Friday, October 31, 2008

Bud American Amber: What Does it Mean to Oregon's Craft Brewers?

Over at Beervana, Jeff poses a question about the effect on craft brew sales if Budweiser's American Ale (which he proclaims is not half-bad) is a hit. Could it, he wonders, actually help sales of craft beers by bringing in new customers that would previously not look past macro-brews? Does this theory make sense economically? Well, yes.

Maureen Ogle points out that this idea is not new to the business of, shall we say, 'sophisticated foods.' That Starbucks appears to help nearby coffee shops instead of hurt them.

First the economics. It is pretty obvious to everyone that there are two competing forces at work here - the expansion of overall demand and the capturing of that demand by particular brands. In cases where the niche demand is a small part of the overall demand for the basic category (beer or coffee in our two examples) one might expect that the increase in overall demand to outpace the capturing of the market, especially at first. In economics terms, is American Ale a complement to craft brews or a substitute? Here are some thoughts:

One wonders is what the end game is. Budweiser has huge advantages in scale, supply chain, distribution and marketing: once the demand for taste in beer hits its zenith, what next, do brewers start competing heavily on cost. If so, this is where Bud wins. However, if the entire demand expansion is based on the idea that beers are distinctive and diverse, it will be hard to dominate with a single beer.

I think that while Bud AA might lead to a vast increase in overall demand for craft brewed ales, it will probably have a bigger impact on beers that have gone for the mainstream, like Fat Tire, with which AA compares favorably, according to Jeff. It is their part of the demand curve that is most contestable by a large brewer.

If American Ale is not an immediate hit for Bud, and I am guessing it will not be, will the marketing types and bean counters at AB have patience and allow it to gain traction, or will the profit motive be so strong that they will abandon it quickly? I give it 50-50 odds.

In the current economic climate, it is a hard time to turn Bud drinkers on to a more expensive beer, will Bud keep prices low to allow it to sell?

Finally, a large part of the craft brew demand is from folks who relish being 'in the know' and cherishing the latest iconoclastic small brewer, will this scuttle Buds attempt to crash the party?

Time will tell...

Apropos of nothing: I picked up a bottle of Elysian's Immortal IPA the other day and noticed, when I cracked it that it was contract brewed by New Belgium. Thus it has the curious distinction of being both the best beer New Belgium brews, and a terrible purchase for a Northwesterner concerned with the carbon footprint of his purchases.

Tuesday, October 28, 2008

Distributors and Double Marginalization

From the Beervana blog, Jeff Alworth points us to an interesting article in Reason magazine. Forgetting the political angle, the article does a good job of describing a quirk in the market for beer - laws requiring a distributor in order for a bottling brewery to sell beer in retail outlets. I have blogged about distributors before, arguing that there may be an efficiency argument for them. Today, I simply want to describe the economics behind this statement:

"For decades wholesalers have quietly added 18-25 percent to every bottle of beer, glass of wine, and shot of liquor you pour down your gullet."

This makes intuitive sense undoubtedly, but what are the economics of it all? It turns out this is a classic case of "double marginalization." Double marginalization occurs when you have two imperfectly competitive firms in a 'vertical' relationship. Vertical refers to the producer/retailer relationship generally, and in this case it is the producer/distributor relationship. Clearly beer producers are not perfect competitors, they do not sell a homogenized product for one, and neither are distributors that have exclusive rights to sell to retailers particular beers. [Note that if they were perfectly competitive, then there would be no problem as price would always equal the marginal cost of providing the beer for sale]

So what happens? Well the basic story is that both firms want to extract their profits and in so doing end up creating a retail price that is significantly higher, and a quantity that is significantly lower, than it would be if they merged (or if breweries could distribute themselves). Here is (I know you were hoping for one!) the graph:

In this picture the demand curve for the downstream firm, or distributor, (denoted d) is given in blue. [In this case we make the simplifying assumption that both firms are simple monopolists - but any market power is enough for the analysis to follow] This is the demand for beer from retail establishments which (since they are highly competitive) closely resembles the demand for beer in the market. Since the distributor is a monopolist they make their price and quantity decision where their marginal revenue (denoted MRd) equals their marginal cost (denoted MCd). Their marginal cost is the price they have to pay the brewer. From this quantity (qu = qd ) they would charge their margin which is the difference between MCd and Pd. Thus the distributor gets a profit equal to the dark red shaded area.

So where does MCd come from? Well, note that depending on what the brewer (the upstream firm = u) charges, the quantity demanded will be read off of the downstream firm's MR curve. Thus the downstream firm's MR curve is the same as the upstream firm's demand curve, creating an upstream firm MR curve. The brewer's MC curve comes from the cost of making the beer and so they set MRu=MCu and lo and behold, the quantity demanded from the brewer is the same as a the quantity sold by the distributor, qu = qd. The brewer's profits are given by the light red shaded area. So consumers would pay pd (assuming competitive retailers) and consume qu = qd beer.

Now let's consider what would happen if the brewery distributed itself (getting rid of the middle person). They would now face the blue demand curve, set quantity at q* and the price would be at p* = pu. The brewer's profits would now be both the light red and the blue shaded areas. So consumers would pay less (p* instead of pd), consume more and brewers would earn more profits.

Interestingly, I once had the owner of an Oregon brewery tell me that he/she likes distributors and thinks that they should remain in place. The owner said that the distributors were their advocates in retail establishments far and wide that they otherwise would not have access to. Perhaps then distributors provide a service not accounted for by this analysis. But if this is efficient, then doing away with laws requiring distributors should leave them in place.

I, for one, would love to see that experiment.

NB: "Marginal" refers to the extra cost or extra revenue from making and selling one more bottle of beer. Marginal revenue is below demand because for a monopolist, making and selling one more bottle means that you have to charge just a little less to get the last person to buy it. But this means that you charge that slightly lower price on all your beer, which dampens total revenue. So the effect on marginal revenue is amplified and thus MR is below D.

Friday, October 17, 2008

Fresh Hop Beers

I spent yesterday evening at the Pilsner Room with my personal guide through all things beer, Jeff Alworth, sampling a variety of fresh hop beers, starting with John Hariss' Lupulins. Last year John (seen here) created a masterpiece using Amarillo hops. Those hops are unavailable this year and so he used the same recipe and made three different beers, one hopped with Mt. Ranier, one with the ubiquitous (and delightful) Cascades, and one with Nuggets. Jeff and I both were super high on the Nugget variety as we felt the typical Cascade floral notes were quite subdued in that one. We also had Deschutes fantastic Hop Trip, Double Mountian's excellent offering, Killer Green and, for a change in style, Hopworks' Octoberfest which is also excellent. What a great night. I have to say, I liked the Deschutes fresh hop ale the best, followed closely by John's Nugget variety and Double Mountain's Killer Green. However, that said, the best beer I had yesterday was a pint of John's sublime Prodigal Sun IPA that was being served on cask. Yum.

Speaking of Amarillo hops, John, who stopped by our table for a chat (his brewery is on the other side of the glass wall and there was some sort of Full Sail thingy going on because I spied Irene Firmat and Jamie Emmerson - he apparently doesn't realize one m is enough - and general noshing at a shrimp cocktail spread) told us that the reason there are no Amarillo hops available is that it is a proprietary hop and there is not that much in cultivation. Apparently it started as a wild variant that was discovered on a hop farm and cultivated.

Anyway, this is supposed to be beeronomics and as much as my gastronomic adventures are surely fascinating to all of my devoted readers, let's try and turn my drinking into field research so I can write-off my tab.

So what's the deal with all of these fresh hop beers? Perhaps it is just a way to keep brewers from getting too bored, but I think there is more. In many markets, limited editions, special varieties, alternate versions are thought of as a way to increase demand. The idea is roughly this: for customers that have a strong demand for a product may regularly consume, say, one six-pack of Full Sail beer a week. They may switch from pale to amber and so on, but their demand does not change from week to week. You may be able to increase demand for these consumers from time to time by a special variety that will not last. (It may also be the case that they will just forgo the regular six-pack for the special variety and no new demand will be created). Creating buzz with new products is also useful to get the uninitiated to try a company's beers, to create or solidify a reputation for quality and creativity, and create another opportunity to get people to try 'bigger' beers and thus create more demand.

By the way, in economics the private incentive for firms that have products of multiple varieties is to produce too much relative to the socially optimal amount. Why? Well, the closer you get your product to the idea variety of a consumer, the more you can charge a consumer for that product. But variety is expensive for producers, so overall the costs (and thus prices) overall will rise due to this variety.

John had an interesting insight when I mentioned the recession proof-ness (s0 far) of craft beer. He observed that it may be the bottling breweries that are the recession proof part of the craft brew scene for the supermarket six-pack is not seen as that much of an extravagance, while brewpubs are more vulnerable because a night out in a brewpub where you pay $5 for a pint is probably much more of a splurge for many people. We, I am afraid, will have a long and deep recession in which to test this theory.

So hurry to the Pilsner Room to get your Lupulins before the recession really sets in...

Wednesday, October 15, 2008

Is Beer a Recession Proof Industry?

I blogged a lot about hops shortages and barley prices creating a perfect storm for craft brewers and now the economy has turned south at precisely the time that craft brewers are forced to raise prices. Big trouble right? Apparently not. And from here I outsource and refer you to a great article from the Wall Street Journal on the eve of the Great American Brewer's Festival which is held annually in Denver.

Here are the meat and potatoes:

Despite rising prices and a shortage in hops, craft beer -- beer made by small, independent and traditional breweries -- has grown 6.5% in volume and 11% in sales in the first half of 2008, roughly the same amount as the same period last year, Mr. Gatza says. According to the Brewers Association, in 2006 and 2007, 47 of the top 50 craft brewing companies grew in production to keep up with demand. So far this year about 42 of the top 50 are growing to keep up with demand, Mr. Gatza said.

One of the reasons for this continued growth despite the economic downturn is that craft beer is still one of cheaper luxury items people can buy, with most six packs cost less than $10, says Mr. Norgrove of Bear Republic Brewery. Bear Republic has seen business grow by more than 50% in 2006 and 2007, and is seeing healthy profits gain this year, he says. "We are in one of those industries that is really doing well. I don't want to say it's recession proof, but we are seeing steady growth."

Wow, sales are up 11%! One could possibly infer from this that craft beer, like macrobrews, are an inferior good (in the economics sense, not in the real sense). This means that as incomes fall, you actually consumer more. The classic example of this are the potatoes in the aforementioned meat and potatoes meal. As incomes get tight the plate becomes more potatoes and less meat (and vice versa when people are flush). Perhaps craft brew becomes a substitute for fine wine, scotch and the like. Of course it is more likely that demand just continues to rise as more and more people wake up to the fact that beer doesn't have to taste like crap (pardon me - that is an economic term of art for "Bud"). Oh and what about those macros? Sales are flat, just like the keg the day after the frat party.* Anyway, read the WSJ article, as it addresses how brewers are coping with hops shortages and increasing input prices. Beeronomics indeed...

Oh and one more note about the GABF: Kudos to my old buddy and Ithaca Beer founder Dan Mitchell for coming home with two silver medals. Truth be told, the beer wasn't that great at the beginning, but it is good stuff now.

*I know that at Oregon State Frats the kegs are more likely to be Rogue. ;-)

Friday, October 10, 2008

The Oregon Business Magazine on Oregon's Craft Brew Industry

A little while ago I was contacted by Ben Jacklet of the Oregon Business Magazine who had heard about my pedagogical interest in the Oregon beer industry. Though not directly relevant to his article, I had a very interesting chat with Ben about this great article on the craft beer industry in Oregon. Especially interesting, in my opinion, is the stuff about the Widmer brothers and the reaction of their partnership with AB in the beer community (much more so among consumers than fellow brewers, I have found).

Anyway, since I haven't had time to do much beeronomics blogging, this will have to suffice for now.