunities to potentially completely replace tobacco income. Approximately half of all
tobacco counties have index values greater than 1.0 (Gale, 1997).
All told, the evidence indicates that America's tobacco farming communities are far
less dependent on tobacco than is widely believed. That abrupt declines in tobacco
consumption would inflict severe economic pain on selected individuals is almost certainly
true; that many others would experience temporary economic dislocation is certainly
possible. The notion, however, that realistic policy-induced decreases in tobacco
consumption would wreak havoc throughout much of the tobacco belt is simply not consistent
with the evidence. Appeals to the welfare of tobacco farmers may resonate politically;
but economically they appear to have little justification.42 Indeed, the major economic
losers would be the allotment holders, a less politically-appealing group of people.
7. Conclusion
In the complicated ethical, social, and political domain of tobacco policy, economic
analysis has introduced a base of objective and increasingly sophisticated knowledge into
debates in which rhetoric has often dominated. Particularly with regard to the crucial
issue of how price influences the demand for tobacco products, and how taxation affects
price, economists have contributed empirically-based insights that, in many instances,
have played essential roles in guiding the formulation of tobacco control policy. Indeed,
it is no exaggeration to credit the work of economists with the contemporary global
interest in using tobacco taxation as perhaps the primary tool of tobacco control policy.
In the process of examining the empirical relationship between tobacco price and
consumption, economists have contributed to the evolving theoretical and methodological
literature on the effects of addiction on consumer demand. A "problem" in the traditional
economic model of rational economic behavior, addiction is now receiving the attention
that promises important future contributions of both a conceptual and empirical nature.
Public health policy making will be enriched in the process.
In addition to addressing issues of taxation, price, and demand, economic research
has also offered important understanding of the effects of other tobacco policy measures,
ranging from media counteradvertising to the introduction of restrictions on smoking in
public places. The work of economists has lent perspective to emotional issues in debates
on tobacco policy, such as the implications of tobacco control for employment both inside
and outside of tobacco-dependent regions of states and countries.
In other areas, economics research has been less successful in answering policy
questions. A notable example involves the politically central issue of whether cigarette
advertising increases consumption, and whether ad bans decrease it. Econometric research
has contributed empirical evidence to the debate, but without offering much by way of
resolution. In part this reflects limitations inherent in econometric methods; in part it
reflects the inadequacy of the data needed to quantify "advertising" (and exposure to it)
and evaluate its consequences. Recent work on the impacts of national advertising bans,
both partial and complete, shows promise but is decidedly in its infancy.
42
In the absence of data on the economic vitality of tobacco-growing regions in
other countries, these conclusions cannot be extended to tobacco farm communities outside
of the U.S.
In addition to having enlightened debates on tobacco policy, economic analysis of

smoking serves a broader purpose as well, one not examined in the present chapter.
Constituting by far the largest body of economic research on the consumption of addictive
substances, utilizing the best data available, economic research on smoking informs both
research and policy debates on other addictive substances (Warner et al., 1990; Warner,
1991). This is particularly important in the case of illicit drugs, such as marijuana and
cocaine, for which the availability of useful data has been severely constrained. More
generally, understanding the economics of tobacco lends insight into a whole host of
social, political, and economic issues, such as the political economy of product
regulation and the relationship between, and even meaning of, consumer sovereignty and
paternalism.
The use of tobacco, and particularly cigarette smoking, constitutes one of the great
public health plagues of the latter half of the 20th century, one sure to define much of
global health status far into the 21st century as well. As such, it is critical to
understand the determinants of tobacco use, perhaps especially those that can be addressed
by public policy. Using the conventional tools of their trade, often in novel and
creative ways, economists have been at the forefront of advancing knowledge in this
central area of public health. The impressive body of work described in this chapter
augers a bright future for the contribution of economics to grappling with what will soon
become the leading cause of disease and death worldwide.
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Table of Contents

1. Introduction and overview

4. Advertising, promotion, and the demand for tobacco products

5. Other tobacco control policies and demand

6. Agricultural policy and the macroeconomic implications of tobacco

1. Introduction and overview

2. The impact of price on the demand for tobacco products

2.1 Conventional studies of cigarette demand

2.1.1 Analysis of aggregate data

2.1.2 Analysis of individual level data

2.2 Addiction models and cigarette demand

2.2.1 Imperfectly rational addiction models

2.2.2 Myopic addiction models

2.2.3 Rational addiction models

2.2.4 Critiques of the rational addiction model

2.3 Behavioral economic analyses of cigarette demand

plunger required to receive a preset number of puffs on a cigarette. For example, 50

2.4 Econometric studies of the demand for other tobacco products

3.1 Comparative standards and the effects of tax on price

3.1.2 Effects of taxes on retail price

oligopolistic price increase.

3.2 Fairness standards

favoring imposition of a product-specific (excise) tax relates to the creation of negative

3.2.1 Horizontal and vertical equity

3.2.2 The benefit principle

3.3 Public health standards

3.3.1 The social cost of smoking

3.3.2 The health benefits of increasing cigarette taxes

3.4 Economic efficiency and the pursuit of an optimal cigarette tax

3.4.1 Negative externalities associated with smoking

3.4.2 Other efficiency considerations

4. Advertising, promotion, and the demand for tobacco products

4.1 Theoretical and conceptual issues

4.2 Econometric evidence

advertising expenditures on demand but also the impact of lagged expenditures. As

4.3 Findings from the noneconomic literature

5. Other tobacco control policies and demand

5.1 Health information and counter-advertising

5.2 Restrictions on cigarette smoking

5.3 Limits on youth access to tobacco products

6. Agricultural policy and the macroeconomic implications of tobacco

6.1 Size and nature of the tobacco industry

6.1.2 The U.S. tobacco industry

6.2 The impact of the U.S. tobacco agriculture regulatory system

6.2.2 Relevance of the tobacco program to smoking and health

6.3 The contribution of the tobacco industry to the economy

6.3.2 Tobacco farm communities

In addition to having enlightened debates on tobacco policy, economic analysis of

Conniffe D. Models of Irish tobacco consumption. Economic and Social Review

Experimental and Clinical Psychopharmacology 1995;3:349-57.

Douglas S. The duration of the smoking habit. Economic Inquiry 1998;36(1):49-64.

Douglas S, Hariharan G. The hazard of starting smoking: estimates from a split

Duffy M. Advertising and the inter-product distribution of demand: a Rotterdam Model

smokers on adolescent susceptibility to smoking. Journal of the National Cancer Institute

Department of Agriculture, Economic Research Service, TBS-241; April 1998:40-7.

Haavelmo T. The probability approach in econometrics. Econometrica 1944;12:96-124.

Lluch C. Expenditure, savings, and habit formation. International Economic Review

Modigliani F. Fluctuations in the savings-income ratio: a problem in economic