BACKGROUND: The tobacco industry has often claimed that illicit trade is a consequence of tobacco taxes and that increases in tobacco taxes fuel such a trade. However, the literature has paid little attention to the prices of licit tobacco set by the licit tobacco industry. This can provide indirect information on how the industry perceives the market landscape and the competitive pressure that illicit trade may exert.
METHODS: We developed a theoretical model in which a monopolistic firm sets prices for two consumer segments: those purchasing "expensive" cigarettes and those opting for "cheap" ones. The firm maximises profits using second-degree price discrimination. Illicit cigarettes are perfect substitutes for legal "cheap" products, and the monopolist knows the Illicit trade penetration. The model assumes a positively sloped supply curve for illicit cigarettes (i.e., the marginal cost of illicit supply increases with quantity). An alternative model assumes a price-inelastic illicit supply (a fixed quantity at a demand-determined price). Both models were calibrated to replicate the Chilean cigarette market between 2018 and 2020.
RESULTS: Both models indicate that an increase in illicit supply leads to price reductions for both "expensive" and "cheap" cigarettes. Additionally, a disproportionate decrease in "cheap" cigarette smokers compared to "expensive" cigarette smokers drives price increases. Despite industry claims, the tobacco industry's pricing behaviour in Chile between 2018 and 2020 aligns with a reduction in illicit trade during those years.
CONCLUSIONS: The tobacco industry's pricing strategies provide valuable insights into the significance the industry assigns to illicit trade within the market. The industry's profit-maximising behaviour through price increases is incompatible with claims of growing illicit trade. These results challenge the narrative that higher tobacco taxes drive illicit trade, particularly in contexts where the industry has implemented real price increases during the same period.