The Compensative Effects of Tobacco Leaf Price. Changes on Tax Revenue in China

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1 The Compenstive Effects of Tocco Lef Price Chnges on Tx Revenue in Chin Hilong Ci PhD Cndidte College of Economics & Mngement Chin Agriculturl University Henry W. Kinnucn Professor Deprtment of Agriculturl Economics & Rurl Sociology Auurn University Selected Pper prepred for presenttion t the Southern Agriculturl Economics Assocition Annul Meeting, Atlnt, Georgi, Jnury 31-Ferury 3, 2009 Copyright 2009 y Hilong Ci nd Henry W. Kinnucn. All rights reserved. Reders my mke vertim copies of this document for non-commercil purposes y ny mens, provided tht this copyright notice ppers on ll such copies

2 The Compenstive Effects of Tocco Lef Price Chnges on Tx Revenue in Chin Astrct: Tocco production in Chin is influenced y government-set procurement price for tocco lef, nd n excise tx on tocco lef revenue. This study exmines the increse in the procurement price needed to keep tx revenue constnt in the fce of 50% reduction in the tx rte. This compenstive effect is importnt ecuse reductions in the tx rte re contemplted nd tocco tx revenue is mjor source of funding for rurl communities. Bsed on n equilirium-displcement model of Chin s tocco sector, results suggest the Compensted Effect Elsticity (CEE) is etween 1.0 nd 2.5. This mens 50% cut in the tx rte would necessitte n increse in the procurement price of etween 50% nd 125%. Sensitivity nlysis indictes CEE is most sensitive to the retil demnd nd input sustitution elsticities nd lest sensitive to oligopoly power nd returns to scle. Key words: tocco lef, tx rte, procuring price, compenstive effects - 2 -

3 The Compenstive Effects of Tocco Lef Price Chnges on Tx Revenue in Chin Chin is the world s lrgest consumer of cigrettes. According to 2002 ntionl survey, out 36% of Chin s popultion ge 15 nd over re smokers, or pproximtely 350 million people (Yng 2004). Chin is lso the world s lrgest producer of tocco lef. In 2000, Chin produced 2.24 million tones of tocco, or out one third of world production (Mcky nd Eriksen, 2002). The Chinese government plys n importnt role in tocco production through the Stte Tocco Monopoly Administrtion (STMA) nd the Chin Ntionl Tocco Compny (CNTC). STMA sets overll government policies on tocco, including the lloction of tocco lef production quots mong the provinces, nd production quots for cigrettes (Hu et l., 2007). One of STMA s key policy interventions is to set the procurement price of tocco lef in order to control tocco production. These prices re set ccording to the production loction nd qulity 1. CNTC is n orgniztion tht implements STMA s tocco production policy. By lw, CNTC is the only legitimte uyer of tocco lef. The procurement of tocco lef is one of the CNTC s monopolistic functions. Other gencies or individuls re not llowed to purchse tocco lef without the CNTC s pprovl. Cigrette production is n importnt source of revenue for the centrl government, ccounting for some 10% of totl receipts. At the provincil level locl governments rely on tocco txes to fund services, especilly in the mjor tocco-growing regions of Yunnn, Guizhou, Henn nd Sichun. Prior to 1999 the tx on tocco lef ws 31% compred to n 8% tx on other frm products. In 1999, the tocco lef tx rte ws reduced to 20%. To mke up 1 Every yer, the STMA nnounces list of 200 prices, covering five production regions nd four grding ctegories; ech qulity ctegory includes more thn ten detiled purchse prices

4 for lost tx revenue, STMA t the sme time incresed the procurement price. In 2006, the centrl government cncelled ll griculture txes except on tocco. Some rgue the government should cncel the tocco lef tx ecuse it is unfir for the frmers who grow tocco. So the Chinese government fces dilemm: if they keep the tx they nger rurl constituents; if they kill the tx they lose n importnt source of revenue. In this study we nlyze compromise solution: nmely, simultneous lowering of the tx rte nd increse in the procurement price to keep tx revenue constnt. The question of how much the procurement price needs to e incresed to offset the loss in tx revenue ssocited with reduction in the tx rte hs not een ddressed in the scholrly literture. The purpose of this reserch is to determine the reltive effects of n incrementl chnge in the procurement price nd the tx rte on tx revenue. A secondry ojective is to determine the mrginl effects of these vriles on cigrette consumption, production, price, nd frm revenue. The reserch ojectives re ccomplished y specifying n equilirium-displcement model (EDM) of Chin s tocco sector. The EDM used in this pper originlly ws developed y Muth (1965) nd y Grdner (1975). Since then studies hve generlized Muth s nd Grdner s sic models to include imperfect competition (Hollowy (1991), Azzm (1998), McCorriston et l. (1998), Kinnucn (2003)) nd non-constnt returns to scle (McCorriston (2001); Weldegereil (2004)). The model used in this study is similr to Kinnucn s (2004) in tht it includes imperfect competition in oth the output mrket for the finished good nd n input mrket for rw mteril. It differs from Kinnucn s model, however, in tht it relxes the ssumption of constnt returns to scle. To our knowledge, this is the first ppliction of Muth-type model tht includes oth oligopoly nd oligopsony power nd non-constnt returns to scle

5 Model The conceptul frmework consists of verticlly linked mrkets for tocco lef t the frm level nd mnufctured cigrettes t the retil level. At frm level, frmers produce tocco lef to sell to locl legl gencies nd these gencies purchse tocco lef t price set y the government. Government imposes tx sed on the procurement price. The mnufcturing firms use tocco lef nd other inputs to produce cigrettes nd sle them in retil mrket. Specifiction Consider the mnufcturing industry tht comines tocco lef with undle of mrketing inputs to produce cigrettes x. The industry s production function is given y: x = f (, ) (1) Consumer demnd for cigrettes is seprle from other goods such tht sustitution effects cn e ignored. The retil demnd function for x is given y: x = D( P x ) (2) where P x is the retil price of cigrettes. The mnufcturing firms exercise oligopoly power in the x mrket nd oligopsony power in the mrket. The first-order conditions for mximum profit of mnufcturing firms with respect to nd re 2 : P ( 1 Ω) = P f (1 + Ψ) (3) + x P P f ( 1+ Ψ) (4) = x 2 Here re the optimlity conditions t industril level. Actully we cn get the optimlity conditions t firm level θi ξi ξ directly: P (1 i (1 + ) = Px fi(1 + ), P = Px fi + ). Following Htu Tdesse Weldegeriel ε η η (2004), in the mnner of Bhuyn nd Lopez (1997), the optimlity conditions t firm level cn e weighted y the firm s mrket shre. Summing over ll firms, their ggregte nlogues cn e otined s Eq (3) & (4)

6 where f nd f re the mrginl products of nd nd P nd P re the prices of nd. The prmeter Ψ = ξ / η is Lerner index tht denotes oligopoly power where η is the retil demnd elsticity nd ξ [ 0, 1] is the output conjecturl elsticity ( ξ = 0 for perfect competition nd ξ = 1 for pure monopoly). The prmeter Ω = θ / ε is Lerner index tht denotes oligopsony power where ε is the supply elsticity for, nd [ 0,1] θ is the input conjecturl elsticity ( θ = 0 for perfect competition nd θ = 1 for pure monopsony). The input supply functions for nd re: P = P T (5) s + P = h() (6) where P s is the procurement price of tocco lef set y the government. The supply eqution for the input is specified in inverse form to fcilitte derivtion of the reduced form to e presented lter. The vrile T is n endogenous vrile which represents per unit tx imposed y government on tocco lef nd decides y: T = tp s (7) where t is the tocco lef tx rte. The equtions of tx revenue nd frmers revenue re given y: TR = T (8) FR = P (9) s The system contins nine equtions in nine endogenous vriles ( P, P, P, x,,, T, TR FR ) nd two exogenous ( P s, t ) s well s four prmeters ( x, ξ θ, η,, ε ). Becuse procurement price Ps is n exogenous vrile, which indicte ε is infinite, Ω = θ /ε will equl zero lthough the mnufcturing firms hve oligopsony power - 6 -

7 ( θ 0 ). Following Grdner (1975), we totlly differentite the system of equtions (1) to (9) nd express them in percentge chnges s follows: x = α + β (1 ) x = η Px (2 ) P 1+ μ = P 1+ δ x 1 1+ σ ( ρ 1) + [( ρ 1) β ] 1+ δ σρ 1+ σ ( ρ 1) + β (1 + δ ) σρ (3 ) P = 1+ σ ( ρ 1) σρ 1+ σ ( ρ 1) σρ ( 1+ μ) Px + α + [( ρ 1) α] (4 ) P = T ( 1 τ ) Ps + τ (5 ) P 1 = ε (6 ) T = P + t s (7 ) TR = T + (8 ) FR = P + s (9 ) where the sterisked vriles indicte reltive chnge (e.g. x = dx / x ); θ ξ α = S (1 + ) /(1 + ) is the fctor s cost shre inclusive of oligopsony nd oligopoly rent, ε η herefter referred to s the vlue shre term 3 ; β S /(1 + ) the fctor s vlue shre; = ξ η α nd β re lso the output elsticity with α + β = ρ, where ρ is the (short-run) returns to scle mesure with greter thn (equl to, less thn) unity representing incresing (constnt, 3 The term vlue shre is suggested y Wterson (1980) nd used in Kinnucn s (2003) pper

8 decresing) returns to scle 4 ; σ is the Hicks-Allen fctor sustitution elsticity; τ = T / P is the tocco lef tx expressed s frction of the initil equilirium uyer s price 5 ; ε is the supply elsticity for mrketing services. Prmeter μ = ϖξ /( η + ξ ) represents the chnges in the mrk-up following chnges in the retil price cused y the exogenous shock, where ϖ = lnη / ln P x represents the chnges in the elsticity of demnd for given chnge in the retil price. Prmeter δ = λθ /( ε + θ ) represents the chnges in the mrk-down following chnges in the frm input price cused y the exogenous shock, where λ = lnε / ln P represents the chnges in the elsticity of supply for given chnge in the frm input price. In this study, ll prmeters re ssumed to e positive except demnd elsticity. Retil demnd is downwrd sloping ( η < 0 ); cigrette industry technology exhiits vrile proportions ( σ > 0 ). Importntly, the frm-shre term S = P P x is evluted t the initil / x equilirium point, s is τ in Eq. (5 ). As in Sumner s (1985) nd Kinnucn s (2003) pper, the pproch of Muth is used in solving the system of the eqution (1) to (9) for proportionl chnges in endogenous vriles in response to exogenous chnges in tocco lef tx rte nd procuring price. In other words, ll the endogenous vriles cn e expressed s function of the tocco lef tx rte nd the procurement price. Compenstive effect The question to e investigted is to determine the compenstive effects of the tocco lef price when the tx rte decreses. So, we sustitute (7 ) into (8 ) nd let TR = 0 nd we get: k k 4 If ρ =1(constnt return to scle), α + β = 1. This result is sme s Kinnucn s + =1(see Kinnucn,2003, Appendix A for proof) 5 t = T / P s is the tocco lef tx expressed s frction of the initil procurement price. The reltionship etween t nd τ is τ = t /( 1+ t) - 8 -

9 TR = Ps + t + = 0 (10) P s nd t re exogenous vriles which re controlled y government. In order to keep tx revenue constnt ( TR = 0 ), the key point is how chnges in response to the tocco lef price nd the tx rte, which ctully depends on demnd elsticity of tocco lef. For this purpose, next section we will derive the demnd curve for tocco lef. The proportionl chnge in the totl derived demnd for tocco lef is otined y dropping Eq (5 ) nd (7 ) 6 nd solving the remining equtions simultneously for to yield: = E P p (11) where E η(1 + δ )[( ρ 1) σε β ε α σρ] + (1 + μ)(1 + δ ) σρε β = p η[( ρ 1) ρε β + σ ( ρ 1) α ] (1 + μ) ρ( ρε + σα) is the derived demnd elsticity for tocco lef. According to Eq. (10), to determine the compenstive effect, we need to know how simultneous chnge in the tx rte nd the procurement price will ffect demnd for when the demnd price effect re tken into ccount. For this purpose, we sustitute Eq. (5 ) nd Eq. (7 ) into Eq. (11) to otin the reduced-form eqution for tocco lef quntity: = E (12) Ps + τe t p p Eq. (12) indictes the net effects of the chnges in the exogenous vriles on the equilirium quntity of the tocco lef. P s s coefficient in Eq. (12) equls to derived demnd elsticity nd t s coefficient is proportionl to the derived demnd elsticity. These coefficients, which re properly interpreted s reduced-form elsticity, re importnt to determine the compenstive effect. 6 We wnt to tret tocco lef price nd tx s temporrily exogenous

10 Using the proportionl chnges in the demnd quntity for tocco lef resulting from the exogenous chnges in the tx rte nd procurement price, the proportionl chnge in the tx revenue is found with Eq. (13): TR = ( 1+ E ) Ps + (1 + τe ) t p p (13) Setting TR equl zero, Eq. (13) my e expressed lterntively s: t = 0, if E = 1 (13) p P s 1+ τe = 1+ E p p ( t ) = C p ( t ), if E 1 (13) p where C p 1+ τe = 1+ E p p is the scle prmeter of the compenstive effect. The solute vlue C p of the prmeter indictes how ig the compenstive effect is. The smller solute vlue of the scle prmeter mens tht the price hs igger compenstive effect on the tx revenue. When the derived demnd for tocco lef hs the unity elsticity ( E = p 1), in Eq.(13), the compenstive effect don t mke sense. Eq. (13) shows the compenstive effect which mens how much the price should chnge to keep the tx revenue neutrl if the tx rte chnges. The derived demnd elsticity E p plys n importnt role in Eq. (13). If the demnd for tocco lef is inelsticity ( 1 < p < E 0 ), the coefficient > 0, which mens the price should increse if the reltive chnge of tx rte decrese 1% 7. If the demnd for tocco lef is more elsticity ( E < 1), the coefficient < 0 8, which indictes the price should decrese p C p C p if the reltive chnge of tx rte decrese 1%. Effects on retil mrket t < 0 t > 0 7 Tx rte decrese indictes, while tx rte increse mens. C < 0 E 8 To get this result p, the ctully hve to stisfy the condition p prctice, E cn t e very ig, so here we just limit E 1 <. p p 1 < t E < p 1. However, in

11 Besides the compenstive effect, it is necessry to know the effects on the retil price nd quntity, ecuse Chin hs rtified the WHO Frmework Convention on Tocco Control (FCTC) nd promise to dopt effective tocco policies to reduce cigrette consumption. Solution of the system results in the eqution for proportionl chnges in retil price s follows: P x = E p p x s P s + τe p p x s t (14) where E px ps (1 + δ )( σ + ε ) αρ = η[( ρ 1) ρε β + σ ( ρ 1) α ] + (1 + μ)( ρε + σα) Following Grdner (1975), P s s coefficient cn e interpreted s the elsticity of price trnsmission under imperfect competition mrket if the price of kept t legislted y mens of production control. Here is the generl expression of the price trnsmission elsticity which considers the chnges of the mrket power nd returns to scle. When the ρ =1(constnt returns to scle) nd μ = δ = 0, this elsticity cn e simplified to Grdner s expression 9. In order for percentge mrketing mrgin to remin unchnged, E p x p s must equl one. Otherwise, production control progrm tht rises tocco lef supply price P s will chnge the mrketing mrgin. Sustituting Eq. (14) into Eq. (2 ), the percentge chnge in retil quntity in response to exogenous vriles is given y: x =η E P + ητe p p x s s p p x s t (15) t s coefficient in Eq. (15) is proportionl to the P s s. Under the given initil vlue τ = 0.17, this imply tht the reltive chnges of the procuring price hve igger effects on the E S ( σ + ε ) = ε + S σ S η 9 Grdner s expression under perfect competition is p x p. Here nd re the reltive shre of nd S S

12 equilirium quntity of the cigrettes thn the reltive chnges of the tx rte. For the tocco controlling, it indictes tht procuring price control is more effective thn the tx rte to reduce cigrette consumption. Simultion In this section we use the model together with the estimtes of the prmeter vlues to simulte quntittive effects of the chnges in the tocco lef procuring price nd tx rte. In 2006, the se yer for our nlysis, the totl tocco lef tx revenue is 4.1 illion yun nd frmer s revenue is 20.5 illion yun 10. Next, we will compute the compenstive effects under different scenrio; then, we simulte the effects of 50% decrese in tx rte (which mens tx rte reduced from 20% to 10%) nd corresponding increse in procurement price on endogenous vriles. Prmeteriztion The prmeter vlues used in the simultions re listed in Tle 1. Cigrette demnd elsticity estimtes from prior studies re used in the model. Estimtes of the retil price elsticity rnge from (Hu nd Mo, 2002) to (Bi nd Zhng, 2005). Hu nd Mo (2002) get the demnd elsticity for short run nd for long run using time series dt from ; Ci (working pper, 2008), using time series dt from , gets the demnd elsticity for long run; Bishop et l. (2007) get the vlue using cross section dt t county level; The lrgest estimte is otined y Bi nd Zhng (2005). Bsed on these estimtes we selected -0.5 for the seline vlue. Previous studies hve pid little ttention to mrket power in Chin s tocco industry. Ci use NEIO model nd time series dt from to estimte the output conjecturl elsticity 10 The dt of tx revenue come from we of Stte Administrtion of Txtion nd the vlue of frmers revenue computed using the formul in Tle

13 nd the results show tht the verge vlue of ξ is 0.28 (Ci, 2008). This estimte ws used for the seline nd sensitivity nlysis ws conducted over using the rnge 0.1 to 0.4. Becuse CNTC is the only legitimte uyer of tocco lef, CNTC hs monopsony power nd thus we set θ =1. Becuse the government controls the supply price of the tocco lef we set the frm supply elsticity toε =. The mrketing services supply elsticity ws set to ε = 2, vlue tht seem to e preferred y Grdner (1975) nd Kinnucn (2003). Becuse Wohlgennt (1985) rgues tht the sustitute elsticity should e less thn one, σ is set to etween zero nd 0.6. The frm cost shre prmeter is set to S = 0. 1 sed on dt from STMA. Results To estlish seline we setξ = to indicte oligopoly power, ρ = 1 to indicte constnt ε returns to scle nd = 2 to indicte mrketing services supply elsticity. Tle 2 gives the results of the compenstive effect clculted using eqution (13). According to eqution (13), the scle prmeter C p indictes the percentge increse in the procurement price required to keep tx revenue constnt when tx rte is reduced y 1%. For exmple, if η = 0.5 nd σ = 0. 2, = 1.29, which mens the procurement price must C p increse 1.29% per 1% reduction in the tx rte. Results in Tle 2 imply tht n increse in either the demnd elsticity or the sustitution elsticity will led to smller compenstive effect except under fixed proportions 11. For exmple, if σ = 0, which mens fixed proportion, the results re 1.16 when η = nd when η = 0. 84, 6.4% reduction. However, if σ = 0.2, the corresponding rnge is from to 1.318, 0.57% growth. For the vlue of 11 The igger vlue of the scle prmeter mens tht the price hs smller compenstive effect on tx revenue

14 σ = 0.4 nd σ = 0. 6 the increse rtes re 14% nd 41% respectively. Sensitivity nlysis To show the effects of returns to scle nd mrket power on the compenstive effect, we conducted sensitivity nlysis y setting η = 0. 5 nd ε = 2 nd vrying ρ,ξ, nd σ s indicted in Tle 3. Specificlly, we vried the sustitution elsticity σ etween 0 nd 0.6 nd the returns-to-scle prmeter ρ etween 0.8 nd 1.1. The conjecturl elsticityξ is vried etween 0.1 nd 0.4 to ssess mrket power. The retil demnd nd frm supply elsticities re not ffected y the exogenous shock nd thus we set μ = δ = 0. The results indicte tht n increse in σ or ξ wekens the compenstive effect, while n increse in ρ strengthens the compenstive effect. Turning to mrket power, σ is pivotl prmeter. In prticulr, if σ < η = 0. 5, which implies tht inputs nd re gross complements (see, e.g. Alston nd Scoie, 1983), the compenstive effects ecome smller s the conjecturl elsticities increse. For exmple, in scenrio 1, where ρ = 0.8, if σ = 0. 2 the scle prmeters rnge from when ξ = 0. 1 to when ξ = 0. 4, 24% increse. The procurement price would need to increse more to compenste for the reduction in tx revenue when the industry hs more oligopoly power. Conversely, if > η = 0. 5 σ, which mens tht inputs nd re gross sustitutes, the compenstive effects ecme igger when conjecturl elsticity increses. For exmple, in scenrio 1 where ρ = 0.8, if σ = 0. 6 the scle prmeters rnge from when ξ = 0. 1 to when ξ = 0. 4, 4.5% decrese. Although incresing returns enhnces the compenstive effect, it lso ccelertes the growth speed of the scle prmeters cused y incresing sustitute elsticities. For exmple, in the cse

15 of ξ = 0. 2, the scle prmeters rnge from to when ρ = 0. 8, 102% growth, while the results rnge from to when ρ =1. 1, 104% growth. Furthermore, the increse of returns to scle will reduce the growth speed of scle prmeters cused y incresing conjecturl elsticities. In prticulr, in the scenrio of σ = 0. 2, the results rnge from to when ρ = 0. 8, 23.6% growth, while the results rnge from to when ρ =1.1, 11.3% growth. Effects on the retil mrket To show the effects of the tocco lef tx rte nd procurement price chnges on the retil mrket, tx revenue nd frmers revenue, we set η = 0. 5, σ = 0. 2,ndξ = s seline vlues. We vry ρ etween 0.9 nd 1.1 to ssess the sensitivity of results to returns to scle. In the simultions, 50% tx cut (from 20% to 10%) is entertined, nd the procurement price is incresed y the mount necessry to keep tx revenue constnt. For exmple, when ρ = 0. 9, 50% tx cut would necessitte 65.7% increse in the procurement price to keep tx revenue constnt. Tle 4 gives the simultion results: In the cse of ρ = 0. 9, 50% decrese in tx rte will increse the equilirium quntity of the cigrettes y 0.9%, wheres 65.7% increse in procurement price will decrese the equilirium quntity of the cigrettes y 7.1%. The totl (or net) effect on equilirium quntity is 6.2% decrese. The effect of 50% decrese in tx rte on tx revenue is equivlent to 65.7% increse in the procurement price with opposite sign, which reflects the compenstive effect. Thus, tx revenue is unffected. The tx decrese increses equilirium tocco lef quntity 2.3% nd the procurement price increse reduces equilirium lef quntity 18.0% for net effect of -15.7%. However, ecuse the increse in the procurement price exceeds the

16 reduction in equilirium quntity, frm revenue increses y 50%. Model simultions, therefore, suggest 50% compensted reduction in the tx rte would increse frm revenue y n equivlent percentge. In 2006 tocco grower revenues ws 20.5 illion. The solute revenue gin, therefore, would e pproximtely illion. The simultion results lso indicte tht the increse of the returns to scle cn reduce the effects of the tx rte nd price on the retil mrket, ut it doesn t ffect the totl effect of the frmer s revenue. For exmple, the equilirium quntity of the cigrettes will reduce 5.8% under ρ = 1 nd 5.5% under ρ =1. 1, however the frmer s revenue doesn t chnge. Concluding Remrks The sic theme of this pper is tht the increse of the tocco lef s procurement price cn compenste the tx revenue reduction cused y the decrese of the tx rte. Building on this theme, we develop the model of oligopoly-oligopsony power nd vrying returns to scle in multi-stge production system tht includes fixed proportions technology s specil cse. Results indicte tht the derived demnd elsticity plys n importnt role in determining the compenstive effects. In prticulr, in the cse of constnt returns to scle the derived demnd elsticity for tocco lef minly depends on the vlues of the retil demnd elsticity nd the sustitution elsticity. Therefore, n increse of the vlues of oth retil demnd elsticity nd sustitution elsticity will led to the more elsticity in demnd for tocco lef nd therefore result in the smller compenstive effect. The sensitivity nlysis results show tht the increse of σ nd ξ will weken the compenstive effect,while increse of returns to scle cn enhnce the compenstive effect. The mrket power does influence the compenstive effect, however, the fctor sustitution elsticity

17 ply pivotl role. Specificlly, if < η = 0. 5 σ, which implies tht inputs nd re gross complements, the compenstive effects ecome smller when the conjecturl elsticities increse. Conversely, if σ > η = 0.5, which mens tht inputs nd re gross sustitutes, the compenstive effects ecme igger when the conjecturl elsticity increses. Under the ssumption tht tocco lef nd mrketing services re gross complements ( η > σ = 0. 2 ) nd the mrket power doesn t chnge ( ξ = ), the reduction of the tx revenue which results from 50% decrese in tx rte cn e compensted y 65.7% to 64% increse in tocco lef procuring price. In the cse of constnt returns to scle, the effects on equilirium quntity of the cigrettes nd the frmer s revenue re significnt. A 50% decrese in tx rte nd 64.7% increse in procuring price will led to 5.8% decline in the equilirium quntity of the cigrette nd 50% increse in the frmers revenue, which re consistent with WHO FCTC s principles. For the effects of returns to scle, the results suggest tht the increse of the returns to scle cn week the effects of the tx rte nd the procurement price on the retil mrket, ut it doesn t ffect the totl effect on frmer s revenue. According to economic theory, government controlling price will led to the inventory prolem. However, we ignore this issue for two resons. First, STMA is tocco monopoly gency nd hs the full informtion out cigrette production. So STMA cn set the quot to djust the tocco lef production. Secondly, the supply of tocco lef is inelsticity due to the difficulty of trnsferring to other crops, which implies price increse cnnot produce too much inventory. References Alston, J. M. nd Scoie, G. M. (1983). Distriution of Reserch Gins in Multistge Production Systems: Comment. Americn Journl of Agriculturl Economics. 65,

18 Azzm, A. (1998). Cptive Supplies, Mrket Conduct, nd the Open-Mrket Price. Americn Journl of Agriculturl Economics. 80, Bi, Y. nd Zhng, Z. (2005). Aggregte Cigrette Demnd nd Regionl Differences in Chin. Applied Economics. 37, Bhuyn, S. nd Lopez, R. A. (1997). Oligopoly Power in the Food nd Tocco Industries. Journl of Agriculturl Economics. 79, Bishop, J. A., Liu, H. nd Meng, Q. (2007). Are Chinese Smokers Sensitive to Price? Chin Economic Review. 18, Ci, H. (2008). Mrket Structure nd the Efficiency of Resources Alloction of the Tocco Industry in Chin. Working Pper, Deprtment of Economics & Mngement, Chin Agriculturl University. Grdner, B. L. (1975). The Frm-Retil Price Spred in Competitive Food Industry. Americn Journl of Agriculturl Economics. 57, Weldegeriel, H. T. (2004). Imperfect Price Trnsmission: Is Mrket Power Relly to Blme? Journl of Agriculturl Economics. 55, Hollowy, G. (1991). The Frm-Retil Price Spred in n Imperfectly Competitive Food Industry. Americn Journl of Agriculturl Economics. 73, Hu, T., Mo, Z., Jing, H., To, M. nd Yurekli, A. (2007). The role of government in tocco lef production in Chin: ntionl nd locl interventions. Interntionl Journl of Pulic Policy. 2, Hu, T. W. nd Mo, Z. (2002). Effects of Cigrette Tx on Cigrette Consumption nd the Chinese Economy. Tocco Control. 11, Kinnucn, H. W. (2003). Optiml Generic Advertising in n Imperfectly Competitive Food Industry with Vrile Proportions. Agriculturl Economics. 29, Mcky, J. nd Eriksen, M. (2002). The tocco Atls. Genev, WHO. McCorriston, S., Morgn, C. W. nd Ryner, A. J. (1998). Processing Technology, Mrket Structure nd Price Trnsmission. Journl of Agriculturl Economics. 49, McCorriston, S., Morgn, C. W. nd Ryner, A. J. (2001). Price Trnsmission: The Interction Between Mrket Power nd Returns to Scle. Europen Review of Agriculturl Economics. 28, Muth, R. F. (1964). The Derived Demnd Curve for Productive Fctor nd the Industry Supply Curve. Oxford Economic Ppers. 16, Sumner, D. A. nd Wohlgennt, M. K. (1985). Effects of n Increse in the Federl Excise Tx on Cigrettes. Americn Journl of Agriculturl Economics. 67, Wterson, M. (1980). Oligopoly nd Derived Demnd. Economics Letter. 5, Wohlgennt, M. K. (1989). Demnd for Frm Output in Complete System of Demnd Functions. Americn Journl of Agriculturl Economics. 71, Yng, G. (2004). The Epidemiologic Investigtion of the Smoking Behvior mong Chinese Popultion in Chinese Smoking nd Helth. 62,

19 Tle 1. Definition nd Vlues of Prmeters Symol Definition Vlue η Retil demnd elsticity (solute vlue) 0.35,0.5,0.84 σ Fctor sustitution elsticity 0,0.2,0.4,0.6 ε Tocco lef supply elsticity ε Mrketing services supply elsticity 2 ρ Returns to scle 0.8,0.9,1,1.1 ξ Output conjecturl elsticity 0.1,0.2,0.3,0.4 θ Input conjecturl elsticity 1 τ Tocco lef tx expressed s frction of the initil equilirium frm price ( = T t P = t 1 t P P x /, is tx rte.) S Frmers' cost-shre ( = / x ) 0.1 TR t FR Frmers' revenue ( = P s = ) 20.5 illion TR Tocco lef tx revenue 4.1 illion

20 Tle 2. Compenstive Effect for Alterntive Vlues of the Sustitution Elsticity nd Retil Demnd Elsticity Sustitution Elsticity (σ ) Demnd Elsticity (η ) Note: we ssume μ = δ = 0 in response to the exogenous chnges in tx rte nd procurement price p s. τ

21 Tle 3. Sensitivity of the Compenstive Effect to Conjecturl Elsticity, Sustitution Elsticity, nd Returns to Scle Returns-to-Scle Prmeter σ Conecturl Elsticities (ξ) ρ = ρ = ρ = ρ =

22 Tle 4. Simulted Effects of Simultneous 50% Decrese in the Tocco Lef Tx Rte nd 65.7% Increse in the Procurement Price on Cigrette Consumption, Cigrette Price, Tocco Lef Production, Tx Revenue, nd Frm Revenue Vriles P s ρ = 0.9 ρ = 1 ρ =1. 1 t P s t P s totl totl totl t x P x TR FR