Company Background
British American Tobacco (BAT) is established in the
year 1902 (British American Tobaco, 2013a). The founder of American Tobacco
Company is James Buchana Duke [8]. Together with Britain’s Imperial Tobacco
Company, both companies entered into a joint venture arrangement to trade
outside both the United Kingdom and United States of America [8]. They are in
the tobacco industry and owns over 200 brands, including well-known cigarettes
such as Dunhill, Kent, Lucky Strike and Pall Mall (British American Tobaco,
2013a). They have penetrated around 180 markets and cater to one-eight of the
world’s one billion adult smokers. In the year of 2012, BAT sold 694 billion
cigarettes. The corporation has 44 cigarette manufacturing plants in 39
countries. Besides cigarette, they also produce smokeless snus, cigars, roll
your own and pipe tobacco (British American Tobaco, 2013a), all of which are
consumer goods (also known as final goods) (Investopedia, no date).
Global production of cigarettes amounts to 5.5 trillion a year [4].
China National Tobacco Corporation produces the most cigarettes than other
global companies [5]. However, they only monopolize China’s market and are the
largest state-owned tobacco company, under the State Tobacco Monopoly
Administration [7]. They have a market share of 350 million citizens that smoke,
which accounts to 40 percent [4]. Market
shares of tobacco companies are as followed [4]:
|
Imperial Tobacco
|
5%
|
|
Japan Tobacco International
|
10%
|
|
British American Tobacco
|
13%
|
|
Philip Morris International
|
15%
|
|
Others (including Philip Morris USA and associate
companies in USA and India
|
15%
|
Elasticity
Price Elasticity of Demand (PϵD) refers to “the
responsiveness of quantity demanded to a change in price”, ceteris paribus.
(Sloman, Wride and Garatt, 2012, p. 58). It is categorised based on the
percentage of change in quantity demanded divided by the percentage change in
price: %∆QD ÷ %∆P. Demand curves are usually downward sloping,
therefore there is an inverse relationship between price and quantity demanded (Sloman,
Wride and Garatt, 2012, p. 59). It does not matter that PϵD is a
negative figure, because it is an absolute value which disregards the negative
sign. Another method is the midpoint formula where, the change in quantity over
quantity midpoint is divided by the change in price over price midpoint (Mustapha,
M., 2013).
Elasticity is measured by (Sloman, Wride and Garatt, 2012, p.59):
Elastic (ϵ ˃ 1). A change in price results in a proportionately larger
change in the quantity demanded, as consumers are price sensitive.
Inelastic (ϵ < 1). A change in price results in a proportionately
smaller change in the quantity demanded, as consumers are indifferent to price
changes.
Unit elastic (ϵ = 1). A change in the same proportion of the
price and quantity demanded.
Total Revenue (TR) is the total amount received from sales, before any
deduction of tax or costs (Sloman, Wride and Garatt, 2012, p. 60). TR is Price
multiplied with quantity. Elasticity affects whether TR will increase or
decrease when price changes. Elastic demand is where a price increase leads to
a larger proportion of change in quantity demanded, thus TR falls; vice-versa.
On the other hand, inelastic demand is where an increase in price leads to a
smaller proportion of change in quantity demanded, thus TR rises; vice-versa.
A positive statement is the majority of smokers deem cigarettes are a
necessity because they are addicted to smoking due to the content of nicotine.
Thus, they are less influenced by the changes in price and the demand is fairly
inelastic [19]. Minority of the smokers are generally young adults or younger,
and only smokes occasionally [19]. They have a lower income level and are less
dependent on tobacco; they are more price sensitive and demand is fairly
elastic [19].
PϵD = (-20/20)/(4/8)
= |-2|
= 2
TR (at point a) =
P x Q
=
6 x 30
=
$180
TR(at point b) =
P x Q
=
10 x 10
= $100
PϵD =
(-10/45)/(4/8)
= |-0.44|
= 0.44
TR (at point a) =
P x Q
=
6 x 50
=
$300
TR(at point b) =
P x Q
=
10 x 40
=
$400
In actual fact, elasticity varies in different portions of a demand
curve (Sloman, Wride and Garatt, 2012, p. 62. The demand goes from (a) elastic,
to (b) unit elastic, and finally to (c) inelastic.
The total revenue test is stated as a technique of estimating price
elasticity of demand by comparison with the change in total revenue that is
affected from a change in price, ceteris paribus (Mustapha,
M., 2013).
Price Elasticity of Supply (PϵS) refers to “the
responsiveness of quantity supplied to a change in price”, ceteris paribus. (Sloman,
Wride and Garatt, 2012, p. 66). The formula is the percentage of change in
quantity supplied divided by the percentage change in price: %∆Qs ÷
%∆P (Sloman, Wride and Garatt, 2012, p. 67. Supply curves are usually upward
sloping, therefore there is positive relationship between price and quantity
supplied. Also similar to PϵD, the midpoint formula for PϵS [20].
The supply for cigarettes in the tobacco industry is elastic, PϵS
> 1. A change in price results in a proportionately larger change in the
quantity supplied [21].
PϵS =
(20/40)/(2/7)
= 1.75
Destabilising Speculation
“Speculation will tend to have a destabilising effect
on price fluctuations” when buyers and/or suppliers believe that a change of
price heralds similar changes in the future (Sloman, Wride and Garatt, 2012, p.
74). It is unlikely that the price of cigarettes will decrease; retail price
and tax only shows an upward trend of price increase from 1970 to 2011 in the
United States [22].
An initial rise in price (Sloman, Wride and Garatt,
2012, p. 74:
A rise in demand from D0 to D1,
causes an increase in price from P0 to P1. Suppliers
expect the price to rise further, thus they supply lesser and shift the curve
from S0 to S1. Smokers take the opportunity to buy the
cigarettes before any further increase in price, shifting the demand curve
rightward from D1 to D2. In the end, the price
continues to rise to P2.
Recently in Malaysia, the price of a pack of 20
cigarettes increased [23]. The current price for Dunhill and Kent is RM 12 per pack, from a rise in price only
four months ago [23].
Tax
In a mixed market economy, it is not surprising that
there is government intervention, especially on cigarettes. The tobacco
industry yields high revenue; in 2012, British American Tobacco gained £5,412,000,000
in profits from operation after deducting taxes and costs (Sloman, Wride and
Garatt, 2012, p. 79. Tax is supposedly to increase price and decrease quantity (Sloman,
Wride and Garatt, 2012, p. 79). However, duties on tobacco are a major source
of revenue for the government (Sloman, Wride and Garatt, 2012, p. 80. Incidence
of taxes is shared between consumers and producers (Sloman, Wride and Garatt,
2012, p. 79).
Distribution of taxes is dependent on the elasticity
of demand and supply of cigarettes (Sloman, Wride and Garatt, 2012, p. 79). As
mentioned earlier, the demand for cigarettes is fairly inelastic and the supply
is fairly elastic. When tax is imposed, the supply curve shifts upward by that
amount. Total tax revenue is the new equilibrium price multiplied with the new equilibrium
quantity. The increase in price from P0 to P1 multiplied
by new quantity sold (Q1) is the consumer’s share of tax on
cigarettes. The balance is the producer’s share. In the case of (1) and (2),
price will increase, thus the consumer’s burden will be larger, “the less
elastic is demand and the more elastic is supply” (Sloman, Wride and Garatt,
2012, p. 81).
Negative
Effects of Raising Tobacco Tax
Nevertheless, rapidly rising tobacco excise tax may
force smokers to find a cheaper alternative, illegal smuggled cigarettes [12].
In Malaysia, the tax level steadily increased to 48 percent during the last
eight years, while illicit cigarette trade has increased by 40 percent [23]. In
the year of 2012, it is estimated that the government lost RM 1.9bil to the
black market [23]. Low and middle income earners increases search activity;
smuggled cigarettes can be bought for as low as RM 2.50 per pack [24]. In
addition, underground dealers are unconcerned about the law and would not
hesitate to sell cigarettes to minors [12]. Therefore, the black market is a
strong competitor in the industry [15].
Market
Structure
In the beginning, the tobacco industry was monopolised
by the American Tobacco Corporation [17]. Then, the federal government
attempted to keep the prices low when they broke the monopoly structure [17].
As a result, six companies emerged with their own brand of unfiltered
cigarettes. Thus, the industry “became a classic oligopoly”, with only a few
sellers in the industry [17]. Cigarettes are differentiated products, where
there are differences among brands (Sloman, Wride and Garatt, 2012, p. 197).
In oligopoly, there are numerous barriers to entry.
The first being economies of scale (Sloman, Wride and Garatt, 2012, p. 181).
When British American Tobacco produces more cigarettes, their cost for
producing each additional output decreases [25]. Second, lower costs for an
established firm. As they are in the industry longer, it is likely they have
developed specialisation as well as have connections with reliable and cheap
suppliers (Sloman, Wride and Garatt, 2012, p.182). Thus, they are using minimum
cost to produce maximum output. New firms may find it difficult to compete. Third,
product differentiation and brand loyalty. Consumers may associate the product
with a brand, making it hard for new firms to penetrate the market. Moreover, smokers
usually stick to a brand of cigarettes.
Apart from barriers, another key feature of oligopoly
is the interdependence of firms (Sloman, Wride and Garatt, 2012, p.199). Firms
are affected by its rivals’ actions and have to respond accordingly in order to
maintain their positions as a key player in the industry.
References
Lecture 3 Mustapha, M. (2013). Lecture 3 Markets In Action. Microeconomics [online]. Available from: https://times.taylors.edu.my/
[Accessed 22 October 2013].
British American Tobacco (2013a) Who
We Are. Available from:http://www.bat.com/group/sites/uk__3mnfen.nsf/vwPagesWebLive/DO52ADCY?opendocument&SKN=1
[Accessed 22 October 2013].
Investopedia (no date) Consumer Goods.
Available from: http://www.investopedia.com/terms/c/consumer-goods.asp [Accessed 22 October 2013].
