Tobacco Cartel: Alive and Well

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I have long argued that the 1998 Master Settlement Agreement (MSA) between the big tobacco companies and the states effectively "cartelized" the industry, blocking new entrants to the tobacco market. But a recent article in The Wall Street Journal gave readers themistaken impression that the tobacco giants face intense competition fromnew and smaller companies that didn’t sign the MSA. Because that question is the subject of pending litigation before two federal appellate courts, it’s important to set the record straight.

The barrier to entry erected by the MSA came in the form of escrow payments for “damages” imposed on cigarette makers that had not been sued by the states, were not a party tothe MSA and, in some cases, didn’t even exist when the MSA was signed.

How then, in the Journals words, could “upstart cigarette makers haveswarmed into the market [and] grabbed nearly four percent ... up from justone percent in 1997”? Sorry, but that’s the wrong question. Assuming the Journal has its numbers correct, “wholesale list prices, excluding taxes, have risen nearly 80%”; new and small companies are selling “cut-rate smokes ... for as little as $1 a pack, compared with an average retail price of more than $3 for big-name brands”; “companies that haven’t signed the agreement aren’t bound by its marketing restrictions”; and “it really doesn’t take a lot of capital to start a cigarette company.” Accordingly, if not for the entry barriers created by the MSA, how in the world could four tobacco giants still control 96 percent of that market?

To be sure, the financial incentives are so large that the attorneys generaland their hired gun lawyers may have underestimated the extent to whichentrepreneurs would try to enter the tobacco business. As a result, theimpressive dike that the MSA erected may have sprung a few leaks. First,the four states that settled prior to the MSA don’t require non-signingtobacco companies to pay damages into escrow. Those states – Florida,Mississippi, Texas, and Minnesota – account for 15 percent of U.S. sales.Don’t be surprised if they ultimately enact an escrow requirement to protecttheir cash cow if the small companies get too sassy.

Second, escrow payments are based on all sales within a state. Therefore,cigarettes wholesaled in, say, Texas (where there is no escrow) but retailedin, say, New Jersey (which requires an escrow) are supposedly covered.Still, some new cigarette makers are refusing to pay up. They say they’renot accountable when distributors transport cigarettes for resale out ofstate without the manufacturer’s knowledge or permission. That issue iscertain to be litigated.

Third, under the MSA, the majors pay less to the states if their aggregatemarket share declines by more than two percentage points. The decline since1997, three percentage points, is only one point above the threshold –probably not enough to worry the cartel. Yes, the states lost $190 million in 1999 because of lower settlement payments. But that’s not even 3% of the roughly $7 billion in 1999 payments. Perhaps that explains why some states aren’t vigorously enforcing their escrow provisions. The pressure to enforce will increase if payments to the states decline further.Interestingly, preliminary data for the year 2000 indicate no comparablereduction.

Finally, one of the majors, Brown & Williamson, has tried to circumvent theMSA by forming an alliance with the largest non-signer, Star Scientific.That too will be litigated if it endangers the long-run future of thecartel.

In short, the attorneys general and their billionaire lawyers cooked up asweetheart deal with the tobacco giants. Everyone came out ahead, exceptfor smaller companies and of course smokers, who get socked with the entirecost of the anti-competitive scheme. The Journal's article offers some smallhope that the cartel might ultimately be destabilized. But the trulyastonishing story is how cleverly the parties to the MSA anticipatedvirtually everything that has transpired. Without relief from the courts, the MSA will keep the tobacco cartel alive and well. It’s no accident that the biggest tobacco companies, despite settlement obligations in excess of $200 billion, are registering higher sales, fatter profits, and loftier stock prices.