American Wine EconomicsAn Exploration of the U.S. Wine Industry

James Thornton

U N I V E R S I T Y O F C A L I F O R N I A P R E S SBerkeley • Los Angeles • London

To Julie, Robert, Sarah, and the memory of my parents

List of Illustrations ix

List of Tables xi

Preface xiii

Acknowledgments xv

Introduction 1

1 The Economic Approach to the Study of Wine 11

2 The Wine Product 34

3 Wine Sensory Characteristics 41

4 Grape Growing 53

5 Grape Markets and Supply Cycles 72

6 Wine Production 83

7 Bulk Wine, Private-Label Wine, and Wine Alcohol 105

8 Wine Distribution and Government Regulation 124

9 The Wine Firm 149

10 Wine-Firm Behavior 180

11 The Wine Consumer and Demand 208

12 The Wine Consumer, Quality, and Price 240

13 The Globalization of Wine 276

Conclusion 299

Notes 309

References 327

Index 337

Contents

ix

1. Demand curve for wine / 20

2. Supply and demand curves for wine / 28

3. Change in wine demand / 29

4. Change in wine supply / 30

5. Wine-grape supply cycle / 78

6. Grape surplus, shortage, and cycles / 80

7. Market for bulk wine / 113

8. External cost of alcohol consumption / 135

Illustrations

xi

1. U.S. annual wine sales, 1991–2010 / 211

2. U.S. wine consumption per capita, 1951–2010 / 213

3. U.S. annual average price of wine per 750 ml bottle, 1991–2010 / 215

4. Market share by price segment / 218

5. National shares of wine production by total volume, volume of exports, and value of exports, 2009 / 283

6. National shares of wine consumption by total volume, volume of imports, and value of imports, 2009 / 283

7. Number and size distribution of wine fi rms by nation / 289

8. World percentage shares of the largest wine fi rms / 289

Tables

xiii

The wine industry in the United States is growing rapidly, and wine consumption is becoming an increasingly important part of American culture. The United States now consumes more wine than any other nation in the world. The wine market has recently received increased attention within the discipline of economics. The American Association of Wine Economists, an educational organization started in 2006, is dedicated to promoting economic research on topics related to the wine industry and publishes The Journal of Wine Economics. Colleges are beginning to offer courses in wine economics. As wine consumption increases, so does the demand for wine knowledge. Today, wine is a popular topic that interests and mystifi es many people. Numerous books have been written about wine appreciation, wine tasting, wine history and culture, and different facets of wine business. While many of these describe various economic aspects of wine, they fail to provide a unifi ed and systematic treatment of the wine industry from an eco-nomic perspective. The purpose of my book is to fi ll this void. This book has three specifi c objectives. First, it gives a detailed description of the economic organization of the U.S. wine industry. Information is provided about wine’s unique attributes; grape growing, wine produc-tion, and wine distribution; wine fi rms and consumers; and grape and wine markets. Second, the book uses economic principles to shed light on the behavior of wine producers and consumers in a manner that is accessible to noneconomists as well as students of economics. Lastly, it

Preface

summarizes fi ndings and presents insights from the growing body of studies related to the economics of the wine industry.

This book is intended not only for students of economics but for anyone interested in learning more about the U.S. wine industry from an economic perspective. No formal background in economics is assumed. Analytical material emphasizes the application of economic concepts and principles, which are clearly explained before they are used, supplemented by numerous anecdotes and examples. As a result, this book can be read on its own by wine enthusiasts or used as a sup-plement to a source that contains more formal and rigorous methods of economic analysis by advanced students of economics. Instructors may fi nd it useful as an organizing text for courses in wine economics or as a supplemental text for courses in the economics of industrial organiza-tion or applied economics. It might be read with some benefi t by profes-sors of economics interested in the emerging fi eld of wine economics. It could also serve as a primer for wine professionals who have a limited background in economics.

xiv | Preface

xv

I would like to thank all the economists who have contributed to the development of the emerging fi eld of wine economics. Articles in The Journal of Wine Economics and working papers published by the American Association of Wine Economists were particularly valuable sources for this book, and their authors were a source of inspiration.

I also owe a debt of gratitude to my teachers who inculcated the eco-nomic way of thinking. Special thanks to my mentor, Kelly Eakin, who taught me never to lose sight of basic economic principles and their many applications.

I am especially grateful to Blake Edgar of the University of California Press. His vision of a book on wine economics and the guidance he provided made this book possible. Copyeditor Peter Dreyer and several anonymous reviewers also made suggestions that signifi cantly improved the organization, presentation, and content of this book.

Thanks to Rod Johnson and the other wine professionals who have taken the time to talk with me about the wine industry.

Last, I thank family members for their contribution and support. Sarah McIntire urged me to write a book and enthusiastically followed my progress. Robert McIntire and Janet Daly provided much appreci-ated moral support. Charlie Thornton read an early draft and shared his knowledge of viticulture. Mary Thornton stoked my interest in wine. Paul and Valerie Thornton endured a week-long vacation of wine “lectures” by me and asked many thought-provoking questions about

Acknowledgments

wine-related issues. My parents, Arthur and Paula Thornton, always encouraged me to make the most of my abilities, and for that I am very grateful. Most of all, I thank my wife, Julie. Her enthusiastic encourage-ment and support motivated me to devote the long hours necessary to write this book.

xvi | Acknowledgments

1

This book focuses on the organization, structure, and institutional fea-tures of the wine industry in the United States, and on how U.S. grape growers, wine producers, distributors, retailers, and consumers interact and behave in the market for wine. Wine production and consumption are becoming an increasingly important part of American culture. The U.S. wine industry is growing rapidly and now embraces thousands of fi rms, ranging in size from small family-run businesses to large modern corporations, including multinational conglomerates. Many of these fi rms have nonprofi t as well as profi t objectives. The wine market includes not only buyers who are brand-loyal but also wine snobs and consumers who engage in conspicuous consumption and often equate price with quality, sometimes therefore exhibiting seemingly uneco-nomic or irrational behavior.

Wine is a complex and intriguing product with unique qualities that make it signifi cantly different from a typical manufactured good. It arouses the intellect, pleases the senses, enhances food, promotes good health when consumed in moderation, and has a long and interesting economic history. Because of these attributes, the wine industry lends itself to an interesting and entertaining application of economic con-cepts and microeconomic analysis. Finally, wine economics is emerging as a new specialized fi eld of study within the discipline of economics. A new breed of economist, the wine economist, is starting to populate economics departments, and students are beginning to enroll in wine

Introduction

2 | Introduction

economics classes. Practitioners of the dismal science have caught the wine bug.

THE ECONOMIC IMPORTANCE OF THE WINE INDUSTRY

There are more than 7,000 domestic wine fi rms in the United States.1 In the decade prior to 2012, their number increased by about 7 percent annually, and this trend is predicted to continue unabated. There is at least one wine producer in each of the fi fty states, including fi ve in Alaska, and twelve states have more than 100 wineries. Wine tourism has paralleled the growth of wine fi rms. Estimates suggest that each year, close to 30 million people now visit wineries. In addition, there are more than 23,000 grape growers in the United States, and about half of these produce wine grapes. The dollar value of grape production is higher than that of any other type of fruit grown in the country. Hun-dreds of distributors are involved in delivering wine to consumers through thousands of retailers. Wine-related activities create in excess of a million jobs and contribute more than $160 billion to the U.S. economy each year. One hundred million Americans drink wine. About eleven million of these do so daily, and another forty-fi ve million imbibe at least once a week. Per capita wine consumption has increased each year since 1994, even during the severe recession of 2007–9. Total wine consumption in the United States is now higher than in any other coun-try in the world, but per capita consumption still lags behind thirty-two other wine-consuming nations, which suggests that there is plenty of room for the industry to grow in the future.

THE STRUCTURE OF THE WINE INDUSTRY

From an economic standpoint, the most important characteristics of the structure of a market are the number and size distribution of sellers and buyers, the degree of product differentiation, and the ease with which new fi rms can enter the industry. These attributes signifi cantly infl uence the behavior of fi rms in an industry.

As in most competitive markets, there are a large number of sellers and buyers of wine: thousands of domestic wine fi rms and millions of wine consumers. However, a handful of large fi rms dominate sales of wine by the case. The three largest, E. & J. Gallo, The Wine Group, and Constellation Brands, account for 50 percent of domestic case sales; Gallo alone sells 75 million cases of wine per year in the United States,

Introduction | 3

and another 5 million in eighty foreign countries. The twenty largest fi rms have a combined market share of roughly 90 percent. This means that the remaining 7,000+ wine fi rms account for only 10 percent of the U.S. wine market. However, the degree of market power that large wine fi rms possess is mitigated by signifi cant competition from foreign wine producers, whose exports to the United States account for roughly one-third of sales. What is more, the wine industry can be separated into several submarkets based on the perceived quality and price of wine products. The lower-priced segment of the market is dominated by big fi rms that strategically consider the reactions of their rivals when making pricing and product decisions, while the higher-priced luxury submarket is occupied by a relatively large number of small boutique fi rms who act independently. The mid-price premium segment is a hybrid of the low- and high-quality submarkets and includes a substan-tial number of small proprietors, many medium-sized fi rms, and rela-tively few large producers.2

From an individual wine fi rm’s perspective, the large number of wine consumers does not necessarily translate into an equally large number of wine buyers. Ninety percent of wine produced in the United States is sold to retailers and consumers through distributors, as to a large degree required by state laws. The distributor segment of the wine market is highly concentrated. The fi ve largest distributors purchase 50 percent of the wine produced by domestic wine fi rms. The largest twenty distribu-tors have a market share of about 75 percent. The remaining 25 percent of purchases are accounted for by a few hundred smaller distributors. This means that thousands of wine fi rms must compete to sell their products through a relatively small number of highly concentrated dis-tributors. The alternative is for wine fi rms to sell their products directly to consumers, which given the restrictions imposed by current state laws governing wine distribution and sales can be very diffi cult.

The extremely large number of highly differentiated products offered for sale by fi rms, and the large range of prices that consumers are will-ing to pay for these products, are typical of the wine industry. Wine fi rms in the United States produce and sell more than 15,000 wine prod-ucts. No other industry offers consumers so many product choices. Consumers believe that these products have signifi cantly different char-acteristics. Because of product differentiation, all wine fi rms, both big and small, have a degree of market or monopoly power. Consumers make buying decisions by comparing wine characteristics as well as price. The greater the degree of differentiation of a wine fi rm’s product,

4 | Introduction

the less sensitive consumers will be to a price change, which gives the seller more discretion in setting its price. Differences in wine products can be real or imagined. Wines may differ in terms of their appearance, smell, taste, grape variety, location where the grapes are grown, viticul-tural practices, vinifi cation methods, vintage, label, brand image, pres-tige, and wine critics’ scores, as well as other ways. These perceived differences result in enormous differences in prices among wine prod-ucts. Consumers can purchase a bottle of Charles Shaw wine for as little as $2 in California. On the other hand, a bottle of Screaming Eagle wine sold at auction in 2007 for $3,117.

Unlike in most industries, the ease with which fi rms can enter the wine industry depends in large part on the segment of the market in which they want to compete. New fi rms face few barriers in entering the premium and luxury submarkets, as evidenced by the hundreds of new wine fi rms launched each year. By contracting with an independent vineyard to buy grapes and a custom-crush winery to produce and bot-tle the wine, one can start a small virtual winery that sells a premium or luxury wine with an investment of less than $25,000. A fulfi llment agent can handle the logistics of processing orders and shipping the wine to consumers who submit orders on the proprietor’s website. Most of these activities can be organized and coordinated by telephone or Internet thousands of miles from the location where the grapes are grown and the wine is produced, if the proprietor so chooses. On the other hand, new fi rms face substantial barriers in entering the commod-ity segment of the wine market, which is characterized by economies of large-scale production. To achieve the low unit costs necessary to compete with large fi rms like Gallo and The Wine Group would require a multimillion dollar investment in plant and equipment, as well as millions more for the advertising necessary to persuade brand-loyal consumers to purchase the new wine product.

GOVERNMENT REGULATION OF THE WINE INDUSTRY

The wine industry is characterized by a complex maze of government regulations. Wine, beer, and spirits have the dubious distinction of being the only product class in the U.S. economy to have merited a constitu-tional amendment. The Twenty-First Amendment to the Constitution gives each state the right to regulate the production, distribution, and sale of alcoholic beverages within its borders. States have responded by enacting about 4,000 different laws to regulate suppliers of wine, beer,

Introduction | 5

and spirits. While each state promulgates its own laws, most states require wine to be delivered to consumers through a regulated three-tier distribution channel. Wine fi rms are required to sell their products to licensed distributors, who sell them to licensed retailers, who sell them to consumers. In some states the distributor or retailer is the government itself. Moreover, wine fi rms are prohibited from vertically integrating forward; that is, they cannot own a distributor or retailer. Virtually all states impose additional regulations on the behavior of the producers, distributors, and retailers that operate within the three-tier channel. These may include franchise and territory laws; quantity discount, mini-mum markup, “post and hold,” and uniform pricing regulations; prohi-bitions on credit transactions; and warehousing restrictions; as well as various other regulations. Most states have exceptions to the three-tier distribution requirement that allow wine fi rms a limited opportunity to sell their products directly to consumers, and a few permit direct sales to retailers. However, the direct-to-consumer and direct-to retailer chan-nels in most states are subject to burdensome rules and regulations that make using these channels either challenging or unfeasible.

Why do states regulate the distribution and sale of wine? Why do wine regulations differ across states? What are the economic effects of these regulations on consumers, producers, distributors, and retailers? Do these regulations serve the public interest or special interest? Economic analysis can be used to address these questions.

WINE FIRMS

A wine fi rm is an entity that produces and sells wine. However, to qual-ify as such, must this entity grow its own grapes or can it purchase grapes from independent vineyards? Must it own a winery, or can it contract with another fi rm to produce its wine products? Must it be involved in selling wine to consumers, or can it contract with other fi rms to do so? What if wine is sold under the brand name of an entity that performs none of these activities itself? Should this entity be con-sidered a wine fi rm? Everyone would agree that E. & J. Gallo is a wine fi rm. It grows grapes on thousands of acres of company-owned vine-yard, produces a variety of wine products in seven Gallo wineries, and is directly involved in distributing and selling millions of cases of wine to consumers. But what about the legal entity named Castle Rock Winery? In 2011, consumers purchased 600,000 cases of wine sold under the Castle Rock label, but the Castle Rock Winery does not own

6 | Introduction

a single vineyard or wine-production facility. It contracts with a variety of independent vineyards, wineries, and distributors to produce and sell Castle Rock products. Can Castle Rock Winery really be considered a wine fi rm? If so, then what about Whole Foods Market? Whole Foods contracts with a number of independent wineries to produce more than 100 private-label wine products that it sells directly to consumers in its retail stores across the United States. Surely, if Castle Rock is a wine fi rm, then Whole Foods qualifi es as a wine fi rm also, does it not?

To produce and sell wine, a wine fi rm must make a number of choices. How should it organize and coordinate grape growing, wine production, and wine distribution? What tasks should be performed within the fi rm and which should be contracted out to other fi rms? What particular technology and method of production should be used for tasks done by the wine fi rm itself? How many and what types of wine products should be offered for sale to consumers? What qualities should these products have, and what prices should be charged? How much effort should be devoted to marketing and promoting these wines? The choices a wine fi rm makes determines how it will behave. Some fi rms choose to specialize in producing high-quality premium or luxury products, and others focus on lower-quality commodity wine. Some choose to convey information about wine quality to consumers by building a reputation based on past performance, while others spend a large amount of money to establish a brand name. Some grow their own grapes and make wine in their own production facilities; others contract with independent vineyards and custom-crush producers. Among those who grow their own grapes, some harvest them by hand and others use mechanical harvesters. Why do wine fi rms make such different choices and display such different behavior?

To explain and predict wine fi rms’ behavior, it is necessary to make an assumption about what motivates a wine fi rm to make the choices that it does. Economists typically assume that the objective of a fi rm is to maximize profi t. This implies that it will choose a course of action only if the amount it will add to total revenue is expected to exceed the increment in total cost. The major advantage of making this assumption is that it yields specifi c explanations and predictions. For instance, a fi rm will always choose the technology and method of production that minimizes cost. It will contract with an independent grape grower or winery to produce grapes or wine only if doing so is cheaper than per-forming these tasks itself. It will choose the profi t-maximizing quanti-ties and prices of wine products it sells. It will strive to increase the

Introduction | 7

quality of the wine products it sells if this is expected to result in increased profi t.

The assumption of profi t-maximization would seem to be reasonable for large wine fi rms that are legally organized as corporations. How-ever, it may not be a valid assumption for the vast majority of smaller wine fi rms, many of which are sole proprietorships. Anecdotal evidence and surveys of the attitudes of proprietors suggest that owners of these wine fi rms often have nonprofi t objectives. Many seem willing to trade off profi t for the prestige or aesthetic value of making a high-quality wine product that gets accolades from wine afi cionados and high scores from wine critics. Others appear to willingly trade off profi t for the enjoyment they experience from the lifestyle of a wine proprietor who owns a picturesque vineyard and winery, tends the land, and employs family members.

This raises several interesting economic questions. Can wine fi rms with nonprofi t objectives survive over time in an industry that includes profi t-maximizing wine fi rms? A standard economic argument is that fi rms that fail to minimize cost and maximize profi t in a competitive environment are not viable in the long run. Does this argument apply to the wine industry? If not, how will these non-profi t-maximizing wine fi rms behave? How does this behavior differ from that of profi t-maximizing wine fi rms?

WINE CONSUMERS

A fundamental assumption in economics is that consumers behave as if they are rational when making buying decisions in the marketplace. When considering a wine purchase, a rational consumer evaluates the benefi t and cost of a wine product and buys it only if the benefi t out-weighs the cost. The benefi t of purchasing additional units of a product declines as more is consumed, because each additional unit has a lower value to the consumer than the previous one. This implies that a ratio-nal individual will buy more of a wine product over the course of say a month if the price falls and less if the price rises, assuming that income or other factors that may affect wine consumption do not change. This relationship, called the law of demand, is used by economists to explain and predict consumer behavior and has been validated by numerous empirical studies for a wide range of goods and services.

Many observers of the wine market maintain that wine consumers often display irrational behavior, however, and that the law of demand

8 | Introduction

may therefore be violated for individual wine products, or even for wine purchases in the aggregate. Stories of seemingly irrational wine consum-ers abound. Here are a few. Price has little if any infl uence on the wine-buying decisions of many people who are in the habit of drinking wine with meals. Not only are some people unresponsive to price changes because of brand loyalty, but wine snobs and conspicuous consumers abound in the luxury segment of the wine market, and those who buy wine to be exclusive or advertise their wealth tend to buy less of a lux-ury wine when price falls and availability increases. A typical wine buyer uses price to assess quality: a higher price is always equated with higher quality. Lower the price of a wine, and these consumers will buy less, because they now see it as a lower-quality product, even if the smell and taste have not changed. Wine consumers typically cannot taste a wine before purchasing it, so how can they rationally evaluate its sen-sory qualities? And many who buy wine are unduly infl uenced by wine critics, whose quality scores affect and shape their preferences. How can this be rational?

Do most wine consumers behave as if they are rational? Do wine products, like other goods and services, obey the law of demand? How do income, tastes and preferences, the prices of beverages related to wine, like beer and spirits, and wine quality affect wine consumption? How do consumers assess wine quality, and what characteristics of wine do they value most highly?

THE WINE PRODUCT

Wine looks nice. It can be clear, brilliant, and sparkling, with a range of intense, distinctive, and stunning colors. Wine smells and tastes good. It can have a variety of interesting aromas and fl avors, including fruit, fl owers, spice, earth, vanilla, chocolate, smoke, and meat, as well as a mouthfeel that is fi rm, crisp, or silky. Wine enhances food. Wine and food are natural complementary goods because the acidity, alcohol, tannin, and residual sugar in wine make most types of food taste better. In moderation, wine promotes good health. Hundreds of studies fi nd evidence that a glass or two of wine each day reduces the risk of heart disease, stroke, diabetes, and possibly certain types of cancers.

The complexity of wine arouses the intellect and makes it interesting to study, contemplate, describe, and discuss. It is a complex agricultural good, deriving from grapes of a particular vine variety, climate, soil, landscape, farming practices, production technology, and maturation

Introduction | 9

and storage conditions. Its more than 300 natural compounds produce a seemingly infi nite number of possible aromas and fl avors. These com-pounds can give different wines a distinctive character and personality, which varies depending on where the grapes are grown, the viticultural techniques used, and the vinifi cation methods employed.

Winemaking began more than 5,000 years ago and was regarded in antiquity as a gift from the gods. Throughout the history of civilization, wine has played an important role in commerce, social interaction, religion, and even public health, since historically it was safer to drink than water, and it was often used for medicinal purposes. Today it is an integral part of European culture and is fast becoming an inextricable component of American lifestyles.

THE ORGANIZATION OF THIS BOOK

The remainder of this book is organized into six parts. Chapter 1 dis-cusses important concepts and principles that underlie the economic approach to the study of wine and illustrates how they can be applied to wine-related phenomena.

Chapters 2 and 3 discuss the complex nature of wine, viewed as a class of differentiated goods composed of a common bundle of sensory and nonsensory characteristics. These characteristics and the important notion of wine quality are examined.

Chapters 4 through 8 focus on the three important activities required to produce and sell wine: grape growing, wine production, and wine distribution. Chapter 4 discusses wine-grape planting, growing, and harvesting decisions and the potential trade-off between grape yield, cost, and quality. Chapter 5 describes the spot and long-term contract markets for wine grapes and provides an economic explanation of regu-larly recurring wine-grape supply-and-demand imbalances that culmi-nate in periods of fi nancial boom and bust for grape growers. Chapter 6 covers the economic activity of wine production and emphasizes the pivotal role of the winemaker in the determination of the style, quality, and cost of wine products. Chapter 7 focuses on three important topics related to wine production: bulk wine, private-label wine, and wine alcohol. The pivotal role of the bulk-wine market is explained, and a supply-and-demand framework is used to analyze factors that affect the price and quantity of this intermediate good. Next, the forces underly-ing the trend toward private-label wine and its implications for wine fi rms are discussed. Finally, the controversial issue of the high and rising

10 | Introduction

alcohol content of wine is examined. Chapter 8 delineates wine distri-bution and focuses on the three principal channels available to wine fi rms to deliver their products to consumers. The complex maze of gov-ernment regulation of the distribution system is described, and the eco-nomic effects of these regulations and the behavior of regulators are examined.

Chapters 9 and 10 are devoted to the wine fi rm. Chapter 9 develops the notion of a wine fi rm as a legal entity that organizes and coordinates grape growing, winemaking, and wine distribution. The different ways in which a wine fi rm can be legally organized, the types of contracts it can enter into, and the economic implications of different organiza-tional forms and contractual arrangements are discussed. The objec-tives of wine-fi rm owners and the structural characteristics of the wine market that impose constraints on their choices are discussed. Chapter 10 analyzes wine fi rms’ behavior. It provides an explanation of how they determine the quality of their products, price them, and communi-cate information about their quality to consumers.

Chapters 11 and 12 concentrate on the wine consumer. Chapter 11 begins by describing the demographic characteristics of wine consum-ers, and trends and patterns in wine consumption in the United States. It then analyzes the effect on wine consumption of price, income, prices of related goods, and consumer tastes and preferences. The results and implications of empirical studies of wine consumption are summarized and discussed. Chapter 12 explains how economists measure the value consumers place on the sensory and nonsensory characteristics of wine and analyze the effect of these attributes on prices. The fi ndings of empirical studies of wine quality and price are presented and used to address a number of issues related to consumer behavior, the infl uence of wine critics, and the informational effi ciency of the wine market.

Chapter 13 discusses the trend toward wine globalization, the struc-ture of the global wine industry, and the degree to which the United States participates in the global wine market. Lastly, the conclusion highlights and summarizes insights about wine in America obtained from the economic principles and empirical studies presented in this book.