Abstract
Government regulations designed to promote social welfare can have unintended consequences on efficiency. According to the LeChatelier Principle, regulations that effectively limit substitution possibilities among inputs will reduce firm and industry-wide efficiency. In imperfectly competitive markets, however, government constraints on a strategic variable can facilitate coordination. An advertising restriction, for example, would improve efficiency if it enables firms to produce the same level of sales with less advertising spending. We use data envelopment analysis to estimate the effect of marketing regulations on efficiency in the U.S. cigarette industry. Unlike previous studies, we do not assume that marketing and production technologies are separable. Our results demonstrate that coordination effects dominate LeChatelier effects. Cigarette producers have benefited from advertising restrictions, a result consistent with the capture theory of regulation.
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Notes
Cigarette smoking is the leading cause of mortality in the U.S., resulting in about 400,000 deaths annually, and imposes an annual social cost of $104 billion (Sloan et al. 2006).
In response to lawsuits designed to recover states’ tobacco-related health care costs, the cigarette industry agreed to the National Tobacco Settlement. Four other states (Florida, Minnesota, Mississippi, and Texas) previously settled their lawsuits against the cigarette industry. As well as marketing restrictions, the Settlement included cash payments to states, funds that could be used to pay for these health-care expenses and to develop smoking-prevention programs. The settlement required the industry to pay $2.4 billion annually from December 1998 through 2003) and an additional $183.177 billion over a 25 year period, beginning in 2000. In 2000 and 2001 the payment was $4.5 billion annually, and it was $6.5 billion in 2002. The industry is also required to contribute $325 million annually to the National Foundation and National Public Education Fund, 1999 through 2003. The Settlement requires that the payments be inflation adjusted, based on 3% or the Consumer Price Index, whichever is greater. Consequently, after adjusting for the inflation, the payments are calculated as $2.4 billion (1998), $2.8 billion (1999), $7.6 billion (2000), $8.6 billion (2001) and $11 billion (2002). For further discussion of the Settlement, see the Appendix, Nader (1998), Shapiro (1998), Teinowitz (1998), Wilson (1999), Center for Disease Control and Prevention (2002), The U.S. Federal Trade Commission (2002), and Sloan and Trogdon (2004).
Of course, if advertising is constructive (i.e., it benefits both the firm and its rival), then firms will advertise less than is jointly profit maximizing and an advertising restriction might lower the marketing efficiency of both firms, ceteris paribus. The effect of an advertising restriction is even more complex when firms compete in both price and advertising. See Stivers and Tremblay (2005), Tremblay and Tremblay (2005), and Iwasaki et al. (2008) for further discussion of the price effect of advertising.
An important concern with these studies is that other factors may influence profit rates and stock returns over time. The ceteris paribus assumption is less likely to be a concern in our study, however, because we estimate the effect of a marketing restriction on efficiency. For example, if all firms are profit maximizers and all demand and cost shocks are anticipated, then only government regulations affect efficiency. Thus, a comparison of efficiency estimates over time is appropriate, since the ceteris paribus assumption would hold. Nonetheless, in Sect. 3 we relax the assumption that all demand and cost shocks are anticipated.
This is admittedly an indirect test of a prisoners’ dilemma in advertising. A direct test is very difficult to perform, however, because one must test the hypothesis that a firm’s profit increases when the firm increases advertising from the cartel level, assuming all other firms hold advertising at the cartel level. Because such outcomes are inconsistent with Nash and subgame perfect Nash equilibria, they are generally not observed.
The limited research on advertising by medium has focused on the issues of substitutability among media and scale economies of advertising. Bresnaham (1984) develops a method for estimating the demand for different advertising media. Silk et al. (2002) apply this method by estimating the market demand for media by national advertisers and find that there is weak substitutability and complementarity among media. On the other hand, Seldon et al. (2000) estimate a cost function for advertising in various media using a translog cost model. They find a high degree of substitutability among television, radio, and print advertising in the U.S. brewing industry. If input substitutability is high in the U.S. cigarette industry, then the Broadcast Advertising Ban would not be excessively costly to producers, because they could mitigate the effect of the Ban by reallocating expenditures from broadcast to unrestricted media.
For a more detailed discussion of activity analysis and DEA, see Färe and Grosskopf (2004).
If this is strictly equal, then it imposes the weak disposability of inputs and output and, in this case, output can be increased only when all feasible inputs increase proportionally.
We do not discuss this issue in subsequent sections of the paper, because the focus of our study is on allocative, technical, and overall cost inefficiency. In any case, our mean estimate of scale efficiency (SE) is about 0.02, implying that the industry has operated at close to constant returns to scale during our sample period.
One potential concern with using time series data is technological change (Lynde and Richmond 1999). If technological change were important, our inefficiency scores would decline over time, but our estimates reveal no such trend.
Promotional activity also includes the sponsorship of local public events and the distribution of free samples.
This can occur, for example, if broadcast advertising is highly combative compared to print advertising. From the industry perspective, firms will over-invest in broadcast advertising if it generates negative externalities on rival firms (i.e., it is combative) and will under-invest in print advertising if it generates positive externalities (i.e., it is constructive). This is consistent with Gallet (1999), who found that cigarette advertising became less combative after the Ban.
Because allocative efficiency scores are unbounded, we use a naïve bootstrapping method to generate standard errors. This involves constructing one thousand bootstrapped samples of the efficiency scores, each of which is obtained by random sampling with replacement from the original data set. Then, we calculate standard deviations from the one thousand bootstrapped samples. Because technical and overall cost efficiency are bounded by 1, we use a bootstrap method proposed by Simar and Wilson (1998). We used a method developed by Sheather and Jones (1991) to obtain the efficient bandwidth by regime.
The marketing allocative-inefficiency score is measured as the sum of the absolute values of the weighted allocative-inefficiency scores for broadcast, print, and other advertising. Weights are media share of total cost. The production allocative-inefficiency score is calculated as the sum of the absolute values of the weighted allocative-efficiency scores for labor, materials, and capital. Weights are the input shares of total cost.
For the interested reader, ANOVA tests for differences in mean allocative-inefficiency scores reject the hypothesis that the means are the same in all four regimes at the 1% level of significance for marketing, production, and both marketing and production. ANOVA tests also confirm that the Ban (regimes 1 and 2) led to a significant decrease in all allocative inefficiency categories. Comparing regimes 3 and 4, the Settlement also led to a decrease in allocative inefficiency, but the difference in means in production is insignificant. These tests are suspect, however, because an ANOVA test is valid only for random variables that are normally distributed.
Estimates of overall inefficiency after the Settlement should be interpreted with caution, however, because the Settlement required financial payments to state governments as well as tighter marketing restrictions. Financial stress caused by these payments may have induced belt tightening and may partially explain the lower inefficiency scores after the Settlement.
After reviewing the literature, Färe, Grosskopf, and Lovell (1985) identify nine different causes of inefficiency in production. The only other possibility that readers might be concerned with is market power that can lead to X-inefficiency (Leibenstein 1966). This is unlikely to be important in the cigarette industry, however, because industry concentration has remained stable over the sample period.
For ease of interpretation, we continue to focus our discussion on inefficiency rather than efficiency scores. To illustrate, overall cost efficiency scores (CE) range from 0 to 1, with a value of 1 meaning that there is no inefficiency. In this case, overall cost inefficiency is defined 1 − CE, with a value of 0 meaning that there is no inefficiency.
We also estimate models with a variable to control for changes in clean indoor air regulations, but the main empirical results remain the same.
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Acknowledgements
We wish to thank Rolf Färe, Shawna Grosskopf, James F. Ragan Jr., Barry Seldon, Robin Sickles, Carol Tremblay, Dennis Weisman and two anonymous referees for their helpful comments on an earlier version of the paper.
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Appendix
Appendix
The data include 40 annual observations from 1963 through 2002. Table 4 lists variable definitions and data sources, and Table 5 provides summary statistics. For each year, data are available for broadcast advertising, print advertising, and advertising in all other media. Broadcast advertising includes expenditures on television and radio. Print includes advertising expenditures on newspapers and magazines. The “all other”category includes expenditures on outdoor advertising, transit advertising, direct mail advertising, commercial endorsements, testimonials by celebrities, advertisements posted at retail locations, and advertising on any medium of electronic communication. It also includes promotional expenses such as promotional allowances, public entertainment, coupons, free samples, specialty items, and price promotions. The quantity of an advertising message by media is obtained by dividing advertising expenditures by the price of advertising for the appropriate medium. That is, the quantity of print advertising is defined as the expenditures on print advertising divided by the price of print advertising. The price is defined as the average cost of reaching an audience of one thousand, the cost-per-thousand (CPM) for each medium. These price data are obtained from Robert J. Coen, a marketing executive at Universal McCann, New York Office.
Regarding production, data are available for the number of all employees, payroll of all employees, the cost of materials, and the value of depreciable assets. Because stemmed tobacco leaf is the major material expense, we approximate the price of materials by the producer price index of leaf tobacco. This index is only available from 1985 to 2002, and we use the producer price index of farm products in earlier years. The price of capital is approximated by the producer price index of capital equipment.
The price of cigarettes is the producer price (i.e., the market price minus state and federal taxes per unit). Following Spence (1980), we define the quality adjusted quantity of cigarettes as the real dollar value of total sales, as quality improvements increase cigarette prices. In differentiated goods markets, this implies that profit maximizing firms will minimize the cost of reaching a given level of sales. To avoid biasing our inefficiency estimates, total cost includes all production and marketing expenses but does not include National Tobacco Settlement expenses.
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Iwasaki, N., Tremblay, V.J. The effect of marketing regulations on efficiency: LeChatelier versus coordination effects. J Prod Anal 32, 41–54 (2009). https://doi.org/10.1007/s11123-009-0134-x
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DOI: https://doi.org/10.1007/s11123-009-0134-x
Keywords
- Efficiency
- Advertising regulations
- LeChatelier principle
- Coordination in advertising
- U.S. cigarette industry