Congress recently passed historic legislation that ended the 70-year-old tobacco program. Tobacco growers and agricultural groups largely supported the legislation as a way to adjust to the current realities of tobacco economies and to assist tobacco-growing regions.
But how did a program that was politically untouchable in North Carolina as recently as 20 years ago come to its demise? I’ll argue it’s a prime example of the ultimate triumph of economic forces over political control.
The tobacco program was developed in the Depression years of the 1930s as a way to help farmers who were suffering from low prices. In fact, the tobacco program was just one of several similar programs developed for most major crops.
The idea behind the program was simple. Limit the production of tobacco, and the price will rise. It was expected growers could make more money selling less tobacco at a higher price than selling more tobacco at a lower price. The government controlled production by limiting who could grow tobacco (only those holding a government provided “allotment”) and capping total production (called the “quota”) each year.
In economics lingo, the tobacco program effectively established a collusive oligopoly. In such a market structure, a limited number of firms agree to production totals and a price target. Member firms do not compete on price. Collectively, the member firms expect higher profits than if they openly competed.
Collusive oligopolies are illegal in the United States (although not worldwide — OPEC is an example of a collusive oligopoly) unless they are specifically sanctioned by the federal government. The federal government approved the tobacco collusive oligopoly and the government actively participated in the oligopoly by establishing the production limits and grower shares of total production.
For decades, the program worked well for growers. Tobacco became a very profitable crop, and tobacco revenues pumped billions of dollars into the North Carolina economy. If the program missed its price target, excess tobacco would be taken “off the market” by a grower-financed agency in order to move the market price to the target price. Curiously, because the program kept tobacco prices higher than they would have been without the program, it actually curtailed smoking to some degree by boosting the cost of cigarettes.
Then what brought the tobacco program down? It’s the same thing that can bring down any collusive oligopoly — competition. For a collusive oligopoly to maintain its high price and high profits, it must regulate all major firms in the industry. But it’s precisely the high price and high profits that motivate outside entrepreneurs to enter the industry and compete with the oligopoly.
For U.S. tobacco growers, the new competition came from foreign countries such as Brazil and Zimbabwe. In recent years these countries developed tobacco crops of comparable quality and sold them at rates under the U.S. prices. And not only did these foreign producers take away foreign sales from U.S. growers, but they also entered the U.S. market. By 2000, foreign-grown tobacco made up half of U.S.-manufactured cigarettes.
The U.S. tobacco oligopoly also had to contend with the reduction in cigarette consumption. Smoking declined from 43 percent of U.S. adults in 1966 to 23 percent in 2002.
Because of these forces, the federal government continually reduced the production of U.S.-grown tobacco. In just the last seven years the production of flue-cured tobacco was cut in half. Revenues from growing tobacco in North Carolina were likewise cut by almost half over the same time period.
So tobacco growers saw the writing on the wall. Future cuts in production and revenues were expected. They wanted the program to end as long as they could receive some compensation for dismantling their collusive oligopoly. The negotiations over the past couple of years were about the value of this oligopoly.
The result was the tobacco buyout. Beginning in 2005, the tobacco program will be eliminated and there will be no federal restrictions on growing tobacco. In return, current tobacco allotment holders in North Carolina are expected to receive $3.8 billion over 10 years, with cigarette companies providing the funds.
Collusive oligopolies inherently have the seeds of their own destruction. Economics — here the motivation of competitors to challenge the oligopoly — usually will win. Sometimes collusive oligopolies will collapse from within when members “cheat” on their production allocations. This has been a longstanding problem in OPEC.
Experts think the tobacco buyout may cut the number of tobacco farmers in North Carolina by 75 percent. Ironically, however, because the remaining tobacco farms will be larger and more efficient, the amount of tobacco grown in North Carolina may actually increase and cigarette prices may fall.