Price Anchoring of Smuggled Cigarettes
By Tadhg Looram
Consider the following hypothetical situation: you are a college student in New York City and smoke, on average, 2 to 3 packs of cigarettes a week. A pack of cigarettes costs $13.67 on average (the second most expensive market for cigarettes after London), so $164.04 of your already small monthly college student budget is allocated to cigarettes. Now, imagine that I see you smoking and offer to sell you the exact same brand you smoke, but for cheaper. The only catch is that the pack is from another state and is therefore smuggled. Assuming the alternative would cost you $13.67, how much would you be willing to pay for my cigarettes?
Classical economic theory has a straightforward answer to this question. In the Utopian world of classical economics; actors are perfectly rational and markets operate efficiently. We can accurately determine the worth (and therefore costs) of goods and services and how much happiness we derive from consuming them. Along with rationality, there is the assumption that there is perfect information–meaning, we know everything about the good/service in question. Following these assumptions we are therefore able to accurately consume the optimal amount of goods and services that would maximize our utility.
Now, let’s apply Classical economic theory to our discussion. Mr. Spock, the first officer of the Enterprise in Star Trek, is known for being perfectly rational. We will use him as our cold-calculating, rational smoker. Suppose Mr. Spock is faced with two options. The first is the default option of buying a tax-cleared pack of cigarettes, and the second is purchasing the smuggled pack of cigarettes that I am offering. He knows that Option 1 and Option 2 offer identical products and that the price difference is simply a result of different tax regimes. He is also aware that this exchange is illegal but that the probability of getting prosecuted is near zero, since there are no public records of individual consumers being prosecuted for purchasing a single smuggled pack of cigarettes in New York City. Lastly, since I am approaching him directly, his explicit cost (money spent on the subway) and implicit cost (time spent traveling to as supplier) of looking for a seller is $0 and therefore is not built into Mr. Spock’s reservation price (the maximum dollar amount he is willing to pay in order to purchase this good).
Given that he is willing to go with Option 2 and there is no asymmetric information, it is in Mr. Spock’s best interest to accept any price below that of Option 1, since it would yield a greater consumer surplus. In other words, perfectly rational, cold-calculating, Mr. Spock would most likely answer the question with “I will pay no more than $13.66”. To clarify, this study focuses on the maximum price consumers are willing to pay, rather than the actual price paid.
Are we as rational and good at maximizing our payoff as Mr. Spock is? I decided to investigate this by interviewing Pace University smokers. Alice, one person interviewed, was sitting on the front steps listening to music and smoking a Marlboro Light. She was asked the following question: “would you be willing to buy a pack of cigarettes that are from another state at a cheaper price?” She agreed. She was then asked, “hypothetically speaking, right now if I were to offer you a pack of Marlboro Lights from out of state, given that the alternative is a legal pack of cigarettes from New York City ($13.67), what is the most you would be willing to pay for it?” She thought for a minute and gave her answer. She was then asked a series of questions regarding the pack of cigarette she had on her (price, state of purchase, outlet etc.), her smoking habit (how many years she smoked, how many cigarettes she smokes a day etc.), and general demographic questions (age, ethnicity etc.).
The interview ended with an unusual request. She was asked for her permission to photograph the tax stamp located at the bottom of her cigarette pack. This was important in determining whether the pack she purchased was smuggled or not, since all legally sold packs of cigarettes have a tax stamp with the initials of its respective state. A pack was determined to be smuggled by cross-referencing the state in which the smoker bought their pack of cigarettes, the state on the tax stamp, and the price they paid for it. For instance, Alice bought her pack of cigarettes in Brooklyn for $8 but the tax stamp indicates that the pack was taxed in Virginia. It is evident, by the tax stamp, price paid, and location of purchase, that the pack was smuggled.
After interviewing 79 other smokers, the data was tabulated and examined. 38% of the sample had smuggled cigarettes, of which 42% came from Virginia, the state with the 2nd lowest unit cigarette tax ($0.30). A significant portion of the respondents was consuming smuggled cigarettes. But, unlike Mr. Spock, consumers may not have behaved rationally in setting their reservation prices.
Contrary to my expectations, the respondents in the study demanded high discount rates for smuggled cigarettes. More than half of the respondents would only purchase a pack of smuggled cigarettes if it was 32% to 86% cheaper than legally sold cigarettes. On average, the respondents would not pay more than $9.50 for smuggled cigarettes. When given the chance to maximize their wealth (by accepting any price less than what they would pay for otherwise), the respondents acted irrationally and refused. Instead, they seemed to have a fixed price in mind–$9.50.
Was the average reservation price of $9.50 arbitrary or intentional? It was unclear if there was an underlying reason behind the respondents’ irrational behavior. In order to answer this question, I investigated the likelihood that the respondents would have a smuggled pack of cigarettes relative to their reservation prices. If those who asked for high discounts for a smuggled pack of cigarettes were more likely to have a pack of cigarette on them, it would suggest that the observed low reservation prices were not arbitrary. A logit model was employed to show this relationship. A logit model measures the binary response by maximum likelihood; it models the probability of having a smuggled pack of cigarette with respect to reservation price as the main regressor, along with a vector of control variables. According to the law of supply and demand, as long as consumers’ reservation prices are above the market equilibrium, suppliers have an incentive to produce the quantity demanded. Conversely, if consumers demand a price that is lower than the market equilibrium, producers may not be willing nor able to produce the quantity demanded. For that reason I hypothesized that individuals with high reservation prices ($12.50, $13.50) would find a supplier and therefore, be more likely to have a smuggled pack of cigarettes. I hypothesized that individuals with low reservation prices ($2.50, $4.50, $9.50) for smuggled cigarettes would not find a seller at those price points, and therefore, would be less likely to have a smuggled pack of cigarettes. The results showed that, on average, individuals who would pay no more than $9.50 for smuggled cigarettes were 37% more likely to have purchased a smuggled pack of cigarettes than those who demanded other discounts. Furthermore, 35% of observed smuggled cigarettes came from participants with a $9.50 reservation price, while the average price paid for a smuggled pack of cigarette was $7.30. These results rejected the initial hypotheses. Not only were respondents with a reservation price of $9.50 able to find sellers, but they were more likely to have purchased smuggled cigarettes than respondents with higher reservation prices. The circumstantial evidence suggests that the irrational reservation price of $9.50 was not arbitrary. There was some reasoning behind it.
Why were the majority of respondents unwilling to buy smuggled cigarettes if the price exceeded $9.50? Reality-based economics, more popularly known as behavioral economics, may have an answer. There are many instances when we make decisions based on an irrelevant initial piece of information, this is known as “anchoring.” According to Pompian, the author of “Behavioral Finance and Wealth Management,” anchors are psychological frames we build around an initial piece of information. These anchors influence the way we perceive the actual outcome. For instance, a study conducted at Duke University set up an auction and asked respondents to bid. Before the experiment began they were asked to write down the last digits of their social security number. The study found that individuals who had higher social security numbers tended bid higher. The study concluded that the participants did so because they anchored their decision to the first number they saw (their social security number). This tendency to anchor to information is, in part, due to our inability to accurately determine the value of something on its own. Psychologists refer to this need for comparison as “relativity.” According to Dan Ariely, a well-known behavioral economist and professor at Duke University, we are like an airline pilot at night that needs runway lights on either side of us, helping us touch down our wheels. The majority of the time these runway lights guide us, but occasionally we follow the lights.
This behavioral quirk may be at play in the case of our smuggled cigarettes. Unlike Mr. Spock, the participants did not determine their reservation prices relative to the cost of cigarettes in New York City. Instead, respondents anchored their reservation prices to the cost of purchasing the pack in the state it came from. 48% of the observed smuggled packs of cigarettes came from Virginia where a pack costs, on average, $4.98. I believe the respondents were aware of cigarette prices in Virginia and determined their reservation prices for smuggled cigarettes accordingly. This suggests that the respondents price elasticity of demand is more dependent on Virginian prices than New York prices. In other words, consumers in New York's black market for cigarettes are more sensitive to price changes in Virginia than in New York.
Relativity is necessary for determining a market price for smuggled cigarettes, but why were participants anchored to Virginian prices as opposed to New York prices? Why did they fail to see that they would still gain in consumer surplus by accepting any price below that of the New York price? I believe that the participants rationality was overwhelmed by their sense of fairness. Given that there is perfect information of prices in both markets, and tax-evaded cigarettes are identical to legally sold ones in New York, the participants demanded similar prices to Virginians. In other words, they felt cheated if they had to pay higher prices for identical goods. Several behavioral studies show that we give up a significant amount of wealth for fairness. An article published by the Ronark Times alludes to this by stating that, “a $4.00 or $5.00 pack of cigarettes in Virginia can fetch up to $12.00 to $15.00 in New York City, although most sell for $8.00 to $9.00 because savvy shoppers expect a discount for cigarettes with a Virginia tax stamp.” I personally, would feel cheated if someone sold me a pack of cigarettes from Virginia for $12.00 even though I would still be saving $1.75. The importance of fairness conflicts with the traditional economic rationale that we are constantly trying to maximize our wealth. Mr. Spock, who lives in New York, would not demand Virginian prices simply because it’s fair, nor would he be upset about the $7.00 profit his dealer is making by selling him smuggled cigarettes for $12.50. Instead, he realizes that accepting any price less than a legal pack of cigarettes would yield additional consumer surplus and is, therefore, acceptable.
Understanding that consumers anchored their reservation prices to cigarette prices in Virginia because of emotional reasons may help curb cigarette smuggling. This suggests that simply raising cigarette taxes in New York is insufficient and that prices in Virginia need to rise. New York, Virginia, and bordering states should collaborate to eliminate this black market by exercising uniform cigarette taxes. Since the importance of the tobacco industry varies across the United States, states with low cigarette taxes may be opposed to this. The Coase theorem may be utilized to eliminate this negative externality. The theorem suggests that as long as property rights are defined, private bargaining would generate efficient outcomes and eliminate the negative externality. Since state borders are legally defined, it could be in the best interest of states with high taxes to provide monetary compensation to states with low taxed states in exchange for increases in taxes. For instance, in the short run, New York could subsidize tobacco farmers through the Virginia government and request a proportional tax increase. By doing so, Virginia's economy is monetarily compensated for the tax increases and the prices of smuggled cigarettes in New York would rise, thus reducing demand. This study suggests that cigarette-tax inconsistencies across the U.S. may distort consumer behavior. However, further research needs to be conducted to conclude that this irrational behavior occurs throughout the United States.
The main takeaway from this study is that we are not always the rational utility-maximizing machines that we believe ourselves to be. We are susceptible to influences from our irrational behaviors, and the decisions we make are contingent to our emotions. The silver lining is that irrational decisions can have favorable outcomes. Low reservation prices for smuggled cigarettes are irrational, but they result in lower prices. So next time you walk into your local bodega, instead of paying the usual $9.50 for a pack of Marlboro Lights from Virginia, tell your vendor that he is a crook for charging more than $4.98. Walk out with a fully taxed pack of Tic Tacs, feeling good about paying the same price as your friend in Virginia!
Contact Tadhg Looram
Tadhg Looram is a graduating economics major at Pace University. He has a keen interest in behavioral economics and what makes people tick. He plans on going to graduate school to pursue this field of study. During his time at Pace, he presented an undergraduate research paper at the Eastern Economic Association, presented his capstone project at the Federal Reserve Bank of Dallas, tutored economics and was a volunteer teaching assistant.