Production Quota Buyouts

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Title:
Production Quota Buyouts A Theoretical and Empirical Examination
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Haynes, Dwayne J
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Doctorate ( Ph.D.)
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University of Florida
Degree Disciplines:
Food and Resource Economics
Committee Chair:
Schmitz, Andrew
Committee Members:
Moss, Charles Britt
Burkhardt, Robert Jeffrey
Olmstead, Mercy Anne

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Subjects / Keywords:
buyout -- compensation -- consumer -- peanuts -- production -- quota -- tax -- tobacco
Food and Resource Economics -- Dissertations, Academic -- UF
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Food and Resource Economics thesis, Ph.D.
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Abstract:
This dissertation is a combination of three research papers. The first provides an overview of the U.S. tobacco production quota program as well as the tobacco production quota buyout. Results show that as the spread between the true quota value and the inflated quota value increases, so does the net return to producers from removing the quota. This was the incentive for quota owners to bid up the quota value. The initial implementation of the tobacco quota adversely affected consumers as they faced higher tobacco prices. The Tobacco Quota Buyout made the initial impact on consumers even worse with the levying of a tobacco consumer tax (which was designed to be in place for 10 years). Consumers will, however, realize considerable gains at the end of the buyout when competitive equilibrium is restored after 2014. It is important to stress that under a consumer tax model, producers cannot gain from a production quota buyout if they are only paid the true quota value. The second article provides a theoretical and empirical comparison of two historic production quota buyouts: the 2002 US Peanut Quota Buyout and the 2004 US Tobacco Quota Buyout. The US Tobacco Buyout was paid for by a consumer tax while the US Peanut Quota Buyout was based on compensation from the treasury. Under a TB, producers always gain from the removal of the quota. Under a CTB, producers may lose or gain, depending on the length of the compensation period. Producers, consumers, and society favor a Treasury Buyout (TB) for several reasons. Producers are compensated considerably more under a TB, consumers are not burdened with the charge of funding the buyout, and society does not face additional efficiency losses due to the buyout. Importantly, this study shows that different policy instruments can have markedly different distributional consequences but need not affect the size of economic efficiency gains from a policy change. The third paper analyzes the impact of removing the U.S. tobacco program in both a partial and general welfare economics framework. In a partial-equilibrium framework, a consumer tax-funded quota buyout results in producer gains, consumer losses, and net losses due to higher prices and deadweight losses. Within a general-equilibrium framework, importantly, the tobacco buyout led to a decrease in society’s smoking-related healthcare costs due to the decrease in demand for tobacco. It also led to an increase in worker productivity as employees reduced the amount of smoking-related sick days taken. Of course, these two outcomes depend on what percentage of the smoking population was or was not truly addicted.
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In the series University of Florida Digital Collections.
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Includes vita.
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by Dwayne J Haynes.
Thesis:
Thesis (Ph.D.)--University of Florida, 2013.
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Adviser: Schmitz, Andrew.
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PRODUCTION QUOTA BUYOUTS: A THEORETICAL AND EMPIRICAL EXAMINATION By DWAYNE J. HAYNES A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY UNIVERSITY OF FLORIDA 2013

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2 2013 Dwayne J. Haynes

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3 To my parents, my wife, and my daughter

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4 ACKNOWLEDGMENTS I would like to thank my committee chair and mentor, Dr. Andrew Sc hmitz for his guidance and support over the last several years. He has played an integral part in my development as a researcher and economist and has changed the way I view the world. I will forever be grateful for his leadership, patience and all of th e knowledge he has given me. I would also like to thank the other members of my committee, Dr. Moss, Dr. Burkhardt, and Dr. Olmstead. I gre atly appreciate all of the insight and direction they have provided. To my professors, faculty and colleagues who h ave been instrumental in my progression throughout the years I would especially like to thank Carole Schmitz, Carol Fountain and Jess Herman. At the most crucial times, you all have made the daunting road to success more navigable, and for that, I am truly grateful. Lastly, I would like to thank my family. Without such a devote d and caring support system, this would not have been possible. To my parents, thank you for all you have done and for your unwavering confidence in me. To my wife, thank y ou for being understanding, caring and most of all, thank you for believing in me. To my daughter, thank you for being the mecca of my inspiration. I do this all for you.

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5 TABLE OF CONTENTS page ACKNOWLEDGMENTS ................................ ................................ ................................ ............... 4 LIST OF TABLES ................................ ................................ ................................ ........................... 7 LIST OF FIGURES ................................ ................................ ................................ ......................... 9 ABSTRACT ................................ ................................ ................................ ................................ ... 10 CHAPTER 1 INTRODUCTION ................................ ................................ ................................ .................. 12 The First Paper ................................ ................................ ................................ ........................ 12 The Second Paper ................................ ................................ ................................ ................... 12 The Third Paper ................................ ................................ ................................ ...................... 12 2 TOBACCO PRODUCTION QUOTA BUYOUTS INFLATED QUOTA VALUES ........ 14 Background ................................ ................................ ................................ ............................. 14 Theoretical Framework ................................ ................................ ................................ ........... 16 Quota Implementation ................................ ................................ ................................ ..... 16 Quota Removal ................................ ................................ ................................ ................ 17 Productivity, Efficienc y, and Shifting Supply ................................ ................................ 19 Methodology and Empirical Analysis ................................ ................................ .................... 20 Data ................................ ................................ ................................ ................................ .. 20 Introduction of the Tobacco Quota ................................ ................................ .................. 21 Removal of Tobacco Quota ................................ ................................ ............................. 22 Adjustments in the True Quota Value ................................ ................................ ............. 23 The Buyout after Ten Years ................................ ................................ ............................ 24 Productivity Gains from Shifting Supply ................................ ................................ ........ 25 Net Producer Ga in Present Value Calculations ................................ ................................ ...... 26 The Missing Billions ................................ ................................ ................................ ............... 27 Distributional Effects ................................ ................................ ................................ .............. 27 Landowners vs. Producers ................................ ................................ ............................... 27 Escalating Quota Rents ................................ ................................ ................................ .... 29 Results ................................ ................................ ................................ ................................ ..... 29 3 BENEFIT COST ANALYSIS: GOVERNMENT COMPENSATION VS CONSUMER TAX MODEL S ................................ ................................ ................................ ....................... 41 Background ................................ ................................ ................................ ............................. 41 The US Peanut Quota Buyout ................................ ................................ ......................... 41

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6 Treasury Buyout ................................ ................................ ................................ .............. 42 True quota value ................................ ................................ ................................ ....... 42 Inflated quota value ................................ ................................ ................................ .. 42 Consumer Tax Buyout ................................ ................................ ................................ ..... 43 True quota value ................................ ................................ ................................ ....... 43 Inflated quota value ................................ ................................ ................................ .. 43 Empirical Analysis ................................ ................................ ................................ .................. 44 US Peanut Quota Buyout ................................ ................................ ................................ 44 Treasury buyout ................................ ................................ ................................ ........ 44 Consumer tax buyout ................................ ................................ ............................... 45 US Tobacco Buyout ................................ ................................ ................................ ........ 45 Consumer tax buyout: Tru e quota value vs. inflated quota value ............................ 46 Treasury buyout: True quota value vs. inflated quota value ................................ .... 47 Results ................................ ................................ ................................ ................................ ..... 47 4 THE US TOBACCO PROGRAM BUYOUT: A GENERAL EQUILIBRIUM ANALYSIS INCLUDING NEGATIVE EXTERNALITIES FROM SMOKING ................ 53 The Consumer Tax Buyout Effect ................................ ................................ .......................... 5 3 Partial Equilibrium ................................ ................................ ................................ .......... 53 Declining Demand Conditions and General Equilibrium ................................ ............... 53 Demand for Tobacco and Addiction ................................ ................................ ............... 55 Negative Externalities from Smoking: Review of Articles ................................ .................... 56 Results ................................ ................................ ................................ ................................ ..... 58 5 CONCLUSIONS ................................ ................................ ................................ .................... 65 US Tobacco Quota Buyout ................................ ................................ ................................ ..... 65 Varying the Method of Compensation ................................ ................................ ................... 66 Partial equilibrium Framework versus General equilibrium Framework .............................. 67 APPENDIX A SENSITIVITY ANALYSIS: VARYING ELASTICITIES ................................ ................... 68 B POSITIVE EXTERNALITIES ................................ ................................ ............................... 72 Smoking and Worker Productivity ................................ ................................ ......................... 72 Hea lthcare Costs ................................ ................................ ................................ ..................... 72 LIST OF REFERENCES ................................ ................................ ................................ ............... 75 BIOGRAPHICAL SKETCH ................................ ................................ ................................ ......... 79

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7 LIST OF TABLES Table page 2 1 Economic gains and losses due to $0.30/lb. tobacco quota implementation under various elasticities ................................ ................................ ................................ .............. 31 2 2 Economic gains an d losses under an inflated quota buyout of $0.50/lb., $0.70/lb., and $1.00/lb. (with a true quota value of $0.30/lb.) ................................ ................................ 31 2 3 Economic gains and losses under an inflated quota buyout of $1.00/lb (varied elasticities) ................................ ................................ ................................ ......................... 32 2 4 Impact of varying true quota value on producers ($0.30/lb. versus $0.50/lb) US million dollars ................................ ................................ ................................ .................... 32 2 5 Eleventh year economic gains and losses under the removal of an inflated quota buyout (a comparison between $0.50/lb., $0.70/lb., and $1.00/lb. inflated quota values) ................................ ................................ ................................ ................................ 32 2 6 Producer gain an d net efficiency gain from shifting supply ................................ .............. 33 2 7 Producer impact: Present value of tobacco quota, US billion dollars ................................ 33 2 8 Quota rent distribution from the tobacco buyout: Landowners vs. Producers .................. 33 2 9 Distribution of benefits according to farm size and structure of land ownership, 50/50 split in US million dollars ................................ ................................ ................................ .. 33 2 10 Distribution of benefits according to farm size and structure of land ownership, 60/40 split in US million dollars ................................ ................................ ................................ .. 34 2 11 Q uota rental rates for flue cured and burley tobacco ................................ ......................... 34 2 12 Producer cost increase from possible quota rental value escalation ................................ .. 34 3 1 US peanut quota buyout yearly estimates: Treasury buyout vs. consumer tax buyout (true quota value) ................................ ................................ ................................ ............... 49 3 2 US tobacco: Economic gains and losses from quota implementation ............................... 49 3 3 US tobacco buyout results (consumer tax): True quota value vs. inflated quota value, yearly estimates ................................ ................................ ................................ .................. 49 3 4 US tobacco results (treasury buy out): True quota value vs. inflated quota value, yearly estimates ................................ ................................ ................................ .................. 50 4 1 Economic gains and losses under an inflated quota buyout of 1.00/lb. (with a true quota value of $0.30/lb.) ................................ ................................ ................................ .... 60

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8 4 2 Economic gains and losses upon culmination of the inflated quota buyout ($1.00/lb. quota buyout value) ................................ ................................ ................................ ............ 60 A 1 Economic gains and losse s under quota implementation ................................ .................. 68 A 2 Tobacco buyout (treasury funds) results: True quota value vs. inflated quota value ...... 69 A 3 To bacco buyout (consumer funds) results: True quota value vs. inflated quota value .... 69 A 4 Economic gains and losses under a tobacco quota implementation ................................ .. 70 A 5 Treasury buyout results: True quota value vs. inflated quota value ................................ .. 70 A 6 Consumer tax buyout results: True quota value vs. inflated quota value .......................... 71

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9 LIST OF FIGURES Figure page 2 1 Production quota theoretical model ................................ ................................ ................... 35 2 2 $0.30/lb. p roduction quot a implementation ................................ ................................ ....... 36 2 3 Tobacco buyout ($0.50/lb. inflated quota) ................................ ................................ ......... 37 2 4 Tobacco buyout ($0.70/lb. inflated quota) ................................ ................................ ......... 38 2 5 Tobacco buyout ($1.00/lb. inflated quota) ................................ ................................ ......... 39 2 6 Relationship between tobacco quota value and net producer gain ................................ .... 40 3 1 Theoretical quota buyout ................................ ................................ ................................ ... 51 3 2 Empirical implementation and removal of quota ($0.30/lb. vs. $1.00/lb. quota) .............. 52 4 1 $1.00/lb. q uota buyout ................................ ................................ ................................ ....... 61 4 2 Demand for tobacco ................................ ................................ ................................ ........... 62 4 3 Demand for organic food ................................ ................................ ................................ ... 63 4 4 Theoretical model for demand of addictive good ................................ .............................. 64 B 1 Labor market effect ................................ ................................ ................................ ............ 74 B 2 Healthcare costs ................................ ................................ ................................ ................. 74

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10 Abstract of Dissertation Presented to the Graduate School of the University of Florida in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy PRODUCTION Q UOTA BUYOUTS: A THEORETICAL AND EMPIRICAL EXAMINATION Dwayne J. Haynes May 2013 Chair: Andrew Schmitz Major: Food and Resource Economics This dissertation is a combination of three research papers. The first provides an overview of both the U nited S tate s ( US ) tobacco production quota program and the US tobacco production quota buyout R esults show that as the spread between the true quota value and the inflated quota value increases, so does the net return to producers from removing the quota. Producers gain $53 million a year g iven a $0.30/lb. quota value buyout versus $202 million a year under a $1.00/lb quota value buyout Conversely, the buyout adversely affected consumers because a tobacco consumption tax was used to fund producer compensation Give n a $1.00/lb. quota value buyout, consume rs lose $293 million a year; however, they realize gains $390 million when the buyout ends The second paper contains a theoretical and empirical comparison of the US Tobacco Q uota B uyout and the US P eanut Q uota B u yout While t he former was paid for by a consumer tax the latter was based on compensation from the US T reasury. Under a consumer tax buyout (CTB) producers may lose or gain, depending on the length of the compensation period ; consumers lose as they are the so urce of funding for the buyout, and society loses in the short run as there is a sustained deadweight loss from the buyout Under a treasury buyout (TB) producers ga in, consumers are not taxed to fund the buyout, and society does not face efficiency losses due to the buyout For these reasons, p roducers, consumers, and society favor a TB over a CTB

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11 The third paper analyzes and compares the impact of the US Tobacco Quota Buyout with in both a partial and a general equilibrium framework. In a partial equilibrium framework (as presented in the first paper) a tobacco quota buyout results in producer gains, consumer losses, and net losses because of higher prices and deadweight losses. Within a general equilibrium framework, the tobacco quota buy out resul ts in a decrease of related healthcare costs due to the decrease in demand for tobacco. It also leads to an increase in worker p roductivity as employees reduce the amount of smoking related sick days taken.

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12 CHAPTER 1 INTRODUCTION The F irst Paper This dissertation is a combination of three research papers. The first provides an overview of the US tobacco production quota program as well as the tobacco production quota buyout. T hrough the use of tobacco production quotas, the 1938 US Toba cco Program enhanced and stabilized tobacco prices. Due to many factors, including public health concerns, the program was terminated in 2004 and producers were compensated though it was not legally required, with monies from a consumer tobacco tax. This research determines how producers, consumers and society were affected by the buyout within a welfare economics framework. The Second Paper The second paper offers a theoretical and empirical comparison of two historic production quota buyouts: the 2002 U S Peanut Quota Buyout and the 2004 US Tobacco Quota Buyout. The US Peanut Quota Buyout was based on compensation from the T reasury while the US Tobacco Buyout was paid for by a consumer tax. Given these two buyouts, an important question arises: How does t he method of compensation affect distribution and efficiency? A treasury buyout (TB) is favored over a consumer tax buyout (CTB) for several reasons. Under a TB, p roducers are compensated considerably more consumers are not burdened with the charge of fu nding the buyout, and society does not face additional efficiency losses due to the buyout. The Third Paper The third paper analyzes the impact of removing the US tobacco program in both a partial and general welfare economics framework. In a partial equil ibrium framework, a consumer tax funded quota buyout can result in producer gains, consumer losses, and net losses because of higher prices and deadweight losses. In a general equilibrium framework, society can

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13 gain from the tobacco buyout due to potential savings from a reduction of healthcare costs which are attributable to a decrease in smoking. Additionally, we present a model address ing the addictive qualities of tobacco, and at the same time we co nsider the effects of the quota buyout. Also, we con clude that a p ossible effect of the buyout is an increase in worker productivity when employees who are able to quit smoking reduce the amount of smoking related sick days they accumulate

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14 CHAPTER 2 TOBACCO PRODUCTION QUOTA BUYOUTS INFLATED QUOTA VALUES Background The United States ( US ) Tobacco Program was instituted in 1938 to improve the income of tobacco producers. Its main feature was the use of production quotas, in which tobacco production was restricted below competitive levels. This benefited to bacco producers and landowners (collectively quota holders/owners) by artificially raising the price of tobacco (Schmitz, Furtan, and Baylis 2002). Over time, public health organizations such as the American Cancer Society pressured the government to not support the tobacco industry. As a result, the US government terminated the program in 2004 and compensated tobacco quota holders when they placed a consumer tobacco tax on the purchase of tobacco products for the next 10 years (Womach, 200 5 ) The termina tion of the federal tobacco program was a controversial effort that began in 1997 (Brown, Rucker, and Thurman 2007) and culminat ed 2004. The 2004 Act provided compensation to quota owners and effectively deregulated US tobacco production and prices (Dohlman, Foreman, and Da Pra 2009a). E.C. Pasour Jr. (2005) asked the question: Did the Buyout make sense legally, economical ly, or ethicall y? No. He argue d that marketing quotas had economic values does not indicate that their owners had a legally protected property right in them. If tobacco quota owners had no legally protected property rights, there is no economic or Generally, l egislators from the tobacco states supported the termination of the tobacco program only if the tobacco quota owners were to be compensated. After much debate, the final Parts of this chapter are included in a working paper by Schmitz, Haynes, and Schmitz (2013).

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15 legislation provided all quota owners $7 pe r p ound on the 2002 basic quota; the producers were compensated an additional $3 per pound on the 2002 effective quota. These c ompensation payments were outlined to be paid for by a tobacco consumption tax placed on the buyers of tobacco products to be made in 10 equal annual installments of $0. 70/lb and $0.30/lb (Womach, 200 5 ). This chapter provides a theoretical and empirical analysis of the historic 2004 US Tobacco Quota Buyout. While a considerable amount of literature exists on the impact of institut ing production quotas, little is known about the effect of removing them, especially when the revenue from a consumer tax is used to pay for the compensation. 1 The result of a quota buyout, in part, depends on the magnitude of the compensation to quota ow ners. We estimate (1) the compensation package to producers from the buyout, (2) the domestic and foreign consumer losses, and (3) the net societal losses. In the 2004 US Tobacco Buyout, the money paid to quota owners (i.e., producers and landowners who r ented land to producers) was generated from a tobacco consumption tax. The net gain from the buyout to these quota owners was far less than was the tax revenue. In addition, the producer net gain depended on several factors, including the quota value used as the basis for the buyout. In this chapter w e develop a compensation model based on a consumer tax, which is different from a TB (Schmitz, Schmitz and Haynes, 2012). Under the latter, producers can still gain from a quota buyout even if they are compen sated the true value of the production quota (Schmitz and Schmitz 2010). We present results under various quota values and show why it was in the best interest of quota owners to have an inflated quota value used for the buyout that 1 Kirwan, Uchida, and Whi te (2012) examine the distortionary effects of the tobacco buyout on Kentucky, specifically focusing on farm productivity and reallocation.

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16 exceeded the true econ omic quota value. Theoretically, it was in the best interest of quota owners to inflate quota values prior to the buyout because there would be nothing to gain from a CTB if it were based solely on the true quota value. From a political economy/rent seekin g perspective, the active lobbying on behalf of the tobacco quota owners had a high economic payoff to these groups ( Schmitz, Moss and Schmitz, 2010) Theoretical Framework Johnson (1965) estimated the social cost of quotas as applied to Flue cured tobacco He argued that because the United States had a substantial degree of monopoly power in the international market for Flue cured tobacco in the 1950s, the US Tobacco Program generated net societal welfare gains. In this paper, we extend the analysis to inc lude Burley tobacco and consider the possibility of rent seeking behavior by tobacco producers. Quota Implementation Consider Figure 2 1 where is the supply schedule, is total demand, and is domestic demand. The competitive price and output are and respectively, and exports total to Now consider the effect of a production quota being implemented using the basic theorem s of welfare economics (Just, H u e th, and Schmitz 2004). The price rises to and producers gain Quota owners now receive the true value of the quota from the market while consumers lose 2 Domestic consumers, however, lose only while consumers in the importing country lose There is a net positive 2 the value of the quota, area inflated quota value or true quota value ) will refer to a per the consider the following example:

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17 w elfare gain to the country imposing the production quota (i.e., the exporting country) of The net welfare cost of the quota for both the exporting and importing countries (i.e., the deadweight loss) taken together is Quota Removal As we show, if the buyout exactly equaled the true value of the quota via a tobacco tax, quota owners would have n either reason n or incentive to support the buyout. This i s because their net gain would have be e n zero over t he time period when the tax would have be en in place to pay for the buyout. After that period, the net gain to producers would have fall en because prices would no longer have b e e n supported. The net effect of the buyout on quota owners and consumers from a consumption tax would have b e e n zero unt il the competitive equilibrium wa s restored. As discussed in the next chapter, the consumer tax model discussed here is very different from the standard model of production quota buyouts in which compensation is pai d for by the US Treasury. In the TB the quota owners would still be able to gain if they were to be compensated by an amount equal to the true value of the quota (Schmitz and Schmitz 2010, 2011). What happens when the dollar amount of compensation excee ds the true value of the quota? The n et producer gain from the buyout depends on the perceived value of the quota on which compensation is based relative to the true value of the quota. Therefore, from a rent seeking perspective, it was in the interest of quota owners to lobby for an inflated quota value that was larger than the true quota value We now present two cases where the inflated quota value is used as the basis for the quota buyout. Case 1 : Consider Figure 2 1 where a true value of the quota of and an inflated value of the quota used for the buyout are depicted. The buyout causes the consumer

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18 price to rise to while the producer price falls to Under the inflated quota case, domestic consumers lose and foreign consumers lose the sum of which is Producers gain an amount Case 2 : Instead, co nsider the same true value of quota relative to the even more inflated value of the quota used for the buyout The buyout causes the consumer price to rise to while the prod ucer price falls to Under this case, domestic consumers lose and foreign consumers lose the sum of which is The net producer gain is Clearly, the net producer gain from the quota buyout increases as the spread between the true quota value and the inflated quota value increases. Therefore, it is in the interest of quota owners to lobby the government for a buyout based on t he inflated quota valu e rather than a buyout based on the true quota value To increase the size of the buyout, quota owners will attempt to manipulate quota rental rates so that the quota value presented and argued for in the buyout will be above the true quota value As discussed in more detail later, this is what appeared to have happened in the 2004 US Tobacco Quota Buyout. In the above framework, what happens when the inflated quota is removed and competitive equilibrium is restored at ? In the theoretical model (Figure 2 1 and Case 2), the negative producer gain from removing the quota is Domestic consumers gain and foreign consumers gain This tot als which is a net positive

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19 gain to society. 3 As a result, if quota owners are paid only the true value of the quota, they are worse off than they would have been before the buyout. Productivity, Efficiency and Shifting Supp ly The termination of the US Tobacco Program had several implications on many facets of the tobacco industry more specifically on farm numbers, size, allocation, p roductivity structure and efficiency. Kirwan, Uchida and White (2012) found that in Kentuck y alone, there were huge impacts on farm size from the buyout. They report that the number of tobacco farms plummeted almost 75% from 2002 to 2007. However, according to their study, the average tobacco farm size more than doubled during the same period. O verall, entrants into the tobacco market, post buyout, were significantly larger, more productive, and harvested more than double the tobacco of their pre buyout counterparts (Kirwan, Uchida and White, 2012). Even though this research focused mostly on pr e and post buyout Kentucky tobacco farms the findings can be extrapolated easily to the rest of the U nited S tates when considering the impact of the tobacco buyout. We consider several reasons (including the above, i.e., larger, more productive farms) as to why a tobacco production quota buyout could cause a supply shift. Take, for example, these three key factors: ( 1) efficient producers stay in the market, ( 2) inefficient producers exit the market, and ( 3) new efficient prod ucers enter the market. Figure 2 1 depicts the shift to after the buyout. Output increases from to initially as a result producers gain 4 When equilibrium is restored after the 10 year buyout period the price lowers to and there is a higher output level Producers now gain plus the original gains 3 This is purely an economic gain as consumers benefit from the reduction in the price of a good. This reduction translates to an increase in the consumption of tobacco which inh erently increases healthcare costs to society. We discuss the health impacts and negative externalities associated with the buyout in Chapter 4. 4 Assuming Case 1 from above.

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20 from removing the quota of minus from domestic efficiency loss minus for the loss of the quota. The shift acts effectively as an increase in the quota value which result s in a larger net producer gai n, and a US net efficiency gain from removing the quota. Methodology and Empirical Analysis 5 Data Even though the two major kinds of tobacco grown in the United States, Flue cured and Burley, account for over 90% of US production, payments under the tobacc o buyout for quota owners were the same (Serletis and Fetzer 2008). Thus, we aggregate the production of these two types of tobacco and use average prices and quantities for the 1999 to 2003 period (ERS/USDA 2005) of $1.88/lb and 839.4 million pounds, r espectively. 6 Most studies estimate the price elasticities of demand for tobacco to be between 0.3 and 0.5 (Sloan, Smith, and Taylor 2003; Chan and Capehart 2004). Brown, Snell, and Tiller (1999) estimate the total price elasticity of demand for US Burl ey and Flue cured tobacco to be 0.53 and 1.75, respectively. Serletis and Fetzer (2008) estimate demand elasticities for Flue cured ranging from to and demand elasticities for Burley ranging from to Weimer, Vining, and Thomas (2009) provide price elasticities of between 0.09 and 0.34. Goodwin and Sumner (1990) estimate the aggregate supply elasticity under the tobacco program to be around 4.0 whil e Fulginiti and Perrin (1993) estimate the supply price elasticity to be 7.0. In the absence of the tobacco program, the aggregate long run supply elasticity is assumed to be 5 We determine the distributional effect between producers and landowners who le ased land to these producers in a later section but, briefly, producers gained more from the buyout relative to those landowners who were not producers. 6 Roughly 46% of this US tobacco production was exported between 1999 and 2003 (ERS/USDA, 2005). This production value accounts for the change in stock size over the five year period.

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21 perfectly elastic (Brown, Snell, and Tiller 1999). In view of the wide range of price elasticities, we present results under varying demand and supply elasticities (Appendix A) Introduction of the Tobacco Quota As the base of our analysis w e calculate the yearly effect of the tobacco quota based on average production and price data for the five years prior to the buyout (1999 2003). 7 Consider Figure 2 2 where we depict the implementation of the tobacco quota. 8 Given a total demand elasticity ( E DT ) of 1.1, a domestic demand elasticity ( E DD ) of 0.9, and a supply elasticity ( E S ) of 0.5, the net producer gain and the value of the quota are roughly $88 million and $252 million, respectively (Table 2 1) 9 The total consumer loss is $95 million of which domestic consumers lose $49 million and foreign consumers lose $46 million. The net welfare gain to the exporting country is $38 million while the net welfare cost (i.e., the dead weight loss) to both countries of implementing the quota is $8 million. These results highlight the distinction between net producer gains and the value of th e quota. The value of the quota is roughly three times the net producer gain. How do varying supply and demand elasticities change the results? A more elastic supply curve widens the gap between and ef fectively increasing the net producer gain. For example, under an E S of 1.4 ceteris paribus the net producer gain increases from $87.5 million to $145.7 million (Table 2 1 ). This more elastic supply curve increases net consumer loss to 7 The million dollar amounts presented in the text and tables are yearly estimates unless otherwise stated. 8 In our model, we construct supply and demand curves assuming a $0.30/lb. true quota value 9 The results likely underestimate the net effect of removing the tobacco quota for three reasons: (1) the supply curves we use are relatively inelastic, compared with the above mentioned studies (Goodwin and Sumner, 1990; Fulg initi and Perrin, 1993), because the more elastic the supply curve, the greater the net producer gain and vice versa, (2) we use a quota level of 839.4 million pounds in our model which is less than the 2002 basic quota level of 959 million pounds, and (3) we do not account for the net cost of quota nontransferability across states. In their seminal paper, Rucker, Thurman, and Sumner (1995) estimate this to be around $21 million.

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22 $159 million, with domestic and foreign consumers losing roughly $81 million and $79 million, respectively. The net welfare gain to the exporting country rises to $65 million. On the other hand, using a more elastic demand curve has the opposite effect. For example, for an elasticity of 1.5 for both E DT and E DD the net producer gain falls from $87.5 million to $61.5 million. Removal of Tobacco Quota It is important to note that under a tobacco quota buyout where quota holders are not compensated, the economic impact would be the negativ e of the results in Table 2 1 Clearly in this case, the buyout is simply the reversal of the quota implementation. As shown theoretically, if producers are compensated only the value of the quota in the buyout, their net welfare would remain unchanged. T herefore the incentive for accepting the compensation package depends on the size of the payment that exceeds the true value of the quota ($251.8 million, Table 2 1 ). What are the effects of the quota buyout under an inflated quota value ? 10 Figure s 2 3 2 4 and 2 5 depict the cases where the inflated quota value is $0.50/ lb., $ 0.70/ lb., and $1.00/ lb., respectively. The economic impact for these inflated quota levels is presented in Table 2 2 When the inflated quota value is $0.50/lb relative to the true quota value of $0.30/ lb., the net producer gain is $53 million, the net consumer loss is $73 million (domestic and foreign consumers lose $39 million and $34 million, resp ectively). The net producer gain from an inflated quota value of $0.70/lb is $100 million, the net consumer loss is $143 million (domestic and foreign consumers lose $77 mi llion and $66 million, respectively). For an inflated quota value of $1.00/lb the net producer gain increases to 10 This was done by calculating key economic components (e.g., net producer gai n, net consumer loss, and net efficiency loss) for the varying inflated quota values from $0.50/lb., $0.70/lb., and $1.00/lb. (all while keeping the true quota value constant at $0.30/lb.).

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23 $202 million, the total net consumer loss increases to $29 2 million (domestic and foreign consumers lose $162 million and $130 million, respectively), and the net efficiency loss increases. The effect of varying the supply and demand elasticities is also given in Table 2 3 11 The more elastic the supply curve, th e greater are the net producer gain and the net consumer loss. Regarding a $ 1.00/lb. buyout, for an E S of 1.0 as opposed to 0.7, the net producer gain increases from $202 million to $229 million. The net consumer loss increases from $229 million to $322 mi llion. Conversely, a more elastic demand curve has the opposite effect. For an elasticity of 1.6 for both E DT and E DD the net producer gain is only $131 million while the consumer loss falls to $279 million. The relationship between quota values and net produc er gain is depicted in Figure 2 6 For a buyout quota value of $0.30/lb., there is no net producer gain as this was the same as the original quota. For a $0.50/lb., $0.70/lb., and a $1.00/lb. buyout quota value the net producer gains are $53.1, $99 .5 and $201.9 million, respectively. As the inflated quota value increases so does the net producer gain. Thus from a rent seeking position, producers will try to gain the highest buyout amount by inflating the quota values. Given a true quota value of $ 0.30/ lb. as opposed to an inflated quota value of $1.00/ lb. the net producer gain from quota value escalation is roughly $200 million a year. This was the net gain from the buyout given that producers had already received economic benefits from a $0.30/lb quota. Adjustments in the True Quota Value We consider the possibility of a higher true quota value and its impact on producers For a higher true quota value of $0 .50/lb. as opposed to $0.30/lb. the net producer gain from 11 These figures are available upon request.

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24 introducing the quota is $201 .3 million as opposed to $87.5 million. Correspondingly, the net gain to producers from removing the $0.50/ lb. quota fell from $201.9 million to $157.1 million. Keep in mind that the total net gain to producers from both implementing and eliminating the qu ota is $299.2 million. For the $0.50/lb. quota, the net producer gain from the buyout was roughly 80% of the net producer gain from implementing the quota. Given the $1.00/lb. buyout, the net payout to producers from both implementing and eliminating the q uota does not greatly depend on the true quota value (Table 2 4 ). However as shown earlier, the net gain from removing the quota is heavily dependent on the true quota value relative to the inflated quota value The Buyout after Ten Years After the 10 yea rs of compensation when the buyout is over, competitive equilibrium will be restored. The competitive price and quantity are and respectively (Figure s 2 3 2 4 and 2 5 ). Q uota owners lose the tax area and gain the much smaller area This results in a net producer loss of and a consumer gain of Table 2 5 includes these eleventh year producer impac ts. 12 For the inflated quota values of $0.50/ lb. $0.70/ lb. and $1.00/ lb. the producer gains are million, million, and million, respectively. These values should be taken into account when calculating the net producer gains from the quota buyout. Otherwise, the net producer gains over the 10 year period of the buyout are likely overs tated. The net consumer gain is $168 million for an inflated quota value of $0.50/lb (domestic consumers gain $87 million and foreign consumer gain $81 million). For an inflated quota value 12 Throughout this pap restored. The eleventh year calculations above are per year estimates which are factored into the present value calculations of a later section.

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25 of $0.70/ lb. domestic consumers gain $125 million and foreign c onsumers gain $113 million. For an inflated quota value of $1.00/ lb. the domestic consumers gain $219 million and the foreign consumers gain $171 million. The efficiency gains from removing the quota are also provided in Table 2 5 The US net efficiency gain for a $1.00/lb. quota value is $27.5 million. The aggregate efficiency gain from removing the quota was $95 million for the same quota value. Productivity Gains from Shifting Supply The above results are predicated on the assumption that the removal o f quota does not impact production efficiency. As Kirwan, Uchida and White (2012) report, the opposite is true. 13 For this reason, our previous results likely underestimate both the producer gains from quota removal and the efficiency gains. Consider Figur e 2 5 under the case where supply shifts. 14 If we take a true quota value of $0.30/lb. and an inflated quota value of $1.00/lb., and assume estimates for US production increases of 10%, 15% and 25% due to the buyout, the resulting gains to producers from t he outward shift in supply are roughly $116 million, $177 million and $328 million, respectively (Table 2 6 ). As seen in the theoretical d iscussion (Figure 2 1 ), one can actually have net benefits from quota removal, even when competitive equilibrium is restored. When returning to equilibrium after the 10 th year of the buyout, producers gain or $177 million (Figure 2 5 and Table 2 6 respectively ). In this case, the gain to producers from the return to equilibrium is smaller th an the loss of the quota area of $458 million. However, if we consider a 25% shift in supply, the gain to producers increases to $502 million. On net, a 10% increase in output results 13 The report con cluded that between 2002 and 2007, aggregate productivity growth in Kentucky was 44%. 14 The depicted shift is an example of a 10% increase in output.

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26 in a US net efficiency loss of $242 million w hile a 25% increase yields a net efficiency gain of $83 million. Net Producer Gain Present Value Calculations Two cases 15 are considered that model the impact of the buyout on producers: ( 1) net producer gain present value calculations are made over a 10 ye ar period, and ( 2) net producer gain present value calculations are made over the same 10 year period as above and an eleventh year is added to show the effect of allowing competitive equilibrium to be restored. 16 In the first case, under a 5% discount rate net producer gains were $410 million, $770 million and $1.56 billion for $0.50/lb., $0.70/lb., and $1.00/lb. inflated quota values, respectively. In the second case, under a 5% discount rate, net producer gains were $327 million, $658 million, and $1.39 billion for $0.50/lb., $0.70/lb., and $1.00/lb. quota values, respectively (Table 2 7 ). As expected, the restoration of competitive equilibrium reduces net producer gain as producers are no longer receiving compensation from the tobacco tax. A producer co mpensation present value calculation (assuming a 5% discount rate) of the $700 million consumer tax (i.e., the $1.00/lb tax area in Table 2 2 ) over 10 years is $5.4 billion. This same calculation under a $0.70/lb inflated quota is $4.06 billion. Under a $0.50/lb inflated quota the producer compensation drops to only $3.17 billion. Finally, under the true quota of $0.30/ lb., the producer compensation is $1.9 billion Thus, by inflating the value of the quota from $0.30/lb to $1 .00/ lb., producers had the possibility of a $3.5 billion increase in compensation over 10 years. 15 Both cases are calculated at 5% and 8% interest rates. 16 After adding the eleventh year, the net produce r gain values of the subsequent years are all zero as equilibrium has been restored.

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27 The Missing Billions In our analysis of the Tobacco buyout an interesting puzzle arose: Approximately $4.2 billion in compensation was unaccounted for. More specifically, our above present value estimate of the $700 million value of the quota is $5.4 billion over 10 years while Womach (200 5 ) and many others suggest that the cost of the Tobacco buyout was about $9.6 billion. In order to arrive at the $9.6 bill ion estimate, we would need a $1.78/lb. tax in our model as opposed to $1.00/lb. This results in a huge net benefit to producers from the Tobacco buyout In this case, the net benefit is more than three times the net benefit of introducing the tobacco quo ta. Distributional Effects Landowners vs. Producers This section focuses on the distribution of rents between producers and landowners from the tobacco buyout. The net producer gain results given in earlier tables were aggregate numbers for producers and l andowners taken together. We use these results to determine the producer versus landowner gains from the buyout. While most tobacco producers owned some quota, about 60% of quota production for each crop was from rented quota. Producers wanting to expand the scale of their operations had to rent quota rights from landowners who owned quota, which added to their cash expenses and management time. The small plot size also discouraged investment in specialized equipment; the use of which was economically just ifiable only if used over a larger area. This was particularly true for tobacco farms, which typically had low tobacco acreage and relied heavily on manual labor (Dohlman, Foreman, and Da Pra 2009b). We show in Table 2 8 the net producer gain and landowne r gain in two situations: (1) the quota was divided evenly between producers and landowners and (2) the producers had roughly 60 65% of the share of quota (Capehart [2004] estimated that at least 62% of the tobacco land

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28 farmed was owned by producers). 17 Und er a 50/50 split and $0.50/lb inflated quota value producers gain $34.5 million while landowners gain $18.6 million. Under a 60% split and $0.50/lb inflated quota value producers gain $37.2 million while landowners gain $15.9 million. Under a 50/50 spl it and $1.00/lb inflated quota value producers gain $131.2 million while landowners gain $70.7 million. Under a 60/40 split and $1.00/lb inflated quota value producers gain $141.3 million while landowners gain $60.6 million. In 2002, there were 56,977 tobacco farms in the United States producing roughly 873 million pounds of tobacco. 18 Table 2 9 presents the distribution of payouts to producers and landowners under a 50/50 split. About 8% of the 56,977 tobacco farms produced 77% of the total tobacco. 19 C orrespondingly, 8% of all the producers and landowners received roughly $101 million and $54 million, respectively. 20 Under the same percentage distribution, 92% of all producers and landowners received roughly $30 million and $1 6 million, respectively. Tab le 2 10 presents the distribution of payouts to producers and landowners under a 60/40 split. Similarly, 8% of all producers gain roughly $109 million while landowners gain roughly $47 million, with 92% of producers receiving roughly $33 million and landow ners receiving only $14 million. 17 In this section, we assume that the landowners are strictly landowners and do not produce tobacco. On the other hand, we also assume that all of the producers own land. It is because of these assumptions that in Table 2 8, the 50/50 split between landowners and producers is skewed in favor of producers as opposed to being exactly half. The aggregate values are taken from Table 2 1. 18 The source of this data is the United States Census of Agriculture. 19 The above source provided the number of tobacco farms and the poundage for these farms. These data were divided into acreage categories (e.g., 0.1 0.9, 1.0 1.9, 2.0 2.9, etc.), showing which size farms produced the most tob acco. 20 3.

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29 Escalating Quota Rents For producers to gain significant sums from the buyout, they prefer a quota at the time of the buyout to have a value that exceeds the true value of the quota given a fixed buyout price. In the case o f tobacco, the buyout price in total was $1.00/lb per year. Given this, the smaller the true quota value is relative to the perceived quota value, the greater is the net producer gain. When the manipulated quota value is higher, the compensation from the government to quota owners via the buyout is greater. Tobacco quota rental rates, from which quota values are derived, have fluctuated over time and have also increased sharply (Table 2 11 ). Rental rates for Burley cured tobacco increased by roughly 50% between 1998 and 2004 while rental rates for Flue cured tobacco more than doubled during the same period. The rental rate should have decreased or remained stable between 1997 and 2003, instead it rapidly increased. So, why the rapid increase in quota re ntal rates? One explanation is that there was a payoff to quota owners from bidding up the rental rate, and hence quota values, in order to receive a payment based on the overvalued quota given a fixed, smaller quota value. Consider Table 2 12 where we sh ow the extra cost to producers from higher land rental rates for a 50/50 split between the producers and landowners and a 60/40 split between producers and landowners. The extra cost to producers from rising quota values is between $79.5 million and $63.6 million. Results The US Tobacco Program instituted in 1938 became controversial for several reasons, and was terminated in 2004. The tobacco producers and landowners could not benefit from the tobacco program buyout if they were paid only the true market q uota value. Through a successful bidding up of the quota rental rate and effective lobbying, the final compensation package was much

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30 greater than it would have been under the true quota value Our results show that as the spread between the true quota valu e and the inflated quota value increases, so does the net return to producers from removing the quota. This was the incentive for quota owners to bid up the quota value. The initial implementation of the tobacco quota adversely affected consumers as they faced higher tobacco prices. The US Tobacco Quota Buyout made the initial impact on consumers even worse with the levying of a tobacco consumer tax (which was designed to be in place for 10 years). Consumers will, however, realize considerable gains at the end of the buyout when competitive equilibrium is restored after 2014. It is important to stress that under a consumer tax model, producers cannot gain from a production quota buyout if they are paid only the true quota value As our study shows, compensa tion was based on far greater quota values that generated significant net producer gains. In turn these net producer gains far exceeded those generated from quota implementation. Given these considerations, the key issues concerning this buyout were the le gality of the buyout itself, the societal efficiency ramifications of the buyout and the amount of compensation to be paid to owners of quota (this i ncluded both producers and land owners). Three points can be made from the issues above : ( 1) there was no r eal legal basis for the tobacco buyout, ( 2) even though there was a huge burden on consumers due to the nature of the buyout from an economic stand point, the US Tobacco Buyout eliminated the deadweight loss due to the initial quota implementation, and ( 3) as we have shown in our analysis, quota holders successfully exhibited rent seeking behavior as they were compensated the inflated amount of the buyout.

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31 Table 2 1. Economic gains and losses due to $0.30/lb. t obacco quota implementation under various el asticities 21 Component Area 1999 2003 Average (US million dollars) Value of the Quota 251.8 251.8 251.8 Net Producer Gain (NPG) 87.5 145.7 61.5 Net Consumer Loss 95.1 159. 4 69.2 Domestic Loss 49.2 80.7 35.8 Foreign Loss 45.9 78.7 33.4 Net Welfare Gain to Exporting Country 38.0 65.0 26.0 Net Efficiency Loss (Aggregate of both Countries) 8 14 8 Table 2 2. Economic gains and losses under an inflated quota buyout of $0.50/lb. $0.70/lb., and $1.00/lb. (with a true quota value of $0.30/lb.) 22 Component Area 1999 2003 Average (US million dollars) Inflated Value of Qu ota 410.8 526.4 700 Net Producer Gain 53.1 99.5 201.9 Consumer Loss 73.3 143.2 292.5 Domestic 38.9 76.7 162.1 Foreign 34.4 66.5 130.4 US Net Efficiency Gain 14.2 22.8 39.7 Net Change in Efficiency 18.0 41.0 87.0 21 and represent the total demand elasticity, the domestic demand elasticity, and the supply elast icity estimates, respectively. Values in the third column reflect the following elasticities: E DT E DD E S = 0.5. Values in the fourth column reflect the following elasticities: E DT E DD E S = 1.4. Values in the fifth column reflect the following elasticities: E DT E DD E S = 0.5. 22 Using more elastic demand curves yielded lower net producer gains and vice versa. Using more elastic supply curves resulted in higher net producer gains. Values in the third column reflect $0.50/lb. a quota value and the following elasticities: E DT E DD E S = 0.6. Values in the fourth column reflect a $0.70/lb. and the following elasticities: E DT E DD E S = 0.7. Values in the fifth column reflect a $1.00/lb quota value and the following elasticities: E DT E DD E S = 0.5.

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32 Table 2 3. Economic gains and losses under an inflated quota buyout of $1.00/lb. (varied elasticit ies ) 23 Component Area 1999 2003 Average (US million dollars) Inflated Value of Quota 688.1 683.4 Net Producer Gain (NPG) 229.1 130.9 Consumer Loss 322.2 278.6 Domestic 179.1 149.2 Foreign 143.1 129.5 US Net Efficiency Gain 50.0 18.3 Net Change in Efficiency 109.2 149.9 Table 2 4. Impact of varying true q uota value on producers ($0.30/lb. versus $0.50/lb ) US million dollars Component $0.30/lb. $0.50/lb. NPG from Quota Implementation 87.5 201.3 NPG from $1.00/lb. Quota Buyout 201.9 157.1 Total 289.4 358.4 Table 2 5. Eleventh year economic gains and losse s under the removal of an inflated quota buyout (a comparison between $0.50 /lb., $0.70/lb., and $1.00/lb. i nflated quota values ) 24 Component Area 1999 2003 Average (US million dollars) Net Producer Loss 142.0 189.8 294.55 Cons umer Gain 168.0 238.1 389.55 Domestic 86.5 125.4 218.54 Foreign 81.5 112.7 171.01 US Net Efficiency Gain 25 N/A N/A 27.5 Aggregate Efficiency Gai n 26.0 48.3 95.0 23 Values in the third column reflect the following elasticities: E DT E DD E S = 1.0. Values in the fourth column reflect the following elasticities: E DT E DD E S = 0.9. 24 Values in the third column reflect a $0.50/lb. quota value and the following elasticities: E DT E DD E S = 0.6. Values in the fourth column reflect a $0.70/lb. quota value and the following elasticities: E DT E DD E S = 0.7. Values in the fifth column reflect a $1.00/lb. quota value and the following elasticities: E DT E DD E S = 0.7. 25 Under a 25% supply shift (see next table).

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33 Table 2 6. Producer gain and net efficiency gain from shifting supply Component Area 26 Quantity Percent Shift 10%, 15% and 25%, Respectively Producer Gain from Shifting Supply 115.5 177.1 328.1 Producer Gain from Shifting Supply (equilibrium restored) 176.7 271.0 502.0 Loss of Removing Quota 458.7 458.7 458.7 Original US Net Efficiency Gain 39.7 39.7 3 9.7 US Net Efficiency Gain Including Supply Shift 242.3 148.0 83.0 Table 2 7 Producer impact: Present value of tobacco quot a US billion dollars $0.50/lb Inflated Quota $0.70/lb Inflated Quota $1.00/lb Inflated Quota Interest Rates Interest Rates Interest Rates Years 5% 8% 5% 8% 5% 8% 10 0.410 0.356 0.769 0.668 1.559 1.355 15 0.327 0.295 0.658 0.586 1.387 1.228 Table 2 8. Quota rent distribution from the tobacco buyout: Landowners vs. Producers Title Quota Sha re Net Gain (US$ million) Quota Share Net Gain (US$ million) Inflated Quota Value of $0.50/lb Producers 50% 34.5 60% 37.2 Landowners 50% 18.6 40% 15.9 Total 100% 53.1 100% 53.1 Inflated Quota Value of $0.70/lb Producers 50% 64.7 60% 69.7 Landowne rs 50% 34.8 40% 29.9 Total 100% 99.6 100% 99.6 Inflated Quota Value of $1.00/lb Producers 50% 131.2 60% 141.3 Landowners 50% 70.7 40% 60.6 Total 100% 201.9 100% 201.9 Table 2 9. Distribution of benefits according to farm size and structure of land ownership 50/50 split in US million dollars Percent of Distribution of Benefits Landowner Gains Producer Gains Total 8% receive 77% of benefits 54.4 101.0 155.4 92% receive 23% of the benefits 16.3 30.2 46.5 100% 70.7 131.2 201.9 26 In reference to Figure 2 5.

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34 Table 2 10. Distri bution of benefits according to farm size and structure of land ownership 60/40 split in US million dollars Percent of Distribution of Benefits Landowner Gains Producer Gains Total 8% receive 77% of benefits 46.6 108.8 155.4 92% receive 23% of the bene fits 13.9 32.6 46.5 100% 60.5 141.4 201.9 Table 2 11. Quota rental rates for flue cured and burley tobacco Year Flue cured Effective Quota (million lbs ) Estimated Flue cured quota rental rate 1 (cents/lb ) Burley Effective Quota (million lbs ) Estimate d Burley quota rental rate 27 (cents/lb ) 1997 1,019.8 35.0 879.8 23.0 1998 819.6 43.0 867.5 24.0 1999 671.5 51.0 690.1 31.0 2000 553.0 56.0 362.0 46.0 2001 545.3 57.0 369.0 49.0 2002 545.3 57.0 349.0 49.0 2003 536.2 61.0 330.0 54.0 2004 500.0 66.0 3 31.0 52.0 Data source: Tobacco and Peanuts Division, Farm Service Agen cy (FSA); Tobacco Situation and Outlook Repo rt TBS 246, April 2005 ERS/ USDA for basic and effective quotas. Table 2 12. Producer cost increase from possible quota rental value escalati on Year Average Quota Rental Rate (US$) Total Poundage (millions) Total Cost of Quota (US$ millions) Extra Cost to Producers 50/50 Split (US$ millions) Extra Cost to Producers 60/40 Split (US$ millions) 2001 0.53 457.2 242.3 9.1 7.3 2002 0.53 447.2 237. 0 8.9 7.2 2003 0.575 433.1 249.0 28.2 22.5 2004 0.59 415.5 245.1 33.2 26.6 Total 1753 973.4 79.5 63.6 27 From the tobacco costs of production accounts published by ERS. Covers the states of KY, TN, VA, NC, SC, and GA.

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35 Figure 2 1. Production quota theoretical model

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36 Figure 2 2. $0.30/lb. p roduction quota implementation with

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37 Figure 2 3. Tobacco bu yout ($0.50/lb inflated quota) with

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38 Figure 2 4. Tobacco buyou t ($0.70/lb inflated quota) with

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39 Figure 2 5. Tobacco b uyout ($1.00/lb inflated quota) with

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40 Figure 2 6. Relationship between tobacco quota value and net producer gain

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41 CHAPTER 3 BENEFIT COST ANALYSIS: GOVERNMENT COMPENSATION VS CONSUMER TAX MODEL S In benefit cost analysis, a conside rable literature exists on the impact of int roducing production quotas, but little is written on the distributional and efficiency effects of removing production quotas whereby producers are compensated from the US Treasury. Likewise, this also applies to a production quota buyout in which compensation to producers is paid for through a consumer tax (Just, Hueth, and Schmitz, 2008; Schmitz and Zerbe, 2008). This article provides a theoretical and empirical analysis of two historic production quota buyouts: the 2002 US Peanut Quota Buyout and the 2004 US Tobacco Quota Buyout. The US Tobacco Buyout was paid for by a consumer tax while the US Peanut Quota Buyout was based on compensation from the T reasury. An important question arises: Does the method of compe nsation affect distribution and societal efficiency? The following analysis ( 1) examines each of the quota buyouts und er varying compensation methods and ( 2) determines the economic impact each buyout has on the government, producers, consumers, and societ y when the method of compensation is varied. Background The US Peanut Quota Buyout The Peanut Marketing Quota Program was established in the early 1930s. Like other production quota programs, it was designed to foster high and stable prices, thereby sup porting the incomes of peanut growers. The 2002 US Farm Program eliminated the peanut program at the beginning of the 2002 crop year (Schmitz, Schmitz, and Rossi, 2006), in part, due to growing World Trade Organization ( WTO ) concerns. In this article, the dissolution of this peanut Portions of this chapter have been submitted to the Journal of Benefit Cost Analysis (2013) for review under the same title. The submitted article was co authored by Andrew Schmitz, Ph.D., D.Litt., and Troy G. Schmitz, Ph.D.

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42 compensated for the loss of their quota. Under the quota buyout, holders of the peanut quota were compensated at the annual quota val ue rate of $0.11 per pound ($220 per ton) 1 The total peanut poundage upon which the payment was made totaled 2.4 billion pounds. Authorized compensation was paid to quota holders over a five year period, whereby quota holders received $0.55 per pound ($11 00 per ton). These payments were intended to compensate owners for the loss of an income producing asset. Treasury Buyout True quota v alue In the TB case, there are several results from removing the quota that differently affect s the government, producers, consumers, and society. Consider Figure 3 1 where t he government cost of removing the quota is provided the true quota value was used as the basis of compensation. Producers lose and gain Since they are compensated the value of the quota they also gain 2 This results in a net producer gain of Consumers gain and there is also a gain to society of when competitive equilibrium is restored. Inflated quota v alue When an inflated quota value (not considered in Schmitz and Schmitz, [ 2010 ] ) is used as opposed to a true quota value as the basis for compensation, is the new government 1 Data obtained through correspondence with Dr. E. L. Dohlman (peanut specialist, ERS/USDA). Professor Stan Fletcher (University of Georgia, highly regarded specialist who works on the economics of US peanut production and marketing) estimated the value of the quota to be approximately $0.10 per pound. 2 Schmitz and Schmitz (2011) show that the true value of the quota equals exactly the gain to producers when the quota is implemented plus the gain to producers when the quota is removed. However, this is not the case under a consumer tax buyout (Schmitz, Schmitz, and Haynes, 2012).

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43 cost (Figure 3 1) In this case, producers gain 3 C onsumers gain due to quota removal and t he gain to society remains the same at when compet itive equilibrium is restored. Consumer Tax Buyout True q uota v alue In the CTB case, is no longer the government cost; it is now the actual consumption tax value (Figure 3 1) Unlike the TB case, removing the quota using the tru e quota value does not result in a net producer gain in Period I. 4 In Period II, producers lose which is exactly equal to the producer gain from implementing the quota. There is also no difference to consumers in Period I, as th ey continue to lose as they would have if the quota remained in place. In Period II, however, consumers gain the area Similarly to the consumer tax effect, society does not gain or lose during Period I. There is, however, a gain of in Period II. Inflated quota v alue When the inflated quota value is used as the basis for compensation, there is a net producer gain of in Period I (Figure 3 1) In Period II, at the end of the compensation period, producers lose when equilibrium is restored. Consumers 3 Given that the value of the quota is the basis of compensation to producers in the event of a buyout, the term forms of rent seeking behavior, and thereby increase the amount of compensation they would receive from a buyout. 4 Period I refers to the period of compensation before competitive equilibrium is restored and Period II refers to the period when competitive equilibrium is restored (Schmitz, Schmitz, and Haynes, 2012). It is important to note that Period I may be one or more years, depe nding on the length of the buyout. Additionally, the results we present in the empirical section are yearly estimates.

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44 are worse off under this compensation method as they lose in Period I. On net, c onsumers gain when competitive equilibrium is restored in Period II, just as they did given the true quota value Therefore, the consumer gains do not depend on the nature of the buyout. Additionally, there is an increasing loss to efficiency during Period I. However, there is an efficiency gain in Period II which results in an overall societal net gain The following applies the theoretical framework a bove to both the 2002 US Peanut Quota Buyout and the 2004 US Tobacco Quota Buyout in order to determine how producers and consumers are affected by varying methods of compensation. In the empirical analysis, two scenarios are considered regarding the buyou t: ( 1) the true quota value is used for the basis of the buyout or ( 2) an inflated quota value is used as the basis for the buyout. Empirical Analysis US Peanut Quota Buyout Treasury b uyout The empirical assessment of Schmitz and Schmitz (2010) on the pea nut buyout concluded that the annual government cost was roughly $264 million for a period of five years (Table 3 1). 5 Producers gained $53 million per year of compensation from the buyout on net. Additionally, Schmitz and Schmitz (2010) estimate a $236 mi llion consumer gain due to the removal of the quota (Table 3 1). 5 As Schmitz and Schmitz (2010) did not account for the possibility of inflated quotas in their analysis of the US Peanut Quota Buyout, the assumption of the analysis in this paper is that the true quota value was used as the basis for the buyout.

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45 Consumer tax b uyout Consider the case in which compensation to producers is in the form of a consumer tax. Under a consumer tax compensation scheme there is no government cost. The producer gain in Period I is zero given that a true quota value would have been used as the basis for the buyout. There is a producer loss of $211 million in Period II. Additionally, in Period I, consumers are neither better nor worse off financially due to, and during, the buyout. In Period II, consumers gain $236 million. In both the TB and CTB scenarios, the removal of the quota would have result ed in a $25 million gain in efficiency because the deadweight loss would have been removed (Table 3 1). A significa nt difference between a TB and a CTB is the timing of the restoration of competitive equilibrium. Given a TB of five years, as was the case with US peanuts, competitive equilibrium was restored in the first year of the buyout when the quota was removed. Th is is because, along with the quota being removed, the deadweight loss is also removed as the government assumes the cost of the buyout. Given a CTB, equilibrium would have been restored in the last year of the buyout because, even though the quota were re moved immediately, competitive equilibrium would not have been restored because the consumer tax used to compensate producers would have kept the inefficiency wedge in place. US Tobacco Buyout The following empirical analysis pertains to the 2004 US Toba cco Buyout. Even though there are two major kinds of tobacco grown in the United States, Flue cured and Burley (accounting for over 90% of US production [Serletis and Fetzer 2008]), payments were equal under the tobacco buyout for quota owners. The produc tion of these two types of tobacco were aggregated

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46 and average prices and quantities were used for the 1999 2003 period of $1.88/lb and 839.4 million pounds, respectively (ERS/USDA, 2005) 6 as the basis for the buyout. The above mentioned data was used to build a model similar to Figure 3 1. Consider Figure 3 2 where the true quota value is $0.30/lb and the inflated quota value is $1.00/lb. 7 The competitive price is ($1.77/lb ) and the corresponding output is (890 lbs ). By introducing a production quota (839 lbs ), the price increases to ($1.88/lb ) and as a result, consumers lose $95 million Producers gain $88 million and now receive the true value of the quota from the market, equaling $252 million The deadweight loss created by the quota is $8 million These results are shown in Table 3 2 Consumer tax buyout: T rue quota value vs. inflated quota value As previously stated, the US Tobacco Buyout was in the form of a consumer tax. In this case, on net, removing the quota using the true quota value results in producers gaining nothing in Peri od I. However, using the inflated quota value yields a $202 million per year net producer gain over the 10 year compensation period (Period I). At the end of the compensation period, immediately when equilibrium is restored, producers face a net loss of ei ther $88 million under the true quota value or $295 million under the inflated quota value (Period II). Consumers continue to lose $95 million per year in Period I, so there is no net change to their welfare under the true quota value buyout. However, this value escalates to $292 million per year, given an inflated quota value buyout. Consumers immediately regain $95 million when competitive 6 This production value accounts for the change in stock size over the five year period. 7 We present a true quota value of $0.30/lb. as an ext reme case to show the possible effects of bidding up quota values through lobbying and other forms of rent seeking behavior.

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47 equilibrium is restored (CER) under the tru e quota value buyout or they regain $390 million under the inflated quota value buyout (Table 3 3 ). Treasury buyout: T rue quota value vs. inflated quota value Instead of using a consumer tax for the buyout, what if the government paid producers compensation for their loss of tobacco quota? In this case, the government cost of re moving the quota using the true quota value ($0.30/lb.) would have be en roughly $252 million per year over Period I. If an inflated quota value ($1.00/lb.) were used instead, this amount would increase to $839.4 million per year over Period I. Given a tru e quota value, producers gain $164 million per year of compensation from removing the quota. Given an inflated quota value, producers gain $752 million per year of compensation from the remov al of the quota (Table 3 4). Consumers gain $95 million in both t he true quota value and inflated quota value cases from the removal of the quota. Additionally, in either case, there is an efficiency gain of $8 million due to the removal of the quota (Table 3 4). Results There are sharp differences but also similarities between the two different types of buyouts discussed in this paper especially when the buyouts are based on true quota values Under a TB, producers always gain from the removal of the quota. Under a CTB, producers may lose or gain, depending on the leng th of the compensation period. As our theoretical section highlights, in the simplest case, the consumer impacts and efficiency gains from the remov al of the quota are identical between a TB and a CTB. Under an inflated quota value, producers gain the mos t given a TB. Once again, it is possible for producers to gain from a CTB buyout, but these gains are considerably less than under a TB. In the simplest scenario, s imilar to the true quota value case, consumers are unaffected by a CTB, as are the net effic iency gains. In the case whe n multiple years of

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48 compensation within Period I are included consumer losses and net efficiency losses can be significant under a CTB. Producers, consumers, and society favor a Treasury Buyout for several reasons. Producers a re compensated considerably more under a TB, consumers are not burdened with the charge of funding the buyout, and society does not face additional efficiency losses due to the buyout. Importantly, this study shows that different policy instruments can hav e markedly different distributional consequences However efficient policy instruments need not affect the size of economic efficiency gains

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49 Table 3 1 US peanut quota buyout yearly estimates: Treasury buyout vs. consumer tax buyout (true quota value) Components Treasury Buyout* Consumer Tax Buyout Government Cost 264 N/A Tax Amount N/A 264 Producer Net Gain Period I 53 0 Producer Gain Period II 0 211 Consumer Gain/Loss Period I 236 0 Consumer Gain/Loss Period II 0 236 Efficiency Gain/Loss Per iod I 25 0 Efficiency Gain/Loss Period II 0 25 *The elasticities used are given in Schmitz and Schmitz, 2010. Table 3 2 US tobacco: Economic gains and losses from quota implementation ( and ) 8 Comp onent Area 1999 2003 Average (US million dollars) True Value of Quota 251.8 Net Producer Gain 87.5 Consumer Loss 95.1 Deadweight Loss 8.0 Ta ble 3 3. US tobacco buyout results (consumer tax): True quota value vs. inflated quota value, yearly estimates and True Quota Value Inflated Quota Value Component Area US million dollars Component Ar ea US million dollars Tax Value 251.8 Tax Value 700.0 Producer Gain Period I N/A 0 Producer Gain Period I 201.9 Producer Loss Period II 9 87.5 Pr oducer Loss Period II 294.6 Consumer Loss: Period I 0 Consumer Loss: Period I 292.5 Consumer Gain: Period II 95.1 Consumer Gain: Period II 389.5 Efficiency Loss Period I 0 Efficiency Loss Period I 87.0 Efficiency Gain Period II 8.0 Efficiency Gain Period II 95.0 8 See Appendix A for results under varying elasticities. 9 This refers to net producer loss during the period immediately after the buyout (competitive equilibrium restored).

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50 Table 3 4. US tobacco results (treasury buyout): True quota value vs. inflated quota value, yearly estimates and True Quota Value Inflated Quota Value Component Area US million dollars Component Area US million dollars Government Cost 251.8 Government Cost 839.4 Net Producer Gain 164.3 Net Producer Gain 751.9 Net Consumer Gain 95.1 Net Consumer Gain 95.1 Efficiency Gain 8 Efficiency Gain 8

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51 Figure 3 1 Theoretical quota buyout

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52 Figure 3 2 Empirical implementation a nd removal of quota ($0.30/lb vs. $1.00/lb quota)

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53 CHAPTER 4 THE US TOBACCO BUYOUT: A GENERAL EQUILIBRIUM ANALYSIS INCLUDING NEGATIVE EXTERNALITIES FROM SMOKING The Consumer Tax Buyout Effect Partial Equilibrium Within the above framework, we can de termine empirically the effect of the tobacco buyout on consumers and producers. Consider Figure 4 1 where a $1.00/lb. quota buyout is depicted. The net producer gain from the remov al of the quota is $202 million per year (Table 4 1). The total net consume r loss from removing the quota is $292 million per year (Table 4 1). Therefore, given a present value calculation of the above estimates (with a 5% discount rate), over the 10 year compensation period, producers gain $1.3 billion and consumers lose $2.3 bi llion from the removal of the quota Given these gains and losses, the benefit cost ratio for this period is 0.70. Upon the culmination of the 10 year buyout, when competitive equilibrium is restored, producers immediately lose $295 million, because the co nsumer tax is no longer in place. Meanwhile, consumers gain $390 million in the absence of the tax (Table 4 2 ). In this case, the benefit cost ratio at this point in time is 1.32. Declining Demand Conditions and General Equilibrium While the above model as sumes a demand schedule for tobacco at the time of the buyout, the actual demand for tobacco products has fallen sharply since that time. According to Brown and Snell (2012:1): With large increases in both federal and state excise taxes late last decade, U S cigarette consumption had declined from 4 to 8 percent per year from 2007 to 2011 was 292.7 billion cigarettes, down from 435.6 billion in 2000. Portions of this chapter have been submitted to the Journal of Agricultural and Applied Economics (2013) for review. The submitted paper was co authored by Andrew Schmitz, Ph.D., D.Litt., and Troy G. Schmitz, P h.D.

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54 Consider the US tobacco produc tion quota buyout under falling demand conditions. As time moves forward, the demand for tobacco shifts left as less tobacco is consumed. Importantly, this results in a loss of consumer surplus from the decreasing demand when measured only in the tobacco m arket. In a general equilibrium framework, however, at least part of the consumer surplus losses that occur during a buyout can be attributed to both a change in preferences away from tobacco and a change in relative prices favor ing non tobacco product co nsumption. As we show below, the losses previously measured in the tobacco market are most likely overstated. Under this scenario there could be subsequent impacts in additional markets (e.g., healthcare costs decrease because fewer people are smoking for reasons including higher prices for tobacco products). In Figure 4 2 at price the quantity demanded of tobacco is and consumer surplus is If demand shifts to quantity demanded falls to for price The loss in consumer welfare is Note that the expenditure on tobacco has been reduced by Given a general equilibrium framework, as an example consider a potential change in tastes and preferences wherein consumers transfer the would be expenditure on tobacco to another market (organic food). In Figure 4 3 the price and qu antity of organic food are and respectively, with the tobacco demand of Now, if from Figure 4 2 is spent on organic food w e set equal to in Figure 4 3 price rises to and consumption rises to There is a gain in consumer welfare of which is positive, plus a producer g ain of Thus, the impact of reducing smoking is:

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55 Demand for Tobacco and Addiction An important consideration regarding the demand for tobacco over time is the fact that it is an addictive good. This ad dictive property somewhat complicates the analysis of the quota valuation of changes in consumption of addictive goods resulting from policy interventions presents a ch allenge for cost falling since the tobacco buyout (mostly due to rising federal and state taxes which subsequently raise prices), there are a certain number of consumers whose demand is not lik ely to be affected by higher prices because of their addiction. According to the Centers for Disease Control and Prevention ( CDC ) over 50% of smokers have tried to quit at least once and failed (Bloomberg.com 2012). Understandably, it is important to try to include addiction into the demand for cigarettes. Figure 4 4 depicts a theoretical model where is the addicted demand schedule, is the non addicted demand schedule, and is the total demand schedule (summed horizontally ). In the case of a CTB because of consumer price increases, the non addicted smokers eventually leave the market thereby reducing societal healthcare costs I f the remaining smokers are truly addicted, facin g demand their consumption of cigarettes is not affected by the high taxes and/or price of cigarettes. These trends continue until there are only addicted smokers left in the market and healthcare costs can no longer be reduced. An issue with the demand for a harmful and addictive good is that of utility. More specifically, B ruber (2002) state s: W ith respect to smoking, people may recognize that smoking provides them with utility (benefits) in the current time period, but that they will experience some disutility (such as impaired health) in some future time periods.

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56 Taken a step further, future impaired health is not only a disutility to the individual, it is also a disutility to society, especially regarding healthcare costs. This ties right into the next section on healthcare costs associated with smoking. Negative Externalities from Smoking: Review of Articles In Appendix B we discuss the effect of smoking on worker productivity. Annual costs due to smoking related absence s total $97 billion (CDC, 2008). W e also examine healthcare expenditures in relation to cigarette consumption in Appendix B Annual healthcare costs attributable to smoking total $96 billion (CDC, 2008). Cigarette smoking is the primary ris k factor for t he development of chronic obstructive pulmonary disease ( COPD ) in the United States. COPD is the third leading cause of death in the United States which claimed the lives of 124,477 people in 2007 (CDC, 2010). Approximately 85 % to 90% of COPD deaths are c aused by smoking (CDC, 2004). Cigarette smoking and exposure to tobacco smoke are associated with premature death from chronic disease and account for at least 30% of all cancer deaths and early cardiovascular disease and deaths (CDC, 2004). Between 2000 a nd 2004 an estimated 443,000 persons in the United States died prematurely each year as a result of smoking or exposure to secondhand smoke (CDC, 2005). Secondhand smoke exposure predicted COPD and other tobacco related mortality in a 17 year cohort study in China. The study followed 910 subjects who were exposed to secondhand smoke at home or at work, of which, 249 died due to coronary heart disease, lung cancer, COPD or ischemic stroke. The general conclu sion was that there is evidence supporting that s econd hand smoke causes COPD and ischemic stroke (NCBI, 2012b). According to the CDC, in 2009 the incidence of lung cancer in the U nited S tates was 205,974 and the number of deaths was 158,081 ( US Cancer Statistics Working Group, 2013). Lung cancer death s surpass colon, breast and prostate cancer combined (American Cancer

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57 Society, 2012). The lung cancer five year survival rate is 16.3% compared to colon, breast and prostate cancer at 65.2%, 90% and 99.9%, respectively (Howlader et al., 2012). Active s moking is responsible for about 90% of lung cancer cases (Alberg and Samet, 2003). In a major ruling (November 27, 2012), Federal Judge Gladys Kessler ordered that major tobacco companies must : (1) say that they have deliberately deceived smokers; (2) tell the public the truth regarding the dangers of smoking; and (3) inform the public that smoking kills more people than murder, car crashes, drug abuse, and AIDS, combined (AP 2012). In 1999 a large class action law suit was launched against the tobacco com panies and a settlement occurred. The Master Settlement Agreement awarded : (1) $206 billion to the states spread out over 25 years; (2) $1.5 billion over 10 years to support stat e antismoking measures ; and (3) $250 million to fund researc h into reducing yo uth smoking, ban ning on the use of cartoon characters sporting event sponsorship s and the dissolution of tobacco trade organizations (Jones, 2010). Healthday.com (2012a) reported that "a frank and graphic nationwide media campaign to motivate smokers to quit seems to be working are broadcast on virtually every form of media from newspapers to the internet. The most extreme part of the campaign are TV smokers offer very personal and often harrowing testimonials on the devastating health consequences that can re Healthday.com (2012b) reports on new estimates from the US Congressional B udget cent increase in the US tax on cigarettes could have a big impact on public health, though the benefits for the national wallet are less clear. The CBO reports that the tax increase to $1.51 from the current Federal tax of $ could result in more than 3 million

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58 more nonsmokers by 2085 by either spurring people to quit or keeping would be smokers from Investigators analyzed data on more than 47,000 patients who had undergone colorectal resection due to cancer, inflammatory bowel disease, or diverticular disease. The researchers found that smokers faced a 30% higher likelihood of experiencing some type of major complication in the first 30 days after surgery, compared to those who had never smoked. The i nvestigators also found that smokers were more likely to die within that 30 day period than patients who had never smoked (Reuters Health, 2012). Additionally, individuals who smoke may face a higher risk of complications and mortality after colorectal sur gery (Reuters Health, 2012) Results The end of the US tobacco production quota program paid for by a consumer tax had a significant negative impact on the consumers of tobacco products even though, perhaps, some consumers became better off because the hi gher prices persuaded them to give up smoking and find healthier substitutes. With in this context, addiction played a role in the outcome of the buyout as those who truly could not quit smoking paid even more to continue smoking. Importantly, the tobacco related healthcare costs due to the decrease in demand for tobacco. It also led to an increase in worker productivity as employees reduced the amount of smoking related sick days taken. Of course, these two out comes depend ed on what percentage of the smoking population was or was not truly addicted. Additional research in the future will be necessary to determine the true impact that non addicted smokers had on reducing demand.

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59 Further work on this subject migh cost Gabriel (2012) on environmental equivalents. If we compare our estimates on the $2.3 billion consumer loss over 10 years due to the US T obacco B uyout w annual estimates of $193 billion in economic loss attributable to smoking it is clear that the money saved in healthcare costs by even a slight reduction of smoking would outweigh heavily the consumer loss incurred due to higher tobacco pric es. The benefit cost ratios attached to programs aimed at reducing smoking can greatly exceed one when healthcare costs are taken into account. Anot her extension of the present work will be on the effect of the US Tobacco Buyout on the environment. More specifically, t he main research question would be a s follows: What are the potential implications of the U.S. Tobacco Buyout on the amount of litter produced from smoking? G iven that the most frequently litt ered ite ms are cigarette butts approximately 38% of all U.S. roadway litter ( S chult z et al., 2009) it would be interesting to examine how much of the tobacco product litter (TPL) c ould have bee n reduced by the US Tobacco Buyout.

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60 Table 4 1 Economic gains and losses under an inflated quota buyout of 1.00/lb. (with a true quota value of $0.30/lb.) Component Area 1999 2003 Average (US million dollars) Inflated Value of Quota 700 Net Producer Gain 201.9 Consumer Loss 292.5 Deadweight Loss 95.0 Table 4 2 Economic gains and losses upon culmination of the inflated quota buyout ($1.00/lb. q uota b uyout v alue) Component Area 1999 2003 Average (US million dollars) Net Producer Loss 294.55 Consumer Gain 389.55

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61 Figure 4 1 $1.00/lb. q uota buyout

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62 Figure 4 2 Demand for tobacco

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63 Figure 4 3 Demand for organic food

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64 Figure 4 4 Theoretical model for demand of addictive good

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65 CHAPTER 5 CONCLUSIONS US Tobacco Quota Buyout The US Tobacco Program instituted in 1938 became controversial for several reasons, and was terminated in 2004. The tobacco producers and land owners could not benefit from the tobacco program buyout if they were paid only the true market quota value. Through a successful bidding up of the quota rental rate and effective lobbying, the final compensation package was much greater than it would have been under the true quota value Our results show that as the spread between the true quota value and the inflated quota value increases, so does the net return to producers from removing the quota. This was the incentive for quota owne rs to bid up the quota value. The initial implementation of the tobacco quota adversely affected consumers as they faced higher tobacco prices. The t obacco q uota b uyout could have made the initial impact on consumers even worse with the levying of a tobacco consumer tax (which was designed to be in place for 10 years) given the use of an inflated quota for the basis of compensation Consumers will, however, realize considerable gains at the end of the buyout when competitive equilibrium is restored after 2014. It is important to stress that under a consumer tax model, producers ca nnot gain from a production quota buyout if they are paid only the true quota value As our study shows, compensation was based on far greater quota values that generated significant net producer gains. In turn these net producer gains far exceeded those generated from quota implementation. Given these considerations, the key issues concerning this buyout were the legality of the buyout itself, the societal efficiency ramifications of the buyout and the amount of compensation to be paid to owners of quota (this i ncluded both producers and land owners). Three points can be

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66 made from the issues above : ( 1) there was no real legal basis for the tob acco buyout; ( 2) even though there was a huge burden on consumers due to the nature of the buyout from an economic stand point, the US Tobacco Buyout eliminated the deadweight loss because of the initial quota implementatio n ; and ( 3) as we have shown in our analysis, quota holders successfully exhibited rent seeking behavior as they were compensated the inflated amount of the buyout. Varying the Method of Compensation There are sharp differences but also similarities between the two different types of buyouts discussed in this article, especially when the buyouts are based on true quota values Under a TB producers always gain from the removal of the quota. Under a CTB producers may lose or gain, depending on the length of the compensation period. As our theoretical section highlights, in the simplest case, the consumer impacts and efficiency gains from removing th e quota are identical between a TB and a CTB Under an inflated quota value, producers gain the most given a TB Once again, it is possible for producers to gain from a CTB but these gains are considerably less than under a TB Similar to the true quota value case, in the simplest scenario, on net, consumers are unaffected by a CTB as are the net efficiency gains. In the case where there are multiple years of compensation within Period I, consumer losses and net efficiency losses can be significant under a CTB Producers, consumers, and society favor a TB for several reasons. Producers are compensated considerably more under a TB consumers are not burdened with the charge of funding the buyout, and society does not face additional efficiency losses due to the buyout. Importantly, this study shows that different policy instruments can have markedly different distributional consequences but need not affect the size of economic efficiency gains from a policy change.

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67 Partial equilibrium Framework versus Gene ral equilibrium Framework The end of the US Tobacco Quota P rogram paid for by a consumer tax had a significant negative impact on the consumers of tobacco products even though, perhaps, some consumers became better off because the higher prices persuaded them to give up smoking and find healthier substitutes. Within this context, addiction plays a role in the outcome of the buyout as those who truly could not quit smoking paid even more to continue smoking. Importantly, the tobacco buyout led to a decreas related healthcare costs due to the decrease in demand for tobacco. It also led to an increase in worker productivity as employees reduced the amount of smoking related sick days taken. Of course, these two outcomes depend on what pe rcentage of the smoking population was or was not truly addicted. Additional research would be necessary to determine the true impact that non addicted smokers had on reducing demand. lthcare cost Gabriel (2012) on environmental equivalents. If we compare our estimates on the annual consumer loss due to the US tobacco annual estimate s of $193 billion in economic loss attributable to smoking, it is clear that the money saved in healthcare costs by even a slight reduction of smoking would outweigh heavily the consumer loss incurred due to higher tobacco prices. The benefit cost ratios a ttached to programs aimed at reducing smoking can greatly exceed one (in some cases higher than 50) when healthcare costs are taken into account. Anot her extension of the present work will be on measuring the effect of the U.S. Tobacco Buyout on the amount of litter produced from smoking I t would be interesting to examine how much of the tobacco product litter (TPL) c ould have bee n reduced by the US Tobacco Buyout.

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68 APPENDIX A SENSITIVITY ANALYSIS : VARYING ELASTICITIES This section shows the economic effect of varying the supply and demand elasticities of the above models. The first case uses a slightly more elastic demand curve ( as opposed to ). This seemingly minor change has several implications on the economic results of both implementing and removing the tobacco quota. While the value of the quota does not change, producers, consumers, and society are affected differently by its implementation. More specifically, this increase in demand elasticity translate s into a 41 % lower net producer gain, 36 % lower consumer loss, and 25 % higher deadweight loss (Table A 1). Given a TB the more elastic the demand, the higher are the net producer gains and the lower are the consumer gains from the remov al of the quota (in both the true quota value and inflated quota value cases [ Table A 2 ] ). However, given a CTB the more elastic the demand, the lower is the Period I producer gain and the lower is the Period I consumer loss from the remov al of the quota (in the inflated case, as there is no net producer gain in the true quota value case). After competitive equilibrium is restored (Period II), the producer loss and the consumer gain are both lower under the more elastic demand (Table A 3). Table A 1. Economic gains and losses under quota implementation ( and ) Component Area 1999 2003 Averag e (US million dollars) True Value of Quota 251.8 Net Producer Gain 51.2 Consumer Loss 61.1 Deadweight Loss 10.0

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69 Table A 2. Tobacco buyout (treasury funds) results: True quota value vs. inflated quota value and True Quota Value Inflated Quota Value Component Area US $ million Component Area US $ million Government Cos t 251.8 Government Cost 839.4 Net Producer Gain 200.6 Net Producer Gain 788.2 Consumer Gain 61.1 Consumer Gain 61.1 Efficiency Gain 9.8 Efficiency Gain 9.8 Table A 3. Tobacco buyout (consumer f unds) results: True quota value vs. inflated quota value and True Quota Value Inflated Quota Value Component Area US $ million Component Area US $ million Tax Value 251. 8 Tax Value 683.4 Producer Gain Period I N/A 0 Producer Gain Period I 131.0 Producer Loss Period II 51.2 Producer Loss Period II 193.2 Consume r Loss Period I 61.1 Consumer Loss Period I 278.6 Consumer Gain Period II 61.1 Consumer Gain Period II 344.7 The second case uses a sligh tly more elastic supply curve ( as opposed to ). Once again, the value of the quota does not change but the impact on producers, consumers, and society does. In fact, the more elastic the supply curve, th e higher are the net producer gain, consumer loss, and deadweight loss from the implement ation of the quota T he results we see in Table A 4 were higher than those i n both the origina l case and the increased demand elasticity case.

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70 Given a TB the net producer gain was lower under this scenario of a more elastic supply curve while the consumer gains were higher ( Table A 5). Given a CTB the more elastic the supply curve, the higher is the net producer gain and the higher is the consumer loss from the remov al of the quota. After competitive equilibrium is restored, both the net producer loss and consumer gains were significantly higher than they were using the original elasticities (Table A 6). Table A 5. Treasury buyout results: True quota value vs. inflated quota value True Quota Value Inflated Quota Value Component Area US million dollars Component Area US mi llion dollars Government Cost 251.8 Government Cost 839.4 Net Producer Gain 140.5 Net Producer Gain 728.1 Consumer Gain 122.9 Consumer Gain 122.9 Efficiency Gain 12.0 Efficiency Gain 12.0 Table A 4 Economic ga ins and losses under a tobacco quota implementation ( and ) Component Area 1999 2003 Average (US million dollars) True Value of Quota 251.8 Net Producer Gain 111.3 Consumer Loss 122.9 Deadweight Loss 12.0

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71 Table A 6. Consumer tax buyout results: True quota value vs. inflated quota value True Quo ta Value Inflated Quota Value Component Area US million dollars Component Area US million dollars Tax Value 251.8 Tax Value 700.0 Producer Gain Period I N/A 0 Producer Gain Period I 229.1 Producer Loss Period II 111.3 Producer Loss Period II 341.5 Consumer Loss Period I 122.9 Consumer Loss Period I 322.2 Consu mer Gain Period II 122.9 Consumer Gain Period II 451.4

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72 APPENDIX B NEGATIVE EXTERNALITIES Smoking and Worker Productivity Each year there are at least $97 billion worth of productivity losses cau sed by smoking; unbelievably, this estimate does not even include the costs from smoking caused disability during work lives, smoking caused sick days, or smoking caused productivity declin es while on the job (CDC, 2008). The only costs included were those estimated from productive work lives that were shortened by smoking caused death. Additionally, a study done by Weng, Ali, and Leonardi Bee (NCBI, 2012a) concluded that quitting smoking seemed to reduce absenteeism in the workplace and, as a result, there were substantial cost savings for employers. Consider Figure B 1 where we examine the effect of quitting smoking on the productivity of laborers. The supply of labor is denoted by and the demand is denoted by Hourly wage is represented by and quantity of hours worked is represented by Once again, given a consumer tax funded buyout, we can assume that the demand for cigarettes decreases. The effect o n productivity is captured in a supply shift outward from to where quitting smoking has reduced health problems associated with smoking, and thereby has increased the amount of hours laborers can work from to Healthcare Costs The following is a discussion in healthcare costs, recognizing that to some, they are likely to be controversial. While the estimated costs from consuming tobacco are estimate d as being large, one should keep in mind that there may be several major drawbacks from the various studies that have been done. The C D C (2008) report that during the 2000 2004 period cigarette smoking was responsible for $96 billion in direct medical co sts (or roughly 4% of the healthcare costs in 2010). Consider Figure B 2 where we examine healthcare expenditures in relation to

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73 cigarette consumption. Healthcare expenditures are denoted by and quantity of cigarettes consumed is denoted by The supply of cigarettes is represented by while the initial demand for cigarettes is represented by In the event of a CTB as the price rises, a reduction in the demand for cigarettes is captured in a shift from to The quantity demanded shifts from to and healthcare expenditures decrease from to

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74 Figure B 1. Labor market effect Figure B 2 Healthcare costs

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75 LIST OF REFERENCES Alberg, A. J., and Samet, J. M. (2003). Epidemiology of lung cancer. CHEST Journal, 123(1_suppl), 21S 49S. American Ca ncer Society ( 2012 ) Cancer facts and figures 2012. Cancer facts and figures. Retrieved from http://www.cancer.org/acs/groups/content /@epidemiologysurveilance/documents/docum ent/acspc 031941.pdf AP (2012, November 27). Judge orders tobacco companies to say they lied. Retrieved from http://www.usatoday.com/story/news/nation/2012/11/27/judge smoking cigarettes tobacco lied/1730305/ Bloomberg.com ( 2012 ) Internet site: http://www.bloomberg.com/news/2012 11 08/more than half of u s smokers have tried to quit.html (Accessed November 29, 2012). Brown, A. B., Rucker, R. R., and Thurman, W. N. ( 2007 ) The end of the federal tobacco program: economic impacts of the dereg ulation of US tobacco production Applied Economic Perspectives and Policy, 29(4), 635 655. Brown, A. B., Snell, W. M., and Tiller, K. H. ( 1999 ) The changing political environment for tobacco implications for southern tobacco farmers, rural economies, tax payers, and consumers. Journal of Agricultural and Applied Economics, 31(2), 291 308. Brown, A.B., and Snell W.M. ( 2012 ) Tobacco situation and outlook report Washington, DC: United States Department of Agriculture, Economic Research Service. Bruber, J. ( 2002 ) Smoking s i nternalities. Regulation, 25, 52. Capehart, T. ( 2004 ) Trends in US tobacco farming. Economic Research Service, U nited S tates D epartment of A griculture CDC ( 2004 ) The health consequences of smoking: a report of the Surgeon General. At lanta, GA: US Department of Health and Human Services. http://www.cdc.gov/tobacco/data_statistics/sgr/sgr_2004/index.htm (Accessed November, 2012) CDC ( 2005 ) Annual smoki ng attributable mortality, years of potential life lost, and economic costs --United States, 1997 -2001. Morbidity and Mortality Weekly Report 54:625 -8. CDC ( 2008 ) Smoking attributable mortality, years of potential life lost, and productivity losses Unit ed States, 2000 2004. Morbidity and Mortality Weekly Report 57(2008):1226 8. CDC ( 2010 ) National Center for Health Statistics. Final Vital Statistics Report. Deaths: Final Data for 2007. Vol. 58, No. 19.

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76 Chan, K. K., and Capehart, T. (2004). Health conce rns or price: Which takes credit for declining cigarette consumption in the US?. American Agric ultural Economics Association, 9, 43 46. Dohlman, E., Foreman, L., and Da Pra, M. ( 2009a ) The post buyout experience: Peanut and tobacco sectors adapt to polic y reform. Economic Information Bulletin No. EIB 60, Economic Research Service, United States Department of Agriculture, Washington, D.C. ( http://www.ers.usda.gov/publications/eib60/ ). Dohlman, E., Foreman, L., and Da Pra, M. ( 2009b ) Removal of government controls opens peanut and tobacco sector s to market forces. Amber Waves, 7(4), 20 27 ERS/US DA ( 2005 ) Tobacco situation and outlook report. Economic Research Service, United States Department of A griculture. Fulginiti, L., and Perrin, R. ( 1993 ) The theory and measurement of producer response under quotas. The Review of Economics and Statistics 7 5(1), 97 106. Goodwin, B. K., and Sumner, D. A. ( 1990 ) Market supply parameters under mandatory produ ction quotas. North Carolina State University, Raleigh, NC. Unpublished manuscript. HealthDay.com ( 2012a ) Internet site: http://consumer.healthday.com/Article.asp?AID=670098 (Accessed November 28 2012) HealthDay.com ( 2012b ) Internet site: http://consumer .healthday.com/Article.asp?AID=671078 (Accessed November 28 2012) Howlader, N., Noone, A. M., Krapcho, M., Neyman, N., Aminou, R., Altekruse, S. F ., Kosary C.L., Ruhl J., Tatalovich Z., Cho H., Mariotto A., Eisner M.P., Lewis D.R., Chen H.S., Feuer E.J., C ronin K.A. ( 2012 ) SEER cancer statistics review, 1975 2009 (vintage 2009 populations). Bethesda, MD: National Cancer Institute. Johnson, P. R. (1965). The social cost of the tobacco program. Journal of Farm Economics, 47(2), 242 255. Jones, W. ( 2010 ) Th e master settlement agreement and its impact on tobacco use 10 years later. Lessons for physicians about heath policy making. CHEST, 137(3), 692 700. Just, R. E., Hueth, D. L., and Andrew. Schmitz (2004). The welfare economics of public policy. E. Elgar. J ust, R. E., Hueth, D. L., and Andrew. Schmitz (2008). Applied welfare economics. E. Elgar. Kirwan, B. E., Uchida, S., and White, T. K. (2 012 ) Aggregate and farm level productivity growth in tobacco: before and after the quota buyout American Journal of A gricultural Economics, 94(4), 838 853.

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77 NCBI ( 2012a ) US National Library of Medicine, National Institutes of Health. Internet site: http://www.ncbi.nlm.nih.gov/pubmed/23078132 (Accessed November 29, 2012) NCBI ( 2012b ) US National Library of Medicine National Institutes of Health. Internet site: http://www.ncbi.nlm.nih.gov/pubmed?term=Secondhand%20smoke%20exposure%20pre dicted%20chronic%20obstructive%20pulmonary%20disease%20and%20other%20tobac co%20related%20mortali ty%20in%20a%2017 years%20cohort%20study%20in%20Chin (Accessed November 28, 2012). Pasour Jr., E. C. ( 2005 ) The tobacco quota buyout: more legal plunder, there is no economic, legal, or ethical reason to compensate those who have benefited from a governm ent enforced cartel. The Foundation for Economic Education. The Freeman, Ideas on Liberty. 55(1) < http://www.thefreemanonline.org/features/the tobacco quot a buyout more legal plunder/ > Reuters Health ( 2012 ) Internet site: http://www.reuters.com/article/2012/11/09/us smokers colorectal surgery idUSBR E8A81LG20121109 (Accessed November 25, 2012). Rucker, R. R., Thurman, W. N., and Sumner, D. A. ( 1995 ) Restricting the market for quota: an analysis of tobacco production rights with corroboration from congressional testimony. Journal of Political Econom y, 103 (1), 142 175. Schmitz, A., Furtan, H., and Baylis, K. ( 2002 ) Agricultural policy, agribusiness, and rent seeking behaviour. University of Toronto Press. Schmitz, A., Haynes, D.J., and Schmitz, T.G. (2013). Production quota buyouts under inflated qu ota values. University of Florida. Working paper. Schmitz, A., Haynes, D.J., and Schmitz, T.G. (2013). Benefit cost analysis: Government compensation vs. consumer tax models. Submitted to the Journal of Benefit Cost Analysis. Schmitz, A., Haynes, D.J., and Schmitz, T.G., Schmitz, E.D. (2013). The US tobacco buyout: A partial and general equilibrium analysis. Submitted to the Journal of Agricultural and Applied Economics. Schmitz, A., Kennedy, P.L., and Hill Gabriel, J. ( 2012 ) Restoring the Florida Everglad es through a sugar land buyout: Benefits, costs, and legal challenges. Environmental Economics. 1, 72 87. Schmitz, A., Moss, C. B., and Schmitz, T. G. ( 2010 ) Agricultural policy, agribusiness and rent seeking behavior (Second Edition). University of Toron to Press. Schmitz, A., and Schmitz, T. G. ( 2010 ) Benefit cost analysis: Distributional considerations under producer quota buyouts. Journal of Benefit Cost Analysis, 1(1). Schmitz, A., Schmitz, T. G., and Rossi, F. ( 2006 ) Agricultural subsidies in devel oped countries: Impact on global welfare. Applied Economic Perspectives and Policy, 28(3), 416 425.

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78 Schmitz, A., and Zerbe, R. O. (2008). Scitovsky reversals and efficiency criteria in policy analysis. Journal of Agricultural and Food Industrial Organizati on, 6(2). Schmitz, T. G., and Schmitz, A. ( 2011 ) Compensation and the twin producer gains from production quotas Theoretical Economic Letters, 1(3), 70 72. Schmitz, T. G., Schmitz, A., and Haynes, D. ( 2012 ) Inflated production quota gains paid for by a consumption tax Theoretical Economics, 2 (1), 67 68 Schultz P W Large L B Tabanico J Bruni, C., Bator, R. (2009). Littering b ehavior in America: Results of a Nation al s tudy. San Marcos, CA: Action Research/Keep America Beautiful Serletis, G. S. and Fetzer, J. J. ( 2008 ) Modeling the impact of the US t obacco quota buyout, office of economics. US International Trade Commission. Working paper. Sloan, F. A., Smith, V. K., and Tayl or Jr, D. H. ( 2003 ) The smoking puzzle: information, risk reception, and choice Harvard University Press. US Cancer Statistics Working Group, Department of Health and Human Services, Centers for Disease Control and Prevention and National Cancer Institu te ( 2013 ) United States Cancer Statistics: 1999 2009 Incidence and Mortality Web based Report. Weimer, D. L., Vining, A. R., and Thomas, R. K. ( 2009 ) Cost benefit analysis involving addictive goods: contingent valuation to estimate willingness to pay for smoking cessation. Health economics, 18(2), 181 202. Womach, J. ( 200 5 ) Tobacco q uota b uyout. RS22046 CRS Report for Congress, Congressional Research Service: Library of Congress, Washington, D.C.

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79 BIOGRAPHICAL SKETCH Dwayne J. Haynes completed both his un University of Florida in Gainesville. In addition to his coursework and dissertation research, Economics Department. Por tions of his dissertation hav e been presented in the Southern Agricultural Economics Association meetings (2013) and the Fifth Annual Conference of the Society for Benefit Cost Analysis (2013). After completion of his doctoral degree (May 2013), Dwayne c ontinu ed his education by pursuing a p ostdoctoral research appointment at the University of Florida foc using on welfare economics.