Valuing Big Tobacco, Part V

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 |  Includes: LO, MO, PM, RAI
by: CRG Research

In this series, we are going to value the common equity shares of Reynolds American, Inc. (NYSE:RAI), Lorillard, Inc. (NYSE:LO), Altria Group, Inc. (NYSE:MO) and Philip Morris International Inc. (NYSE:PM). In this article, we examine the microeconomic factors impacting the tobacco industry. In our previous article, we examined the valuations of the firms.

The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers' plans remain the same. When the price elasticity of demand is between 0 and 1, the good is said to have an inelastic demand. The elasticity of demand of tobacco is 0.61 (Institute 16).

The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. As the price of tobacco increases, the demand for substitutes for tobacco products increases. Further, as the price of tobacco products increases, the demand for complements, such as coffee, decreases.

Income elasticity of demand is a measure of the responsiveness of the demand for a good or service to a change in income, other things remaining the same. Tobacco products have an income inelastic demand. As income increases, the percentage of income spent on the good decreases.

The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. In the long run, the supply of tobacco is almost perfectly elastic. However, the momentary supply curve is vertical or almost perfectly inelastic.

In the long run, as the price of tobacco increases, the quantity of tobacco supplied increases by a greater percentage than the price of tobacco increases. In the short run, the price of tobacco increases by a greater percentage than the quantity supplied of tobacco increases.

When a market price allocates a resource, the people who are willing and able to pay that price get the resource. Tobacco products are allocated by market price. The people who are willing and able to pay that price get the resource. However, two kinds of people decide not to pay the market price: those who can afford to pay but choose not to buy, and those who are too poor and simply can't afford to buy.

Taxes increase the prices paid by buyers and lower the price received by sellers. So taxes decrease the quantity produced and lead to underproduction. Subsidies, which are payment by the government to producers, decrease the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction. Tobacco is both heavily taxed and subsidized.

Between 1995 and 2010, the federal government spent $1.1 billion on tobacco subsidies. Other estimates place the amount spent on subsidies at $1.3 billion. The amount spent on subsidizing tobacco crops is expected to decline as farm subsidy reform is implemented. In other words, the prices paid by buyers is expected to increase and the prices received by sellers is expected to decline. Also, taxes on tobacco products could increase.

An externality is a cost or benefit that affects someone other than the seller or the buyer of goods. Tobacco has an external cost on society. The tobacco producers do not consider the cost when they decide how much tobacco to produce. The result is overproduction.

Tax incidence is the division of the burden of a tax between the buyer and the seller. The demand for tobacco products is inelastic. When demand is inelastic, buyers pay more of the tax incidence than sellers. Further, the supply of tobacco is elastic in the long run and thus buyers pay more of the tax incidence than sellers.

A production quota is an upper limit to the quantity of a good that may be produced in a specified period. The US moved away from tobacco quotas and implemented subsidies to smooth the transition to a market-determined supply. With a subsidy the market price falls, but the total price received by sellers increases.

With production quotas, the price received by sellers and the market price increase. The market price of tobacco products should increase following the expiration of the subsidy. However, the size of the deficit should shrink, all else being equal.

An oligopoly is a market structure in which a small number of firms compete. The tobacco industry is an oligopoly. The tobacco manufacturers produce identical products. The firms are interdependent and there is temptation to cooperate.

There isn't much fluctuation in the quantity demanded of tobacco products, since the demand is inelastic. As prices rise due to taxes, the quantity demanded remains relatively stable. The revenue of tobacco products manufacturers should be relatively stable.

To be continued...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.