Logo of Philip Morris International (Cigarettes Guide, 2013)
Facts about tobacco cigarettes, 1/3 of the adult population worldwide are smokers, that give nicotine about 1.2 billion customers. Tobacco cigarettes are selling at an average rate of 10 million cigarettes every minute but smoking one cigarette lower life expectancy by 10 minutes and tobacco kills one person every 10 seconds and are responsible for killing 4 million people each year (Stephen Scarlett, 2011).
A video showing the history of tobacco (Bill madhousebill, 2013)
The cigarette market is known by everyone and tobacco itself has a long history and it is heavily traded since the 16thcentury( The Globalist ,2013). When tobacco cigarette was first introduced to the world, no one thought it could bring such a powerful impact in the world and despite aplenty government intervention such as raising health awareness from tobacco smoking, the tobacco industry still manage to generate billions of USD per year due to the inelastic demand (World Lung Foundation, 2012), thus a research has been conducted on Philip Morris International, a major producer of tobacco cigarettes to find out how it effect the economy.
The history of Philip Morris International (PMI) is traced back to 1847 when Mr. Philip Morris opened his first shop selling tobacco and cigarettes in London, the company was passed down from generations to generations of Mr. Philip Morris family until the year 1894. In mid-1950, due to the massive revenue made by the company, the company launched Phillip Morris International to market its cigarette and tobacco products around the world (Philip Morris International, 2011). After more than 150 years of operation, PMI is growing strong with record revenue of 31billion in 2012, up by 0.9% in 2011. (Wall Street Journal, 2013). PMI is a global tobacco company with its headquarter in New York, America, with more than 87000 employees worldwide. PMI adapts the oligopoly market structure, the company competitors are Imperial Tobacco Group, British American Tobacco and Japan Tobacco (Yahoo , 2013).
A documentary showing the addiction of nicotine (Stephen Scarlett, 2011)
Nicotine found in cigarettes is one of the most additive drug in the world and also there is no close substitute good to tobacco cigarette, these cause the price elastics of demand for cigarettes to be inelastic, which is if the price of cigarette goes up, the demand will only reduce by a very tiny portion
Graph showing inelastic price of demand for cigarettes
The government has come up with numerous ways to reduce the demand of cigarette such as showing warning on the cigarette packets, restrict legal age for purchasing cigarette and also increase legal age for smoking, however, ‘Market Watch’ reported that despite the cigarette volume sold has decreased in developed nations but Philips Morris profit increased by 5.1% because of the cigarette price increased (Market Watch, 2013). In the developed countries, cigarette consumption is declining as more and more people are aware of the risk of smoking, however PMI revenue is not decreasing because PMI raise the prices of cigarettes to make up for the loss in quantities sold.
Warning label on a cigarette package (Quizlet , 2013)
As shown in the graph above, at price A, the total revenue is the red region, if PMI increased the price to B, the total revenue will increased to the blue region. Although the quantity demanded has fallen but it is covered by the rise in price.
The government in Senegal also come up with a 45% high taxation on PMI cigarette to discourage the consumption of cigarette. As shown in the graph above, taxation will reduce the supply from S1 to S2, causing the equilibrium point to move from A to B, which reduced the quantity demanded and also increased the price, however, since the demand is inelastic, the producer is able to pass on most of the tax incidence to the consumers. The total tax revenue on cigarette received by the government is the red and yellow region combined. The tobacco industry generate a huge sum of revenue to the government every year. In the UK, the government is able to generate 2.6Billions pound tax revenue from tobacco in 2011(Tobacco Manufacturers Association, 2013).
As the oligopoly market suggested, Philip Morris International has a kinked demand curve
The kinked demand curve is shaped as shown above is because it is composed of 2 different demand curve because of the game-playing behavior, the firms in this industry are interdependence of each others. If the oligopolistic firm increased price then the rivals will not follow because the rival firms will be able to get more customers due to their lower price, this will cause a large quality demanded to fall for the initiating firm and that lead to the elastic demand. If the oligopolistic firm reduced price then the rivals will follow or else the rival firms will lose substantial market share, this causes the initiating firm to see very little changed in quantity demanded so it leads to the inelastic part of the demand.
The marginal revenue associated with the kinked demand curve is shown below
Producers in oligopoly market structure are always interdependent on each others, In the US, Philip Morris announced a 20% price cut on its cigarette brand and also increased its advertising. This move by Philip Morris was quickly responded by R.J. Reynolds Tobacco Company by reducing their cigarette price and also increasing their advertising cost. The firms in oligopoly have to always keep track of competitors move because a single wrong step will lead to massive loss in market share and profits (Harvard Business Review, 2003)
Large firm is able to experience economies of scale, which is as output is increasing but the average cost is decreasing. PMI experiences economies of scale in many sectors, one of it is that PMI is able to purchase raw materials and machines in a highly-discounted price as PMI is buying in bulk, this enabled them to produce goods in a very low cost. Besides that, PMI is able to get financial support from banks easily, banks are more willing to financially support PMI as there are less risk associated. PMI is also able to get better interest from the banks since large firm deals in a huge sum of money. PMI has relationships with 15 major banks in the world such as HSBC,CITI and Société Générale (The Banker , 2012)
Over the years, PMI has acquired many other firms to increase their market share, for example, in 2005, Philip Morris International acquired PT HM Sampoerna Tbk which is the largest tobacco company in Indonesia (Philip Morris International, 2011). This reduced competition for both companies and also allowed the company to experience greater economies of scale, however diseconomies of scale might also happen when a firm gets larger which is the rise in average cost as output is increasing, one reason is because workers might get demotivated in a large firms because of specialisation ,workers tend to focus on a task alone which leads to boredom and feeling insignificant, this ultimately reduced productivity.
There are very high barriers to entry into an oligopoly market structure, large firm like PMI is able to produce goods in a very minimum cost due to economies of scale, new firms have to incur a much higher cost to produce the goods and have to charge consumers a much higher price to earn profit and thus cannot compete with existing firms and are forced out of the market. PMI also has a huge and strong customers loyal to their products, ‘Marlboro’ which is the largest selling brand of cigarette in the world is made by PMI(Chart Bin ,2007) , the presence of such strong established brand acts as a powerful barrier of entry for new firms to enter the market as consumers are already used to the brand. Besides that, PMI can also set different pricing strategy to force out competitors. In late 2011, PMI uses predatory pricing by reducing ‘Marlboro’ price by 40% to a very low price of $0.79 per pack in Senegal(Global Post, 2011) to force out locally made cigarettes, although predatory pricing is an anti-competition illegal act but it is difficult to find evidences (Forbes, 2012)
Since 1964, evidence showed that tobacco smoking caused deadly health problem has led to a sharp decline in demand for tobacco cigarette. A documentary of smoking: ‘why people smoke and how harmful it is’ can be seen on the video above (KesikMax, 2012). In addition to all the regulation imposed by the government, PMI is also facing threats from non-government agency such as ban on smoking in restaurant and also ‘quit smoking campaigns’. While smoking is becoming less socially acceptable, it is undeniable that the quantities demanded for tobacco cigarettes have fallen. PMI has responded by introducing smokeless cigarette which claimed to be less health risk (Forbes, 2012). PMI also support charity by providing over 30million per year to charity (Philip Morris International, 2011). Besides that, PMI also award scholarships to deserving students (PR web, 2010), all these to maintain PMI company a positive image.
Over the years, tobacco cigarettes which is Philip Morris’s main product has been proved over and over again to bring devastating effect on the human body but many countries never impose a total ban on tobacco cigarette because that will cause a massive tax revenue loss and creating a huge black market. In many parts of the world, smoking advertisement is completely banned, however, according to the statistics released yearly, it proven that the advertisement banning causes minimum effect (TIME, 2013). One reason is because the cigarette manufacturers like PMI received free advertisement as individual received peer pressure to smoke. The tobacco industry has been established for centuries and although the governments have imposed numerous regulations on smoking, the tobacco industry is still going strong and unlikely to disappear anytime soon.
References
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http://www.forbes.com/sites/greatspeculations/2012/01/06/philip-morris-twin-strategies-keep-it-smokin-hot/ [Accessed 20 October 2013]
Global Post (2011) Senegal: Outrage over $0.79 packs of Marlboro cigarettes. Available from:
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http://www.pmi.com/marketpages/pages/market_en_id.aspx [Accessed 18 October 2013]
PR Web (2010) Philip Morris International Awards College Scholarships to 41 Students. Available from: http://www.prweb.com/releases/PMI/scholarships/prweb4371724.htm [Accessed 21 October 2013]
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