1. Impact of a Menthol Cigarette Ban: Economic Effects and Unintended Consequences November 15, 2010 1

2. L IKELY O UTCOMES FROM A MENTHOL BAN No Significant Reduction in Aggregate Smoking Development of a Sizeable Black Market for Menthol Cigarettes Harmful Unintended Consequences o Increase in Organized Crime Activity o Increase in Youth Access to Cigarettes 2

3. N O S IGNIFICANT R EDUCTION IN A GGREGATE S MOKING Overall cigarette demand is highly inelastic. Inelastic demand indicates that even if the menthol ban raised the cost of all cigarettes, the decline in overall consumption would be low. However, the menthol ban directly would affect the price of menthol cigarettes only, as the legal sale of non-menthol cigarettes would not be restricted. These facts indicate that a majority of menthol cigarette smokers would either switch to non-menthol brands or purchase contraband menthol cigarettes in response to a ban. 3

4. D EVELOPMENT OF A SIZEABLE BLACK MARKET We estimate a low elasticity of demand for menthol cigarettes, which implies that many menthol smokers have strong preferences for menthol cigarettes. Hence, many menthol smokers likely would purchase menthol cigarettes in the black market, even if the price of these cigarettes would be high. Our study of previous black markets in cigarettes indicates that the elasticity of substitution between legal and illicit cigarettes is high. Namely, as the relative price of cigarettes sold through legal channels increase, contraband cigarette sales expand greatly. Given a high demand for menthol cigarettes and a robust supply of illicit menthol cigarettes that likely would be available after a ban, the volume of transactions that would occur in a black market likely would be large. 4

5. D EVELOPMENT OF A SIZEABLE BLACK MARKET The eventual size of the black market is difficult to predict, as it depends greatly on a number of uncertain factors, including: o The level of enforcement efforts, and the ultimate availability of supply o The reluctance consumers must overcome to purchase on the black market o The overall demand structure for menthol and non-menthol cigarettes Nevertheless, we benchmark the post-ban size of the black market using parameter estimates that emerge from our preliminary economic analysis. In our paper, we evaluate a broad range of parameter estimates, as the data upon which we rely are limited, and thus much uncertainty exists for each parameter estimate. On the following slide, one estimate of black-market sales is developed (from what we find to be reasonable empirical approximations of these underlying parameters). We stress that this estimate represents only a rough approximation of the black market, given the limitations of currently available information. 5

6. 6 DEVELOPMENT OF A SIZEABLE BLACK MARKET Given a menthol own-price elasticity of -1.4; a cross price elasticity between non-menthol cigarettes and the price of menthol ones of 1.1; and an increase in the “full price” of menthol cigarettes of 25%, we find that the size of the post-ban black market would be: o Approximately 70% of the current menthol cigarette volume o Over 85% of the current menthol cigarette sales revenue o Black market would be larger if the “full price” of menthol cigarettes increased by less than 25% over current prices Substantial federal, state and local governments taxes would be lost from this shift towards black market sales from current legal channels.

7. U NINTENDED CONSEQUENCES Increases in Organized Crime o Given the size of the potential black market for cigarettes, the financial incentives to enter this market would be high. o Higher enforcement efforts, which likely would be needed for the ban to have an effect on aggregate smoking, could result in greater organized crime activity. Specifically, enforcement efforts could increase the rents organized crime earns from selling banned cigarettes (by reducing competition from “mom and pop” distributors), and thus increasing incentives to be a large supplier. Increases in Youth Access o Increases in the supply of cigarettes through non-regulated sources may lead to increases in youth access to all cigarettes. o Canadian black market experience suggests that youth access to cigarettes increased as a result of the growth in the black market for cigarettes. 7