Publications

The smuggling of cigarettes in Canada became a serious problem in the early 1990s and has remained so despite measures implemented to curb the problem.  In the early 1990s, smuggling was undertaken by ordinary consumers who would cross the border in their car to bring back through policed points of entry Canadian cigarettes exported by Canadian cigarette manufacturers.  This kind of smuggling technology is called “Mom and Pop” smuggling and it was used by Canadian cigarette manufacturers to implement a second-degree price discrimination scheme with consumers with high willingness to  pay choosing to buy legal cigarettes and consumers with lower willingness to pay electing to buy illegal ones.  This smuggling technology requires cigarettes manufacturers to have distribution systems in Canada and in the United States.  Smuggling got so ubiquitous in 1994 that taxes were decreased significantly, labels “not for sale in Canada” were printed on exported cigarettes packages and enforcement was tightened.  Increased border enforcement made it more risky to smuggle cigarettes through policed entry points.  This led to a technological switch as “Mom and Pop” smuggling gave way to “Mob” smuggling.  Cigarette manufacturers had to negotiate with the mob which relied on speed boats to bring legally-exported Canadian cigarettes back into Canada. The two smuggling technologies just described have manufacturers engaging in export-to-smuggle.  Finally, when the government enforced an export tax on cigarettes, it put an end to the manufacturers' second degree price discrimination scheme, but it did not put an end to smuggling and counterfeiting.  The mob started using imported tobacco to manufacture their own brands of cigarettes that try to replicate established brands.  Smuggling remains pervasive, but well-meaning government interventions have induced changes in smuggling technologies from the rather benign Mom and Pop technology to the current situation in which the mob controls everything.  In hind sight, the effects of government interventions are regrettable.

Our paper builds a theoretical model in which consumers discount utility from illegal cigarettes in relation to legal ones.  This is achieved through a parameter that could be construed as a social conscience parameter.   Several results emerge.  First, once taxes are increased enough to trigger smuggling, a decrease of a similar magnitude will not be sufficient to completely eliminate smuggling.  We also show that a tax increase provoking as switch from a no-smuggling equilibrium to a smuggling equilibrium can raise the number smokers.  In contrast, a tax increase from a smuggling equilibrium reduces the number of smokers. Third, the price of legal cigarettes tend to increase more in response to a sales' tax when there is smuggling than when there is none.  Labels on packages accentuate the degree of differentiation and can have a positive or negative effects on the volume of illegal cigarettes.  Finally, we show that prices of legal and illegal cigarettes are less responsive to tax changes under a counterfitting regime than under an export-to-smuggle one.