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Monopsony Abuse or Efficient Purchasing? Quality Measurement in the

Tobacco Leaf Market

Article  in  Journal of Competition Law and Economics · June 2010

DOI: 10.1093/joclec/nhp022

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Journal of Competition Law & Economics, 00(00), 1–14
doi:10.1093/joclec/nhp022

MONOPSONY ABUSE OR EFFICIENT

PURCHASING? QUALITY MEASUREMENT IN THE
TOBACCO LEAF MARKET

F. Andrew Hanssen 

ABSTRACT
In the recent case of Deloach v. Philip Morris, plaintiff tobacco growers accused
the major cigarette manufacturers of using unusually structured tobacco auc-
tions to engage in monopsony collusion. The DeLoach case produced one of
the largest antitrust settlements ever. The objective of this paper is to evaluate
the claims of exercise of monopsony power by exploring why tobacco wholesal-
ing systems (which have evolved dramatically over time) have taken the various
forms they have. The paper concludes that the ways in which tobacco leaf has
been sold—including the allegedly collusive auctions—developed to combat
the fundamental problem that the quality of tobacco leaf is very costly to
measure.
JEL: D2; D4; D8; K2; L1; L2; L4; L8

I. INTRODUCTION

In the recent case of Deloach v. Philip Morris, plaintiff tobacco growers

accused the major cigarette manufacturers of using tobacco auctions and
direct contracts to engage in monopsony collusion.1 On October 1, 2003, a
federal district court in North Carolina granted final approval to a settle-
ment in which all defendants but one agreed to purchase specified amounts
of tobacco over the next ten years, and to pay $200 million in cash. The
remaining defendant, R.J. Reynolds, reached a similar agreement two years
later, adding another $33 million to the pot.2 The DeLoach case thereby
produced one of the largest antitrust settlements in history.
The DeLoach suit is only the latest in a long line of conspiracy claims
involving the purchase of tobacco leaf—industry participants and academic
researchers have for many years suggested that the form in which tobacco is


Department of Economics, Colby College, Waterville, ME 04901, USA. E-mail: ahanssen@
colby.edu. I would like to thank Chip Bamberger, Rob Fleck, Jim Meehan, Alex Raskovich,
and Randy Rucker for helpful comments. This research was completed while I was on leave at
the Economic Analysis Group of the U.S. Department of Justice; I thank the Department for
its support. The views expressed are my own and not those of the Department of Justice. As
always, I am responsible for any errors.
1
DeLoach v. Philip Morris Co., Inc., 206 F.R.D. 551 (M.D.N.C. 2002).
2
For settlement details, see http://cases.justia.com/us-court-of-appeals/F3/391/551/559412/.

# The Author (2009). Published by Oxford University Press. All rights reserved.
For Permissions, please email: journals.permissions@oxfordjournals.org
Page 2 of 14 Journal of Competition Law and Economics

sold facilitates monopsony collusion.3 In part, such allegations may spring

from the simple fact that tobacco growers are small and numerous, whereas
tobacco buyers ( primarily cigarette companies) are large and few. But there
is no denying that the system used to sell tobacco leaf at the time of the
DeLoach suit had some unusual features. For instance, tobacco was auc-
tioned in very small lots, so that as many as 500 individual sets of bids
might be held in a given auction house on a single day. Each auction lasted
less than a minute on average, and many took no more than a few seconds.
There was relatively little variation in price across auctioned lots, and some
( perhaps many) bids ended in ties, at which point the auctioneer decided
how the tobacco was to be allocated across bidders.4 All in all, it is not sur-
prising that the system was regarded with suspicion.
Yet “unusual” need not mean “anticompetitive,” as has been frequently
demonstrated. My objective in this paper is to explore the history of tobacco
wholesaling, so as to understand better why it has taken the various forms it
has. My intention is not to provide a definitive answer to the “did they or
did they not collude” question, but rather to show that one need not resort
to theories of collusion to explain the peculiar nature of the tobacco leaf
market.
On the basis of my historical review, I conclude that systems for selling
tobacco leaf developed and evolved primarily to deal with a fundamental
and recurring quality measurement problem.5 The U.S. Department of
Agriculture has defined more than 130 different quality grades for tobacco
leaf, based on things such as position on the stalk, texture, and condition.6
And although an expert may have no trouble identifying the quality of a par-
ticular leaf (from its aroma, texture, color, and so forth), cigarette

3
See, e.g., RICHARD B. TENNANT, THE AMERICAN CIGARETTE INDUSTRY 206 (Yale University
Press 1950); WILLIAM H. NICHOLLS, PRICE POLICIES IN THE CIGARETTE INDUSTRY 257
(Vanderbilt University Press 1951).
4
On tie bids, see, e.g., NICHOLLS, supra note 3, at 259; Max I. Lloyd, George Abbot III &
Russell W. Sutton, The U.S. Flue-Cured Tobacco Auction Marketing System, in THE U.S.
TOBACCO MARKETING SYSTEM: PROCEEDINGS OF A SYMPOSIUM 14 (Paxton Marshall ed.,
1989); William M. Snell, Price Differentials for Quality Tobacco, Price Compression and
Eliminating Tie Bids—The Case of Burley Tobacco, in PAPERS ON THE MARKETING OF U.S.
PRODUCED TOBACCO, TOBACCO MARKETING COST STUDY COMMITTEE (Paxton Marshall
ed., 1990); Third Amended Complaint, DeLoach v. Philip Morris Co., Inc., No.
00-CV-1235 (M.D.N.C.).
5
For a detailed analysis of measurement costs and how markets evolve to deal with them, see
Yoram Barzel, Measurement Costs and the Organization of Markets, 25 J.L. & ECON. 27 (1982).
For a discussion and application to motion picture contracts, see F. Andrew Hanssen, Revenue
Sharing in Movie Exhibition and the Coming of Sound, 40 ECON. INQUIRY 380 (2002).
6
See Agricultural Marketing Service, U.S. Department of Agriculture, http://www.ams.usda.
gov/tob/index.htm. Individual cigarette manufacturers use their own quality classifications,
which are just as detailed but are tailored to the firms’ idiosyncratic needs. For a discussion of
the factors affecting leaf quality, see Wesley W. Weeks, Why Stalk Positions of Flue-Cured
Tobacco Leaf Are Important in the Manufacturing of Cigarettes, in PAPERS ON THE MARKETING
OF U.S.-PRODUCED TOBACCO 61 (J. Paxton Marshall ed., 1995).
 Quality Measurement in the Tobacco Market Page 3 of 14

companies are purchasing millions of pounds of tobacco—billions of

tobacco leaves—per year. Inspection of each and every leaf would be insu-
perably costly. Yet the absence of inspection may give growers the incentive
to “cheat,” in the form of mixing low-quality leaf with high-quality leaf.
Any attempt to sell tobacco leaf in large quantities must grapple with this
problem. In recent years, direct contracts between cigarette companies and
tobacco growers have largely replaced auctions as the principal mechanism
by which tobacco leaf is sold. As the discussion to follow will demonstrate,
this means that tobacco marketing has come full circle. Direct contracts
were used by the first American tobacco growers over 200 years ago, and
were replaced by auctions in attempt to better resolve quality measurement
problems. And direct contracts have re-surfaced because the nature of the
quality measurement problem has changed.

II. THE ALLEGED CONSPIRACY

In mid-2000, approximately 500,000 tobacco farmers and quota holders
from North Carolina, South Carolina, Georgia, Florida, Tennessee, and
Alabama filed a lawsuit against four large cigarette manufacturers (Philip
Morris, R.J. Reynolds, Brown and Williamson, and Lorillard) and the leaf
buying agents who purchased tobacco for them. The case was known as
DeLoach v. Philip Morris. The suit charged defendants with conspiring to fix
the price at which tobacco leaf could be purchased. The principal accusation
is summarized in the following statement from the Third Amended
Complaint:

Beginning sometime prior to 1996, the Defendant manufacturers conspired among

themselves and with the Defendant leaf buyers and others with the purpose and effect of
fixing, stabilizing, and maintaining prices, allocating sales, limiting production and other
unlawful practices designed to artificially and anticompetitively reduce the price of
tobacco bought by Defendants from plaintiffs and other members of the Class.7

Many of the allegations involved tobacco auctions—as the Third Amended

Complaint states, “[the] conspiracy was carried out, at least in part, by
rigging tobacco auctions.”8 However, direct contracts between growers and
cigarette manufacturers (which were then becoming increasingly common)
were also singled out in the complaint, on the grounds that these contracts
were “anticompetitively limiting the producers’ ability to enjoy the benefits
of competition for their tobacco.”9 Both the alleged rigging of tobacco auc-
tions and the fact that the use of “anticompetitive” direct contracts had
increased over time were taken as evidence of a collusive conspiracy.

7
Third Amended Complaint, supra note 4, at 45.
8
Id. at 20.
9
Id. at 26.
Page 4 of 14 Journal of Competition Law and Economics
III. TOBACCO

Tobacco is grown in at least sixteen states, with roughly two-thirds of it pro-

duced in Kentucky and North Carolina.10 The vast majority of American
tobacco is used for cigarettes.11 Two types of tobacco are employed to man-
ufacture “blended” cigarettes: flue-cured tobacco and burley tobacco. These
two tobacco types were at the center of the DeLoach suit.12 Flue-cured
tobacco gets its name from the fact that it is dried on metal racks through
which hot air is forced (this gives the tobacco a distinctive flavor and color).
Flue-cured tobacco accounts for slightly more than half the tobacco pro-
duced in the United States, and roughly 95 percent of flue-cured tobacco is
used for cigarettes.13 Burley tobacco is instead “air cured”—allowed to air
dry in barns sheltered from sun and wind. Burley is more strongly flavored
and slower burning than flue-cured tobacco (burley is also used as pipe
tobacco). Roughly one-third of the tobacco produced in the United States is
burley, and approximately 90 percent of U.S.-produced burley is used for
cigarettes.14 Flue-cured tobacco is grown primarily in Georgia, North
Carolina, and Virginia, whereas burley is grown primarily in Kentucky and
Tennessee.15
For most of the twentieth century, the market for tobacco leaf was heavily
regulated. Although much of that regulation has been unwound over the last
few years, it was still in effect when the DeLoach suit was launched. Law
then required tobacco to be auctioned at local stations rather than at more
central points, so growers delivered bales of tobacco to warehouses scattered
throughout tobacco country. Each warehouse grouped bales into lots of six
to eight, and auctioned off each lot individually.16 As many as 500 or more
lots were sold daily at a given warehouse, with lots typically selling for
similar prices. The auction of a particular lot would take only a few seconds;
the warehouse owner called an opening bid, from which the price could

10
Thomas Capehart, Tobacco Industry Downsizing, Restructuring, USDA AGRIC. OUTLOOK No.
AGO-288: 8 (Jan.–Feb. 2002), available at http://www.ers.usda.gov/publications/agoutlook/
jan2002/ao288c.pdf.
11
According to the USDA, in 2004, 91 percent of all tobacco grown in the United States was
used for cigarettes. U.S. DEP’T OF AGRIC., TOBACCO SITUATION OUTLOOK YEARBOOK
2005, available at http://usda.mannlib.cornell.edu/reports/erssor/specialty/tbs-bb/2005/
tbs2005.pdf [hereinafter USDA].
12
The Third Amended Complaint states “[t]he relevant product market is the purchase of
flue-cured and burley tobacco.” Third Amended Complaint, supra note 4, at 18. Some
American cigarettes contain foreign tobacco (for example, Camel cigarettes contain Turkish
tobacco), but (at least until recently) in relatively small amounts. Tobacco imports have
grown substantially in recent years. See USDA, supra note 11.
13
Id.
14
Id.
15
See id.
16
The bales varied in weight from about 70 pounds for burley tobacco to about 700 pounds
for flue-cured tobacco. For a description of tobacco auctions, see, e.g., Lloyd, Abbot &
Sutton, supra note 4; NICHOLLS, supra note 4, at 257.
 Quality Measurement in the Tobacco Market Page 5 of 14

either rise or fall. Tie bids were allowed, in which case it was left to the dis-
cretion of the warehouse owner how the tobacco was to be allocated across
bidders.17
In the last few years, direct contracts between tobacco companies and
individual growers have largely replaced auctions. In addition to listing a
quantity to be purchased, direct contracts typically specify growing and har-
vesting practices to be followed, chemicals that can and cannot be used, and
the specific leaves that must be provided and when they must be harvested.18
In the year 2000, 28 percent of burley sales was through direct contracts
between tobacco companies and tobacco growers,19 and in 2002, nearly 80
percent of flue-cured tobacco was grown under contract.20 Today, only a
tiny fraction of U.S.-produced tobacco is sold by auction, and the vast
majority of tobacco is sold under direct contract.

IV. AUCTIONS VERSUS CONTRACTS

A variety of mechanisms are used to transfer products from sellers to

buyers—auctions, short-term contracts, long-term contracts, and spot
markets. The particular mechanism chosen presumably depends on the
characteristics of the product and of the buyers and sellers. All forms of
transferring goods from sellers to buyers involve costs, in terms of organiz-
ing, negotiating, and policing sales. Any given buyer – seller pair has the
incentive to adopt the system that minimizes its transaction costs.
Although an enormous theoretical literature investigates the revenue-
generating properties of various types of auctions (and other selling pro-
cedures), relatively few researchers have analyzed the circumstances under
which auctions are preferable to other forms of selling. Wang develops a
model that predicts that the more similar are buyers’ valuations, the more

17
Lloyd, Abbot, and Sutton write, “[i]n the case of tie bids, he [the auctioneer] allocates sales
to tie bidders in rotation.” Lloyd, Abbot & Sutton, supra note 4, at 17. Nicholls writes, “[a]n
auctioneer testified that ‘from 25 to 30 percent of the time,. . . several buyers offer the
maximum bid simultaneously. In this case, he would ‘give them a chance to bid again.’ If
none did so, he would award it to one of them at his own ‘discretion’.” NICHOLLS, supra
note 3, at 259.
18
See Carolyn Dimitri, Contracting in Tobacco? Contracts Revisited, USDA OUTLOOK NO.
TBS-254-01 (June 2003), available at http://www.ers.usda.gov/publications/tbs/jun03/
tbs25401/tbs254-01.pdf, and the copies of contracts that she has made available online at:
Tobacco Contract Information, http://www.cpes.peachnet.edu/tobacco/contracts/contracts.
htm.
19
William M. Snell & Daniel Green, Tobacco Contracting Issues and Update for 2001 (Dep’t of
Agric. Econ., Univ. of Kentucky, 2001), at 2.
20
Dimitri, supra note 18, at 2. One effect of the movement to direct contracts has been a
closing down of tobacco auction warehouses. KENTUCKY TOBACCO TASK FORCE,
LEGISLATIVE RESEARCH COMMITTEE, RES. REP. NO. 301, TOBACCO CONTRACTING IN
BURLEY TOBACCO 6 (Tom Lewis ed., Nov. 2001)
Page 6 of 14 Journal of Competition Law and Economics

likely negotiations will be preferred to auctions.21 The model developed by

Bajari, McMillan, and Tadelis predicts that relatively complex contracts, for
which ex post changes in terms are more likely, will be sold through
one-to-one negotiations, whereas simpler products may be sold through
auction.22 Bulow and Klemperer’s model predicts that expected revenue
from an auction will always be higher than expected revenue from a nego-
tiated sale, implying that an auction will be preferred by sellers unless it is
more costly by a sufficient margin.23 Finally, McAfee and McMillan demon-
strate that expected revenue from an auction increases with the number of
bidders, implying that as the number of bidders falls, an auction becomes a
less attractive form of selling.24
In short, there is no single compelling theoretical argument for the estab-
lishment of auctions rather than direct contracts (or vice versa), or for the
specific features an auction should have.25 Therefore, to understand better
the systems used for selling tobacco leaf, I will turn to an investigation of
how those systems developed.

V. THE HISTORY OF SELLING IN THE TOBACCO MARKET

Suspicion that tobacco selling practices mask anticompetitive behavior is not

a recent phenomenon. For example, in 1950 Anthony Tennant wrote,

In the regions of its use the [tobacco] auction system has long been the subject of contro-
versy. Opponents have charged it is merely the device by which large buyers oppress the
growers, that it is easily manipulated to depress the price of tobacco or to award special
treatment.26

Similarly, in 1951, Nicholls stated,

21
Ruqu Wang, Auctions versus Posted Price Selling, 83 AM. ECON. REV. 838 (1993). The
intuition is that when buyers have similar valuations, a single negotiation will yield close to
the highest available price, and a single negotiation is presumably less costly than holding an
auction.
22
Patrick Bajari, Robert McMillan & Steven Tadelis, Auctions versus Negotiations in
Procurement: An Empirical Analysis, 25 J.L. ECON. & ORG. 372–99 (2009).
23
Jeremy Bulow & Paul Klemperer, Auctions versus Negotiations, 86 AM. ECON. REV. 180
(1996).
24
Preston McAfee & John McMillan, Bidding for Contracts: A Principal-Agent Analysis, 17
RAND J. ECON. 326 (1986).
25
The empirical literature comparing alternative sales procedures is sparser still. Leffler and
Rucker investigate timber sales, and find that auctions are less likely than contracts when the
timber is sold on a per unit basis, and contracts are more likely than auctions when a lump
sum is paid for a given lot. Keith B. Leffler & Randal R. Rucker, Transaction Costs and the
Efficient Organization of Production: A Study of Timber-Harvesting Contracts, 99 J. POL. ECON.
1060 (1991). Bajari, McMillan, and Tadelis, supra note 22, examine procurement contracts,
and they find that the more complex the contracts, and the smaller the number of potential
buyers, the more likely are negotiations to be used rather than auctions.
26
TENNANT, supra note 3, at 206.
 Quality Measurement in the Tobacco Market Page 7 of 14
The oligopsonistic conditions prevailing in the auction leaf market suggest the possibility
that the few large buyers may have developed policies which minimized or avoided
aggressive price behavior in the purchase of leaf.27

I do not intend to address such allegations directly, but rather seek to

demonstrate that one need not resort to theories of anticompetitive behavior
to explain the form that tobacco selling has taken. As the discussion that
follows will indicate, the history of tobacco wholesaling demonstrates the
centrality of the quality measurement problem.

A. Direct Contracts to Auctions28

The standard form of tobacco selling during the early colonial period, when
the large-scale cultivation of tobacco first began, was direct contracting
between seller and buyer. Most tobacco was grown in Virginia, with tobacco
growers selling their goods directly to London merchants, loading the
product on the merchants’ boats at wharves located on the edge of each
individual plantation. This form of selling had two distinct advantages.
First, each load of tobacco could be traced back to a single identifiable
grower. Second, the same growers dealt with the same buyers year after year.
Together, these two things helped ensure the provision of tobacco of the
desired quality—as is well recognized, there is less incentive for one side to
cheat the other when an entire future relationship would be put at risk.29
Consistently, Tennant writes of this period, “There was little point in
packing worthless tobacco or foreign materials when there was a continuing
relationship between buyer and seller.”30
Direct contracts were abandoned when tobacco cultivation spread from
the coastal plantations to the backcountry, which both increased the number
of growers and reduced the average grower’s size. With so many farmers pro-
ducing tobacco in so many places—and most of the growers being very
small—direct contracting was no longer cost-effective. The initial response
was to set up local stores, at which tobacco could be swapped for goods of
various kinds; however, this had the disadvantages inherent in any barter
system. Eventually, market centers were established in major cities adjacent
to the tobacco growing areas—Richmond, Petersburg, Lynchburg, and
Norfolk. Tobacco was packed in hogsheads (oak barrels) in the backcountry

27
NICHOLLS, supra note 3, at 257.
28
This section draws on TENNANT, supra note 3; NICHOLLS, supra note 3; George A. Duncan,
The U.S. Burley Auction Marketing System, in THE U.S. TOBACCO MARKETING SYSTEM:
PROCEEDINGS OF A SYMPOSIUM 1 (Paxton Marshall ed., 1989); Lloyd, Abbot & Sutton,
supra note 4; Robert S. Sowell & Darrell W. Donahue, Alternative Systems for Marketing U.S.
Flue-Cured Tobacco, in PAPERS ON THE MARKETING OF U.S. PRODUCED TOBACCO: TOBACCO
MARKETING COST STUDY COMMITTEE (Paxton Marshall ed., 1990).
29
See, e.g., Benjamin Klein & Keith Leffler, The Role of Market Forces in Assuring Contractual
Performance, 89 J. POL. ECON. 615 (1981).
30
TENNANT, supra note 3, at 210.
Page 8 of 14 Journal of Competition Law and Economics

and transported to the market by river or horse, where, still sealed, the hogs-
head would be sold. Because it was impossible to link the leaves in the hogs-
heads to individual farmers (each hogshead typically contained the produce
of a number of growers), the incentive to cheat increased substantially, and
so did cheating. Farmers included sticks, stones, and dirt in the hogshead,
so as to raise the measured weight.
In 1730, in response to this cheating, Virginia established a system that
prohibited the export of tobacco hogsheads until they had been officially
inspected (nascent tobacco growing areas, Maryland and North Carolina,
passed similar laws soon thereafter). Officially appointed inspectors removed
each and every hogshead from around the tobacco, drove a spike into the
compressed leaves, pried the tobacco apart, and examined it. Only after
inspection had been conducted could the tobacco be shipped.
The system of hogshead inspection worked satisfactorily when tobacco
leaf was of uniform quality and the major objective of the inspection was
keeping rubbish out of the hogshead. Tennant notes that during this period,
tobacco leaves were deemed either “good enough to smoke” or worthless,
with no further quality gradations considered relevant.31 As time passed,
however, buyers began to appreciate that leaves from different parts of the
tobacco stalk produced different flavors. The development of flue-cured
tobacco rendered differences in leaf quality even more important—not only
were cured leaves subject to greater quality variation, but they were far more
perishable (that is, more likely to mold or decay if not packed properly). As
a result, buyers began to frequent tobacco warehouses to inspect the tobacco
after the hogsheads had been opened. From there, it was only a small step
to actual sale at the warehouse, rather than at the marketplace. By the first
quarter of the nineteenth century, the inspector had become an auctioneer,
and hogsheads were auctioned off to the highest bidder.
At these early auctions, hogsheads were still broken open for the buyers
to inspect. However, the packed nature of the tobacco within the hogshead
made it difficult to discern the quality of the tobacco leaf even when the
hogshead was opened. Growers therefore began to leave their tobacco in
loose-leaf form until after purchase, because loose tobacco could be more
easily examined.32 This change was implemented most quickly for flue-
cured tobacco, where quality gradations were most important—by the end
of the nineteenth century, auctioning loose-leaf flue-cured tobacco was the
norm.33 By contrast, burley tobacco, which had fewer quality grades, contin-
ued to be sold through hogshead auction until 1929 (when the last market

31
Id.
32
At the same time, manufacturers were developing local manufacturing facilities, so that
packing in a hogshead for transport was less necessary.
33
By the 1830s, at least some manufacturers were buying loose flue-cured tobacco, and by the
1840s some of this loose tobacco was being sold through the auction warehouses. TENNANT,
supra note 3, at 213.
 Quality Measurement in the Tobacco Market Page 9 of 14

closed); the first loose-leaf burley auction did not open until 1905.34
Furthermore, burley tobacco was more likely to be shipped east for proces-
sing (necessitating packing in hogsheads for transport), and kept better in
hogsheads than did flue-cured tobacco.
By the mid-twentieth century, most tobacco was being sold at auction, in
hand-tied bundles placed on wooden sticks. However, hand-tying was very
labor-intensive, and was subsequently superceded—in the mid-1960s for
flue-cured tobacco35 and in the 1980s for burley tobacco36—by the use of
mechanically packed bales. Although the labor cost savings generated by
mechanical packing were substantial, the use of bales apparently led to an
increase in the mixing of leaves of different quality on the sales floor. This
comingling of quality grades—referred to as “nesting,” because it involves
placing low-quality leaf in the midst of high-quality leaf—has been a
problem of great concern in recent years.37 Lloyd, Abbot, and Sutton define
nesting as “the concealment of inferior tobacco or a different style of
tobacco within sheet of tobacco.”38 Johnson attributes nesting to the fact
that farmers are able to engage in outright cheating without being caught.39
Duncan and Henry estimate that nesting accounts for 1 to 5 percent of
volume of burley tobacco sold,40 whereas Jenkins states that 8 percent of
one company’s purchases turned out to be nested tobacco.41 As will be dis-
cussed, the nesting problem appears to be behind the recent return to direct
contracting for tobacco leaf.
The potentially devastating effect of failing to resolve adequately the
quality measurement problem is perhaps most dramatically illustrated by
what happened in the Maryland tobacco market. Maryland was once an
important producer of tobacco; today, relatively little tobacco is grown there.

34
Id.
35
O. Witcher Dudley III, Seeking an Ideal Tobacco Marketing System, in THE U.S. TOBACCO
MARKETING SYSTEM: PROCEEDINGS OF A SYMPOSIUM 55 (Paxton Marshall ed., 1989).
36
See Duncan, supra note 28.
37
Many of the participants in the 1989 symposium organized by Paxton Marshall cited nesting
as one of the most pressing problems the industry had to deal with. THE U.S. TOBACCO
MARKETING SYSTEM: PROCEEDINGS OF A SYMPOSIUM (J. Paxton Marshall ed., 1989).
Duncan and Henry suggest a number of possible solutions to the nesting problem, all of
which would require significant investment in inspection. George A. Duncan & Zachary
A. Henry, The Burley Bale and Integrity of Leaf in the Burley Sale Lot, in PAPERS ON THE
MARKETING OF U.S. PRODUCED TOBACCO, TOBACCO MARKETING COST STUDY
COMMITTEE (J. Paxton Marshall ed., 1992).
38
Lloyd, Abbot & Sutton, supra note 4, at 20.
39
Paul R. Johnson, Price Differentials for Quality Tobacco, Price Compression and Eliminating Tie
Bids: The Case of Flue-Cured Tobacco, in PAPERS ON THE MARKETING OF U.S. PRODUCED
TOBACCO: TOBACCO MARKETING COST STUDY COMMITTEE 10 (J. Paxton Marshall ed.,
1990).
40
Duncan & Henry, supra note 37, at 93.
41
J.M. Jenkins, Seeking and Ideal Tobacco Marketing System, in THE U.S. TOBACCO MARKETING
SYSTEM: PROCEEDINGS OF A SYMPOSIUM 45 (J. Paxton Marshall ed., 1989).
Page 10 of 14 Journal of Competition Law and Economics

All Maryland tobacco was sold in hogsheads well into the 1930s, long
after hogsheads had been abandoned elsewhere. Hogshead selling was less
problematic when used for Maryland tobacco—Maryland tobacco had fewer
grades than tobacco grown elsewhere, and did not pick up extra moisture
easily (it was a very thin leaf ), so that redrying outside the hogshead was
seldom required. Furthermore, most of the Maryland crop was exported to
France through the late 1920s, necessitating early packing in hogsheads.42
Maryland growers had an apparently captive market in France: French ciga-
rette manufacturers advertised their product as containing “Maryland
Tobacco.” Nonetheless, the inability of French buyers to measure quality
before purchase created a severe cheating problem. Most sellers were too
small to fill an entire hogshead, so that hogsheads were shared. Thus, cheat-
ing, in the form of packing poor material in with one’s own leaf, was imposs-
ible to attribute to any given grower. Not surprisingly, such cheating became
common, so common that French buyers gradually substituted other
tobaccos for the Maryland grades. Maryland tobacco growers thus lost their
principal market, and most went out of business.
In short, the auction system litigated in DeLoach has a long history. It and
its antecedents developed in attempt to deal with the fact that tobacco leaf
varies enormously in quality, quality variation is costly to measure, and the
leaf is purchased in large quantities.

B. Back to Direct Contracts

As was the case with previous changes in selling procedures, the recent
movement from auctions to direct contracts appears to have been driven by
quality measurement problems. For a number of years, tobacco companies
had been complaining about an inability to obtain through auction precisely
the quality of tobacco desired; indeed, both buyers and sellers acknowledged
that the range of quality levels available had dwindled over the years.43 For
example, whereas for many decades flue-cured tobacco was harvested at
four or five separate times (corresponding to the four or five different pos-
itions on the stalk from which the leaves can be taken), the number of har-
vests had shrunk to two or three by the late 1990s, with some growers taking
their entire crop in a single pass. Several economists have suggested that this
is a puzzle: presumably, if the price differentials are sufficient, farmers will
harvest and grade their tobacco more precisely—so why do not companies

42
TENNANT, supra note 3, at 213.
43
The Kentucky Tobacco Task Force put it as follows: “Tobacco companies have been
dissatisfied with aspects of the auction system for quite some time, feeling that they have
been paying premium prices for sub-standard tobacco. . . . The tobacco companies have
indicated that they moved to a contracting system to specify more completely how they
would like their tobacco graded, handled, and processed.” KENTUCKY TOBACCO TASK
FORCE, supra note 20, at 3.
 Quality Measurement in the Tobacco Market Page 11 of 14

simply offer a wider spread of prices so as to obtain a wider range of

quality?44
A plausible explanation is that offering higher prices would not, in fact,
increase the quality range—why would a grower sort more precisely when he
or she would get the same price for unsorted ( possibly nested) product? In
short, there is an Akerloff-style lemons problem.45 An inability to distinguish
among quality levels leads to average quality pricing, which in turn brings
about the removal of higher quality product from the market. As noted
earlier, it was the change from hand-tied bundles to mechanically packed
bales that increased nesting (that is, the mixing of leaves of varying quality).
Auctions create perverse incentives, because they leave the buyer unable to
distinguish one grade of leaf from another, except at very high cost.46
Direct contracts, by contrast, allow tobacco companies to specify precisely
the product attributes they require (for example, position and grade of leaf,
time of harvest, and so forth). Not surprisingly, the most marked character-
istic of the new tobacco contracts is their precise definitions of quality stan-
dards.47 Although cigarette firms vary in the particular mix of tobacco they
seek, the basic quality provisions are fairly uniform across contracts. Among
the terms stipulated are precise definitions of how and in what way tobacco
leaves must be stripped and separated from the stalks, bans on the inclusion
of foreign matter, the agronomic practices to be followed, and the chemicals
that can and cannot be used. The contracts run from one to three years in
duration, and require the grower to sell the entire crop to the buyer under
the contracted terms. The contracts also contain termination and revocation
clauses for “non-conforming” tobacco. Various mechanisms for resolving
disputes (sampling and testing procedures, for example) are defined.

44
Both Johnson, supra note 39, and Snell, supra note 3, blame the lack of quality grading on
the absence of price differentials for corresponding quality differentials. For example, Snell
writes, “limited price differentials send a very disturbing message: Quality is no longer
important. As a result, producers have responded to this market information by adopting
poor quality-control production and marketing practices.” He continues, “A one price/
limited-price differential market provides producers with economic incentives 1) to market
extremely low quality tobacco (that is, trash tobacco or tobacco too high in moisture) and 2)
to mix all grades into one or two grades.” Id. at 14 –16. Although Professor Snell has the
issues right, he appears to have the causality backwards: the fact that growers have the
incentive to do 1) and 2) regardless of the price offered would be expected to lead to a shrinking
of price differentials.
45
George A. Akerloff, “The Market for Lemons”: Quality Uncertainty and the Market Mechanism,
84 Q.J. ECON. 488 (1970).
46
Johnson points out that sorting requires effort, and there is little point in expending
resources if one is not to be compensated for it (and there is no point in trying to
compensate if the buyer cannot establish the quality of the product being sold). Johnson,
supra note 39, at 10,
47
For more details on the specific contractual provisions, see Snell and Green, supra note 19,
and Dimitri, supra note 18, and copies of contracts that Dimitri has made, available online at
Tobacco Contract Information, http://www.cpes.peachnet.edu/tobacco/contracts/contracts.
htm.
Page 12 of 14 Journal of Competition Law and Economics

As one would expect, high-quality tobacco sold through direct contracts

commands a higher price, and low-quality tobacco sells for a lower price,
than equivalent tobacco sold at auction.48 Dimitri puts it as follows:

Tobacco contracts reward high quality and punish low quality. According to industry
experts, this relationship between quality and price is frequently absent from prices in the
auction market, in which growers receive the same price regardless of the grade.49

In the presence of a lemons problem, auctions are unlikely to be the

optimal sales vehicle—only lemons will be put up for auction. Direct
contracts—under which tobacco can be traced to individual growers
and satisfactory provision can be rewarded with subsequent purchases—
reduce a grower’s incentive to cheat. Direct contracts replaced auctions
accordingly.

VI. WHY DID THE SWITCH TO DIRECT SELLING OCCUR WHEN IT

DID?
The thesis of this paper is that quality measurement problems can largely
explain the forms tobacco wholesaling has taken, including the recent switch
to direct contracts. But why did that switch occur recently, rather than
earlier?50
There are several possibilities. First, there has been an enormous consoli-
dation among tobacco growers—as Table 1 shows, the average grower in
1997 was more than three times the size of the average grower in 1959, and
produced nearly five times as much tobacco. With fewer and larger sellers to
deal with, direct contracting becomes much less costly.51
Second, the nature of the demand for cigarettes has been changing (not
simply decreasing) in ways that call for more precise quality measurement.
Demand for well-defined blends (for example, organic) is increasing, which
means that cigarette companies must better control the quality of the leaves

48
Snell and Green examined contracts for burley tobacco and concluded that tobacco sells for
higher average prices under direct contracts than through auction. Snell & Green, supra note
19. Snell and Green find that tobacco sold under contract in the year 2000 went for about 3
cents per pound more than auction tobacco (when the farmer’s savings in grading and
warehouse fees are added in, the differential is a nearly ten cents per pound). Id. at 2. The
Kentucky Tobacco Task Force estimates that growers selling through direct contracts gross
between 8 and 13 cents more per pound on average. KENTUCKY TOBACCO TASK FORCE,
supra note 20, at 6.
49
Dimitri, supra note 18.
50
Recall that hand-tied bundles were replaced by more-difficult-to-inspect mechanically
packed bales in the 1960s (flue-cured tobacco) and the 1980s (burley tobacco).
51
It is worth noting that there has also been a consolidation among cigarette manufacturers.
Recall McAfee and McMillan’s prediction that the expected revenue from an auction
increases with the number of bidders. Auctions become a less attractive means for farmers to
sell their tobacco as fewer and fewer bidders participate. McAfee & McMillan, supra note 24.
 Quality Measurement in the Tobacco Market Page 13 of 14
Table 1. Tobacco farms over time

Number Acres Output Acres/ Pounds/

of farms (pounds) farm farm

1959 415,315 1,108,274 1,646,512,924 2.67 3,964.49

1964 331,365 1,025,240 1,987,526,982 3.09 5,988.00
1969 276,188 876,927 1,643,934,800 3.18 5,952.23
1974 197,764 877,113 1,733,365,121 4.44 8,764.82
1978 188,649 963,224 1,918,189,782 5.11 10,168.04
1982 179,141 931,655 1,871,309,459 5.20 10,446.01
1987 136,682 633,310 1,215,221,360 4.63 8,890.87
1992 124,270 831,231 1,697,831,562 6.69 13,662.44
1997 89,706 838,530 1,747,702,321 9.35 19,482.56

Source: Historical Highlights, in NAT’L AGRIC. STAT. SERVICE, U.S. DEP’T OF AGRIC., THE
CENSUS OF AGRICULTURE (1997).

they use.52 In addition, there are rising concerns about possible FDA regu-
lation, which would make the cigarette manufacturers liable for the chemi-
cals applied in the growing of the tobacco. Direct contracting allows
cigarette companies to specify which pesticides and fertilizers may be
employed (many of the contracts contain just such clauses). Finally, there is
also rising concern about the cancer-causing agent nitrosamine, which tra-
ditional forms of flue-curing produce; direct contracting allows manufac-
turers to require an alternative curing technology.53 In short, as Brown and
Vukina put it, “Purchases via contracts would allow the cigarette manufac-
turer to monitor the agricultural chemicals used on growing tobacco to
ensure the integrity of the tobacco and make farmers accountable for any
illegal agricultural chemical applications to the tobacco.”54
Finally, although this is not a new phenomenon, it is worth noting that
the federal tobacco program probably exacerbated the inefficiencies of the
auction system, further increasing the attractiveness of direct contracting.
For example, both Canada and Zimbabwe sell flue-cured tobacco through
one central auction,55 whereas the United States mandates that auctions be

52
One manufacturer has been using organically grown tobacco, which it has been purchasing
through direct contracts for several years. Blake Brown & Tomislav Vukina, Provision of
Incentives in Agricultural Contracts: The Case of Flue-Cured Tobacco (manuscript, North
Carolina State Univ., 2001). Smokeless tobacco has been produced and sold under direct
contract for some time. Kelly Tiller, Tobacco Issues: Contracting and Use of Tobacco Settlement
Payments, AGRIC. OUTLOOK FORUM 2001 (2001)
53
Brown and Vukina estimate that the new curing technology costs $3,000 to $6,000 per barn.
Brown & Vukina, supra note 52, at 5. This could have two effects. First, in the absence of a
secure and certain sales outlet for his or her tobacco, the average grower may not be willing
to make that investment; direct contracts provide this security. In addition, the investment
(obviously) raises the grower’s fixed cost (by a little bit, at least), which implies a further
increase in the size, and reduction in number, of growers, with the effect discussed earlier.
54
Id. at 7.
55
Id. at 6.
 Page 14 of 14 Journal of Competition Law and Economics

held in local warehouses (about 200 altogether), increasing the cost of using
auctions.56 Recall Bulow and Klemperer’s contention that sellers will prefer
an auction to direct negotiation at equal cost, but if the cost of auctions rises
sufficiently, sellers will be better off with direct negotiation.57

VII. CONCLUSION

Tobacco selling procedures have frequently been termed collusive. Indeed, a

suit alleging collusion by tobacco purchasers recently brought about one of
the largest antitrust settlements in history. This paper reviews the history of
tobacco wholesaling and provides an alternative explanation: the procedures
used to sell tobacco leaf developed to minimize the costs associated with
measuring quality. If quality measurement problems are at the heart of
tobacco wholesaling procedures, changes in the wholesaling procedures
should be associated with changes in the quality measurement problem.
As a review of the history of tobacco leaf selling indicates, that is, in fact,
the case.
Interestingly, the recent trend towards direct contracting is not restricted
to tobacco markets: between 1969 and 1993, the proportion of all agricul-
tural production under direct contracts ( production or marketing) rose from
12 to 32 percent of the total value of commodities sold. These figures are
cited by Brown and Vukina, who explain them as resulting from

[T]he ever more sophisticated marketplace where consumers are increasingly requiring a
more uniform product supply and standardization in quality. Contracts are one vehicle
through which food processors and marketers can respond rapidly to changes in custo-
mer preferences.58

In other words, as with tobacco, quality measurement concerns may be

responsible for the movement towards direct contracting.

56
Federal law mandated that growers sell at a warehouse within 100 miles of the country seat
where the tobacco was grown. Lloyd, Abbot & Sutton, supra note 4. The average U.S.
warehouse was selling less than 300,000 pounds of tobacco per week in the late 1980s,
versus 4 million pounds per week in Canada and 10 million pounds per week in Zimbabwe.
See Sowell & Donahue, supra note 28, at 53. Sowell and Donahue suggest that U.S. selling
costs are at least twice those of producers in Canada or Zimbabwe. Id. More recently,
officials estimated in 1995 that the combined cost to growers and buyers of selling 1kg of
flue-cured tobacco was $0.45 in the United States versus $0.16 in Zimbabwe. See Brown &
Vukina, supra note 52, at 6.
57
Bulow & Klemperer, supra note 23.
58
Brown & Vukina, supra note 52, at 12. Marketing contracts are most common for fruits and
vegetables, accounting for more than 40 percent of total production, by sales value. Large
farms (that is, those with sales greater than $250,000 per year) account for the bulk of direct
contracts. See Economic Research Service, U.S. Dep’t of Agric., More Farmers Contracting to
Manage Risk, AGRIC. OUTLOOK (Jan.– Feb. 1999).

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