9
The Wine Firm
The principal decision-making unit in the wine industry is the wine firm. But what is a wine firm? Interestingly, this question does not have a simple and unequivocal answer. The term firm is commonly used to describe different types of organizations. The economics literature contains various definitions of a firm, each of which provides a somewhat different way to view this type of organization.1 While several of these definitions are complementary, a consensus does not exist on the single best way to conceptualize a firm in all circumstances. With this in mind, the goal of this chapter is to propound a useful way to think about a wine firm, describe its salient characteristics, and discuss the choices it makes and the constraints it faces when making these choices.
WINE FIRM AND WINERY
Exactly what is a wine firm and how does it differ from a winery? Fundamentally, the distinction is one between a decision-making unit and a production facility.
Winery
A winery is a production plant in which wine production activities are performed. It is typically composed of a building that houses various types of winemaking equipment and a warehouse section for storing bulk or packaged wine. It may also have a visitor center or tasting room where wine is sold directly to consumers. Any wine firm that wants to operate a winery must first obtain a license from the U.S. Department of Treasury, Alcohol and Tobacco Tax and Trade Bureau (TTB). For legal purposes the TTB makes a distinction between three types of wineries: a bonded winery, an alternating-proprietor winery, and a custom-crush winery.2
A bonded winery is a production plant owned and operated by a single wine firm. To legally produce wine in such a facility, the firm must obtain a bonded-winery permit and a basic alcohol permit. The bonded-winery permit allows the firm to produce and store wine in the production plant. The basic alcohol permit provides the TTB information on the firm that owns the winery. The wine firm must also post a wine bond ensuring that it will pay the federal excise tax on the wine. As long as wine is stored in the area designated as the bonded portion of the winery, typically, the warehouse, no tax need be paid. However, once the wine is moved out of the bonded area, the firm must pay the tax. This applies even if the wine is moved from the warehouse portion of the winery to the visitor center or tasting room. Wine that is bottled in the bonded winery must have a label that is approved by the TTB.
An alternating-proprietor winery is a production plant that is shared by two or more wine firms. The firm that owns the production plant is called the host. The firms that share the facility are called alternators. The host typically charges rent to the alternators for use of space in the building and winemaking equipment. However, the TTB prohibits the alternators from contracting with the host for labor services, such as the services of the winemaker and other employees. All firms that produce wine in the alternating proprietor winery must have their own bonded winery and basic alcohol permits, and pay their own excise taxes.
A custom-crush winery is a production plant owned and operated by a single firm, called a custom producer, that performs wine-production activities under contract for one or more other firms. The custom wine producer must have bonded winery and basic alcohol permits. The firm that contracts for production activities is called the custom client. A number of alternative arrangements between the custom producer and client are possible. The client firm can enter into a contract with the custom producer to provide all wine-production activities: sourcing the grapes, producing the wine, maturing the wine, bottling the wine, and labeling the wine. Alternatively, the client firm may source its own grapes and contract with the custom producer to produce, mature, bottle, and label the wine. Under some arrangements the custom producer also sells the wine for the client, but typically the client takes delivery of the bottled wine and then sells it to distributors or possibly directly to consumers via the Internet. In this case, the client firm is not required to obtain bonded winery and basic alcohol permits, and the custom producer is responsible for the excise tax. If the client firm takes delivery of the packaged wine for resale, it must obtain a wholesale license from the TTB. However, it cannot sell wine directly to consumers at a tasting room.
In addition to these three types of wineries, the TTB also defines a facility called a bonded wine cellar. A bonded wine cellar blends, bottles, or stores wine on which the excise tax has not been paid. It differs from a winery in that grapes are not crushed and fermented. A firm that operates a bonded wine cellar must obtain a bonded warehouse permit. It is responsible for paying the federal excise tax when the wine is removed from the bonded area of the facility. Under one type of arrangement, a firm that operates a bonded wine cellar may purchase wine on the bulk market from several different suppliers, and then blend, bottle, label, and store the wine for future sale. Another possibility is for a firm to have a bonded wine cellar and stand-alone tasting room, and contract with a customer producer for finished bottled wine that it stores in the bonded warehouse and sells directly to consumers in the tasting room.3
The notion of a virtual winery is also becoming increasingly important in the wine industry. A virtual winery has been defined in various ways, but in general it refers to a situation where a firm produces one or more wine products without owning a winery. The label virtual winery is usually limited to firms that employ a winemaker or contract with a winemaking consultant to supervise and direct wine-production activities that are performed in a production plant owned by another firm. A virtual winery, therefore, is not a production plant per se; rather, it is a specific type of wine-related organization.
Wine Firm
A wine firm is a legal entity that organizes and coordinates the activities required to produce and sell wine to consumers. This includes all activities related to grape growing, wine production, and wine distribution. This entity is legally organized as a proprietorship, partnership, corporation, or limited liability company and can make binding contracts in its own name. It is owned by a single individual, group of individuals, or another firm. The owner may be motivated by profit or nonprofit objectives. To organize and coordinate the production and sale of wine, the firm either contracts for necessary activities with other firms in the marketplace or performs these activities itself by employing workers and other inputs. Any activity that is outsourced is either purchased on a spot market for immediate delivery or a long-term contract market where arrangements are made with another firm to perform the activity at regular intervals over an agreed-upon time period. To perform an activity internally, the firm enters relatively simple contracts with employees that allows it to direct, supervise, and monitor their performance as members of a team that works together to produce the activity.
Wine Brands and Products
A wine firm organizes and coordinates the production and sale of one or more wine products and brands. It is useful to make a distinction between a wine brand and a wine product. A wine brand is a name placed on a wine label that identifies one or more wine products. The TTB requires that a wine label have a brand name. This can be a wine firm’s legal name, trade name, or any other name it desires, as long as it does not mislead the consumer.4 It can identify a single wine product or more than one product that share the same brand name. Wine products differ in terms of grape variety, grape location, vintage, vinification methods, and wine style. Thus, for example, a wine firm that produces ten wine products can sell these under a single brand name or as many as ten separate brand names. It is common for two or more different varietal wine products to be sold under the same brand name.
Some Examples of Wine Firms
A variety of wine related organizations are consistent with the concept of a wine firm presented in this chapter. Some examples are provided in this section.5
E. & J. Gallo is the largest wine firm in the United States by quantity of wine sold, with estimated annual domestic sales of seventy-five million cases of sixty different wine brands. It also sells an additional five million cases per year in more than ninety countries. Gallo is legally organized as a family-owned private corporation. To organize and coordinate grape growing, wine production, and wine distribution, it employs about 5,000 workers. It also outsources many tasks through contracts with other firms. Gallo contracts with independent vineyards to source more than 90 percent of its grapes, estimated to be over a million tons annually, and satisfies the rest of its grape-input requirement from fruit harvested on about 15,000 acres of vineyards it owns. It produces a preponderance of its wine in seven of its own wineries, but also contracts with bulk wine producers for a substantial amount of wine that it bottles and sells under its own brand names. Its wineries are large-scale production plants; the facility in Modesto, California, has the appearance of a refinery and occupies more than sixty-five acres. Unlike most wine firms that contract with other firms for bottles and closures, Gallo undertakes this internally in its own bottle and closure plants. Gallo owns a trucking company that it uses to distribute wine directly to retailers in California, but has contracts with a large number of distributors to move wine to consumers in the other forty-nine states. It also sells wine directly to consumers by various means, including the Internet.
According to the wine industry publication Wine Business Monthly, Castle Rock Winery is the twenty-sixth largest wine company in the United States, with estimated annual sales in 2011 of 600,000 cases; however, it does not own a single vineyard or winery. To produce and sell more than fifty different wine products, it contracts with other firms to grow grapes and make and distribute the wine. Because it acts primarily as a contracting agent it has only eleven employees. Castle Rock has long-term contracts with a relatively large number of independent vineyards located in California, Oregon, and Washington State. It contracts with a number of different wineries in these states to produce wine from purchased grapes and employs a winemaker to oversee winemaking activities. It sells its wine through a large network of distributors in forty-eight states and directly to consumers over the Internet. Castle Rock is considered by many in the industry to be a virtual winery.
The Forman Vineyard wine firm, located in the Napa Valley near St. Helena, California, was founded in 1979. It produces three wine products, sells them under two brand names, and has annual sales of around 3,500 cases. As a legal entity, it is organized as a proprietorship; Rick Forman is the owner/proprietor. Grape growing and wine producing are done by the firm itself, largely by the proprietor and his son. Grapes are grown on three small vineyards, of 8.5, 20, and 60 acres. Two of these vineyards are owned by the proprietor and the other is co-owned with a partner. Vines are pruned and harvested by hand and hand-sorted. During the first few years of operation, wine was produced in an alternating-proprietor winery, but since 1985, it has been made in a relatively small Forman-owned bonded winery with modern equipment and stored in deep caves below the winery. Forman contracts with distributors to sell wine in twenty-five states and several foreign countries. Wine is also sold at an appointment-only tasting room at the winery.
Several additional examples illustrate the diverse manner in which firms choose to organize and coordinate the production and sale of wine products. The V. Sattui Winery, established in 1975, minimizes the outsourcing of tasks to other firms. It grows more than 75 percent of its grapes on hundreds of acres of vineyard land, produces about 40,000 cases of forty different wine products each year in its own production facility, and sells all of this output directly to consumers at its tasting room and by mail to 40,000 wine club members and consumers, who submit website orders. About 65 percent of the wine it produces is sold at its tasting room at St. Helena in the Napa Valley, and it has never contracted with a distributor or sold its wine directly to a retailer. The Kosta Browne Winery, founded in 2001 at Sebastopol, California, purchases all of its grapes from a variety of independent vineyards. It does not own a winery; ten different Pinot noir products are made in a leased production facility and sold under the Kosta Browne brand name. Its annual output is about 10,500 cases, and 85 percent of this is distributed directly to consumers who must sign up for a slot on a mailing list. In 2009, Kosta Browne was purchased by the Vincraft Group, a private equity firm, for an estimated $30 to $40 million. Because Kosta Browne owned neither vineyards nor a winery, the assets purchased were essentially the brand name, the wine inventory, the consumer mailing list, and the services of the former proprietors, who agreed to continue to produce and sell the wine.
The Number and Size of Firms in the Wine Industry
The wine industry is the collection of wine firms that participate in the wine market. Two important characteristics of the structure of a market are the number and size distribution of firms in the industry. These attributes of market structure are important because they affect firm behavior. For example, we would expect firms in an industry with 1,000 rivals to behave differently from firms in an industry with ten rivals. We would also expect firms in an industry made up of 1,000 rivals of equal size to behave differently from firms in an industry in which three large firms have 90 percent of the market and 997 the remaining 10 percent.
To measure the number of firms in the wine industry and their size distribution, it is necessary to choose a specific definition of a wine firm. A wine firm has been defined as a proprietorship, partnership, limited liability company, or corporation that organizes and coordinates the activities required to produce and sell wine to consumers. However, this concept does not necessarily provide a clear line of demarcation between an organization that is and is not a wine firm. To a degree, drawing a boundary is a matter of judgment. For instance, consider the following wine-related organizations, which are becoming increasingly prevalent:
A negociant that neither grows grapes nor ferments wine. It buys wine on the bulk market and blends, bottles, and sells this wine under its own label, or sells finished wine under its own label that is made and bottled by another producer under contract.
A custom-crush winery that provides winemaking services to other organizations under contract, but does not produce and sell wine under its own label.
A custom-crush client that contracts with a custom producer to source grapes and produce and sell wine under its own client label.
A custom client that takes delivery of bottled wine and resells it.
A commercial vineyard that sources its own grapes but contracts with a custom producer to make bulk wine, which it then sells on the bulk market to another firm.
A retail store, such as Whole Foods Market, Costco, or Trader Joe’s, that contracts with a winery to produce a private-label wine.
Which of these wine-related organizations are wine firms and which are not? One might argue that a firm that operates a custom-crush winery that does not sell wine under its own label is not a wine firm because it organizes wine production but not sales. Alternatively, an argument can be made that it is a wine firm if it arranges for the sale of a custom client’s wine product, even though it is not the firm’s own brand. One may even argue that Whole Foods Market is a wine firm. It organizes and coordinates the production and sale of wine by contracting with a number of different wine producers for as many as 100 different private-label wines, which it sells to consumers in its retail stores across the nation. Two Whole Foods wine buyers are actively involved in directing the winemaking activities for these products through specification of the desired wine style and even blending the final wine.6 This is consistent with the concept of a virtual winery like Castle Rock Winery, which most industry observers would consider a wine firm. While private label wine products represent a relatively small proportion of revenues for Whole Foods, the same can be said of large wine and beverage companies like Diageo, which generates only 6 percent of its revenue from wine sales. Similar arguments can also be made for and against including the other wine-related organizations under the group of wine firms. While my definition provides a useful conceptual way to think about a wine firm and illustrates the inherent fuzziness of its boundaries, it does require a degree of judgment in deciding specifically what organizations will be included in the group of firms that make up the industry.
Many wine market analysts prefer to view the winery, rather than the wine firm, as the fundamental unit in the wine industry, and therefore attempt to measure the number of wineries. However, this approach also requires a specific definition of exactly what qualifies as a winery and presents its own problems in drawing boundaries. A winery has been defined as a plant in which wine production activities are performed. These activities include crushing, fermenting, maturing, clarifying and stabilizing, blending, and packaging wine. How many of these activities must be performed in a facility for it to qualify as a winery? In some facilities, only a subset of these activities are performed. For instance, one type of facility may blend, mature, and package wine without fermenting it. Another type of facility may bottle and store wine. Each of these types of facilities must have a license from the TTB to engage in these activities for commercial purposes. If all of these facilities are included in the definition of a winery, then the number of wineries in the United States can be approximated by the number of licenses issued by the TTB. Using this broad definition of a winery, there were 7,626 wineries in the United States in 2010.7
Defining a winery as a production plant is not very informative in understanding the behavior of wineries in the industry that supply wine to consumers. As a result, to measure the number of wineries, some definitions incorporate specific types of wine-related organizations as well as a more restricted notion of a production plant. Perhaps the most widely cited of these is provided by Wine Business Monthly. Included in this definition and measure are two types of wineries: bonded wineries and virtual wineries. A bonded winery is described as a facility that is managed by an organization composed of one or more individuals that has a bonded winery permit from the TTB, or two or more facilities that have separate bonded winery permits but are managed by the same organization. Thus, if the same organization manages three separate bonded facilities, this is counted as a single bonded winery. If three independently managed organizations share the same facility and have separate bonded winery permits, this is counted as three separate wineries. An example would be an alternating-proprietor winery with a host and two alternators. A virtual winery is described as an organization with its own management and winemaker, but without a bonded facility, that produces and bottles at least one wine brand using the services of a bonded facility of another organization.8 Using this definition and measure of a winery, there were 7,116 wineries in the United States in 2011. Of these 6,027 were bonded wineries and 1,089 were virtual wineries. All fifty states have wineries, ranging from 3,458 in California down to two each in Wyoming and Mississippi. Fourteen states have more than seventy wineries apiece.9
The Wine Business Monthly definition and measure of a winery is closely related to the concept of a wine firm as an organizational decision-making unit rather than a production facility. The collection of bonded and virtual wineries included in this measure may well correspond to a group of legal entities that organize and coordinate the activities required to produce and sell wine to consumers, and that most analysts would include as firms in the wine industry. However, it does not resolve the problem of drawing boundaries between wine firms, or even wineries, and other wine-related organizations. A cogent argument can be made that some types of bonded wineries are not wine firms. Judgment is also required in applying the definition of a virtual winery to certain types of organizations to determine if they qualify. Notwithstanding these considerations, the Wine Business Monthly measure is a reasonable approximation to the number of wine firms in the U.S. wine industry.
The most widely used measure of the size distribution of firms in an industry is the concentration ratio. Firms in an industry are ranked from largest to smallest by a proportional measure of size, such as percentage of sales. If n represents the number of firms selected, the sales percentages for the largest n firms are then summed to obtain the concentration ratio for the industry. In 2009, the four-firm concentration ratio in the U.S. wine industry measured by annual sales volume was 56 percent.10 The top two wine firms, Gallo and The Wine Group, produced 137 million cases in 2011, accounting for roughly 40 percent of all domestic wine sales.11 The twenty-firm concentration ratio was close to 90 percent, so that the remaining 7,000 + wine firms together accounted for only 10 percent of case-goods sales. About 70 percent of wine firms sell less than 5,000 cases per year.12 However, this picture of the wine industry as dominated by a handful of large firms is somewhat deceptive. Large firms tend to sell a preponderance of the wine they produce in the lower-priced commodity segment of the market for everyday consumption. Smaller firms concentrate in the higher-priced premium and luxury segments, which supply higher-quality wines to consumers. The market environment at the low end, where a firm has few large rivals, is significantly different from that at the high end, where a firm has many relatively small rivals. As a result, firms may behave much differently in these segments of the market.
THE WINE FIRM AS A LEGAL ENTITY
For a wine firm to exist as a legal entity, the owner must choose a legal form of organization. Once the firm is a legal entity, it can then enter into contracts. These contracts play an important role in the organization and coordination of the activities required to produce and sell wine to consumers. This section focuses on the different ways in which a wine firm can be legally organized, the types of contracts it can enter into, and some economic implications of the different organizational forms and contractual arrangements.
Legal Forms of Wine-Firm Organization
As a legal entity, a wine firm can be organized in four major ways: as a proprietorship, a partnership, a corporation, or a limited liability company. The legal organization of a wine firm has important implications for the ownership, control, and financing of the firm.
A proprietorship is a wine firm owned by an individual or family, called the proprietor. The proprietor has complete control of the firm and the power to make all decisions. He can enter contracts in the name of the firm, but is personally liable for the firm’s obligations and other legal matters. This means that if the wine firm cannot pay its debts or is successfully sued, the proprietor’s house, car, bank accounts, or other personal assets can be seized. Small wine firms are typically organized as proprietorships. Even if the proprietor wishes to increase the size of the firm, this type of legal organization is not conducive to obtaining the financing necessary to do so, since most of the money available to the firm is provided by the proprietor and limited bank borrowing. Some wine firms start as proprietorships and then change their legal structure to expand, but many continue as proprietorships over their lifetimes.
A partnership is a wine firm owned by two or more individuals, called partners. A general partnership shares many characteristics of a proprietorship. The partners share control, profits, and losses of the firm, and all partners have unlimited liability for the obligations of the firm. Each partner has the legal right to enter into contracts for the firm, and all partners bear responsibility for the decisions made by each one individually. However, partners can pool their financial resources to potentially obtain more money for the firm, which is an advantage relative to a proprietorship.13
Unlike a proprietorship or partnership, a corporation is a legal entity that is separate from the individuals who own it, called stockholders. As a “legal person,” a corporation can enter into contracts, own assets, and incur liabilities independent of its owners. The owners have limited liability. If the corporation fails to pay its debts or is sued, the maximum amount owners can lose is limited to their investment in the firm; their other personal assets cannot be seized. Limited liability makes ownership in the firm more attractive and facilitates selling ownership shares to a large number of individuals. This makes it easier for a wine firm to obtain the money it needs to expand. As a result, large wine firms tend to be organized as corporations. It is not always clear exactly who controls a wine firm when it is organized as a corporation. Stockholders elect a board of directors who have the legal authority to make decisions for the wine firm. These decisions are often delegated to managers. Directors and managers may or may not also be owners, and if they are, their ownership shares may be large or small.14
A limited liability company (LLC) is a wine firm owned by one or more members. Members can be individuals, corporations, or other LLCs. An LLC has legal attributes of both a partnership and a corporation. While it has the tax advantages of a partnership, it is a legal entity distinct from its owners like a corporation.15 An LLC can enter into contracts, own assets, borrow money, and sue and be sued, but the assets of owners are protected by limited liability. Because a wine firm organized as an LLC can have from one to a large number of owners and many different types of operating agreements, it is not always clear who controls and makes decisions for the firm. But an LLC with relatively few members is likely controlled in a manner similar to a typical partnership or proprietorship.
The Distribution of Legal Wine Firms
While it is not possible to obtain the information necessary to construct the exact distribution of legal wine firms, I estimate that less than 5 percent are organized as corporations.16 If this estimate is a reasonable approximation, then corporate representation is much smaller in the wine industry than the economy as a whole; 18.5 percent of firms in the United States operate under the corporate form of organization. Only six wine firms are organized as public corporations; the rest are private corporations. Three of the public corporations are involved exclusively in the wine industry, and the other three are wholly owned subsidiaries of public corporations that have operations outside the wine industry. The public corporations are owned by a large number of stockholders. Most of the private corporations are owned by a single family or a relatively small group of unrelated investors. The remaining 95+ percent wine firms are organized as proprietorships, partnerships, and limited liability companies. A preponderance of these noncorporate wine firms are family owned and operated.
The choice of legal organization is related to wine-firm size. The largest wine firms are organized as corporations; the smallest are overwhelmingly proprietorships. This is largely because limited liability offered by the corporate form of organization is an essential feature in raising the large amount of money necessary to finance a large wine firm. Of the largest ten wine firms in the United States in 2011 measured in terms of annual case sales, five are private corporations, three are subsidiaries of public corporations, one is an autonomous public corporation, and one is a limited liability company. These firms have annual sales ranging from 4.5 to 75 million cases (mc) and account for more than 80 percent of domestic wine industry sales volume.17 The largest private corporation is Gallo (75 mc), followed by Trinchero Family Estates (16.5 mc), Bronco Wine Company (12 mc), Jackson Family Wines (5.5 mc), and DFV Wines (4.5 mc). All of these private corporations are owned and controlled by family members. The largest public subsidiary wine firm is Constellation Wines U.S. (47 mc) followed by Ste. Michelle Wine Estates (7.3 mc), and Diageo Chateau & Estate Wines (6 mc). Constellation Wines U.S. generates the largest portion of the parent firm’s revenue (75 percent); Diageo Chateau & Estate Wines contributes the smallest (6 percent).18 The parent firms of Constellation and Diageo are alcoholic beverage conglomerates that also sell spirits or beer. Ste. Michelle is owned by the Altria Group Inc., which has tobacco and smokeless tobacco company subsidiaries. The stocks of the parent firms are widely traded on national stock exchanges. The second-largest wine firm in the United States, The Wine Group (62 mc), is legally organized as a limited liability company and owned by a small group of individuals. Treasury Wine Estates (18 mc), the fourth-largest wine firm, is a public corporation that resulted from a spin-off of the wine division of the Fosters Group in 2011.19
Contracts and Transactions
To organize and coordinate the activities required to produce and sell wine, a wine firm engages in transactions. A transaction involves an agreement between two parties to exchange a good or service for money. The terms of the agreement is called a contract. The contract may be formal or informal, written or verbal, or unstated but implied. For example, a wine firm makes a transaction with a commercial vineyard when it agrees to exchange $800 for a ton of grapes. The terms of the agreement that specify the price, quantity, grape variety, delivery date, mode of delivery, and so on, constitute the contract. A survey of California grape growers estimated that about 20 percent of growers with long-term grape contracts have verbal contracts.20
A wine firm can enter into a variety of different types of contracts. A legal contract is a written, oral, or implied transaction agreement between two parties that is enforceable by law.21 Certain types of transactions may require a written contract to be enforceable, and implicit agreements are the least likely type of contract to have legal status. For example, a verbal agreement by a wine firm to purchase grapes may be enforceable, but not one to buy a vineyard. If a wine firm has a legal contract with another party and this party breaches the contract by not honoring the terms, enforcement may involve requiring the party either to carry out the terms of the contract or to compensate the wine firm by making payment of a specific amount of money.22 However, even if a contract is not legally enforceable, the market may provide an enforcement mechanism. A wine firm that breaches legally unenforceable but legitimate verbal or implicit contracts may develop a dubious reputation and have a difficult time finding grape growers, custom-crush producers, distributors, and so on, with whom to transact, which may be very costly or possibly prevent it from conducting business at all.
Contracts and Transaction Costs
Any cost incurred in making a transaction—other than the good, service, or money payment being transferred—is called a transaction cost. A distinction can be made between two types of transaction costs: search cost and contracting cost. Search costs are the costs of acquiring information about transaction opportunities that may exist. These costs include the time and money spent collecting information about parties with whom to transact, their locations, and the prices and characteristics of the goods they are willing to exchange. For example, if a wine firm wishes to purchase Cabernet Sauvignon grapes, it must devote time and money to obtaining information on vineyards that grow this grape variety and offer it for sale, their geographic location, the attributes of the grapes, and the prices at which these growers are willing to sell.
Contracting costs are the costs of negotiating and enforcing a transaction agreement. For example, once a wine firm finds a grape grower with whom to transact, it incurs initial costs in arriving at an acceptable agreement and describing the terms in a written or verbal contract. A wine firm also incurs the ongoing costs of making sure the grower abides by the terms of the contract and taking necessary action if the agreement is violated. Contracting costs include all opportunity costs, both explicit and implicit. Explicit costs are money payments for resources like legal services used in negotiating and writing contracts and money outlays related to litigation or arbitration, if these enforcement mechanisms are used. Implicit costs do not entail explicit money outlays; rather, they are benefits forgone from not using time and other resources in their next best alternative use when these resources are devoted to negotiating and enforcing an agreement.
Spot and Long-Term Contracts
It is useful to make a distinction between a spot contract and a long-term contract. A spot contract is an agreement between a wine firm and another party to exchange money for a good or service at the same point in time. This type of transaction takes place on the spot market, sometimes called the market for immediate delivery. For example, after sampling the Merlot bulk wine of a custom-crush producer to assess quality, a wine firm might agree to take delivery of 1,000 gallons in five days at its bonded winery facility at a price of $10 per gallon in exchange for a payment of $10,000 when delivery is made. This type of spot contract is relatively easy to negotiate and enforce, since the exchange of bulk wine for money takes place simultaneously, and the transaction is completed quickly.
A long-term contract involves a transaction that extends over time where a wine firm and another party agree to exchange money for a good or service at different points in time. For example, a wine firm may contract with a custom producer today to deliver Merlot bulk wine on a specific date each year for the next three years in exchange for a money payment upon delivery. This type of transaction is more complex than the relatively simple spot-market transaction, and therefore is more difficult to negotiate and enforce. The wine firm and custom producer would likely attempt to negotiate a contract that specifies the quantity, quality, and price of the bulk wine to be exchanged. However, when negotiating these terms, both parties have imperfect information about events that may occur during the contract period, such as changes in the demand for wine and the cost of grapes, as well as a host of other contingencies. Faced with this uncertainty, the wine firm and custom producer must decide whether quantity and price will be fixed over the duration of the contract or allowed to vary from year to year. If allowed to vary, what particular formula will be used? Should the price of bulk wine be tied to the spot-market price or some index of cost? Even if both parties reach an agreement on a specific formula, chances are that it will not adequately account for all possible contingencies. An agreement regarding quality may be even more difficult to negotiate. When making a bulk wine transaction on the spot market, the wine firm can evaluate quality by sampling the wine before entering the contract. However, under a long-term contract, this type of quality evaluation can take place only after the custom producer has completed its side of the agreement by producing and delivering the wine. What, if any, criteria will be established to determine acceptable wine quality? Should the wine satisfy specific measures of alcohol, acidity, and residual sugar, or should it exhibit certain sensory characteristics, such as balance, flavor intensity, and an adequate finish? Who is responsible for taking those measurements or deciding if the wine has these characteristics, the wine firm, the custom producer, or a third party? If the wine fails to satisfy the quality criteria, to what compensation is the wine firm entitled? What if the wine firm insists that the wine be unfiltered, and as a result it develops an off-taste, or inclement weather beyond the control of the custom producer reduces both grape and wine quality? Because the wine firm and custom producer do not have perfect foresight, they cannot possibly account for every possible contingency related to quantity, quality, and price when writing a contract. Even if they could, it would be too costly to specify all of these as terms of the contract. As a result, most long-term contracts are incomplete.23 An incomplete contract may lead to a dispute between the wine firm and custom producer, and eventual litigation. However, enforcement by the courts may be difficult, particularly if it involves a gap in the contract or unclear and vague terms.
Incomplete Contracts and Opportunistic Behavior
The Nobel laureate economist Oliver Williamson argues that incomplete contracts may result in opportunistic behavior defined as “self-interest seeking with guile.”24 Extending the above example, suppose the bulk-wine contract excludes quality criteria, or those criteria are ambiguous. An unexpected decrease in wine demand may induce the wine firm to renege on the contract by refusing to make payment when the bulk wine is delivered. It may claim that the wine does not satisfy the implicit or explicit quality standards of the contract, and that it is therefore invoking the terms of the agreement. The nebulous terms of the contract would make it difficult or costly for the custom producer to establish for a court or an arbitrator that the wine firm’s behavior is inappropriate. As a result, the incomplete nature of the contract creates an economic incentive for the wine firm to exploit the custom producer.
A recent example of an incomplete contract resulting in a highly visible dispute and possible opportunistic behavior involves wine firms and grape growers in California. Most grape contracts specify the price a wine firm will pay for each ton of grapes purchased, but do not specify a harvest date. Growers have publicly complained that wine firms have insisted that they harvest fruit later in the growing season, when grapes have a lower water content and weigh less, reducing their revenue by as much as 30 percent. They argue that wine firms’ motivation for late harvest is the desire to minimize grape input cost, since water lost to overripeness can be added back during the wine-making process at little cost. Wine firms have responded that picking grapes later is necessary to achieve physiological maturity, enabling them to satisfy consumer demand for intensely flavored wines.25
Contracts and Information Asymmetry
When the parties to a transaction have different information about the good or service being exchanged, an information asymmetry is said to exist. If one party has information unknown to the other about the characteristics of the good or service prior to the exchange, this type of information asymmetry is called adverse selection. If one party has better information about implementation of the terms of the exchange, this type of information asymmetry is called moral hazard. In both instances, one party may engage in opportunistic behavior and attempt to use its informational advantage to benefit at the expense of the other. Provisions to minimize the negative effects of adverse selection and moral hazard may therefore be included in a contract.
Consider, for example, a wine firm that desires to purchase high-quality grapes from a commercial vineyard. Suppose vineyards differ in their ability to grow quality grapes, and this is known to the grower but not to the wine firm. The wine firm is faced with the adverse selection problem of not knowing if it is contracting with a grower capable of producing grapes with the desired characteristics. It may contract with a vineyard that delivers grapes of lower than expected quality. The grower benefits at the expense of the wine firm, because it receives a price commensurate with higher-quality grapes. Even if the wine firm knows the vineyard’s ability to produce quality grapes, after it makes the contractual agreement, it may face a moral hazard. It may lack information on the effort put forth by the commercial vineyard in growing and harvesting the grapes during the period of contract implementation. This information asymmetry may allow the grower to benefit at the expense of the wine firm by shirking on the use of costly, quality-enhancing vineyard practices such as canopy management, cluster thinning, and spraying. When the grapes are delivered, the grower can claim that the amount of effort expended, cost incurred, and the quality of fruit produced are commensurate with the agreed upon price, whereas in reality this is not true.26
To minimize the negative effects of adverse selection and moral hazard, the wine firm may include provisions in the contract designed to change the behavior of the commercial vineyard and nullify its informational advantage. These provisions typically affect grape price or viticultural practices of the grower. For instance, a long-term contract negotiated before a new vineyard is planted may require the grower to use a certain clone, rootstock, trellis system, or irrigation technology to achieve a particular level of grape quality. The wine firm may include a provision in the contract of an existing vineyard that allows it to be involved in making management decisions regarding tasks such as pruning, spraying, and harvesting. Another possibility is to include financial incentives in the form of bonuses or penalties for achieving or not achieving measurable characteristics of quality such as sugar and acid levels. In addition to these sorts of provisions that directly affect viticultural practices, the wine firm may include price incentives to indirectly mitigate moral hazard. For instance, the contract may contain a price formula with a component tied to the price of the wine produced from the grapes. This gives the grower a financial incentive to provide maximum effort to produce high-quality grapes to maximize wine quality and price.27
When a wine firm grows its own grapes and hires a vineyard worker to prune grapevines, it may have an informational disadvantage. Adverse selection exists if the worker’s ability to prune vines is unknown to the wine firm. Moral hazard exists if the worker’s output is difficult to observe, and he shirks and puts forth less effort than he is supposed to under the employment contract. The worker’s effort may be difficult to observe if he is a member of a pruning team and his output cannot be easily distinguished from that of other members of the team. One way for the wine firm to deal with the moral hazard is to write an employment contract that pays the worker a piece rate rather than a fixed hourly wage. Piece-rate compensation gives the worker a financial incentive to maximize work effort. One study estimated that pruning an acre of vines took a typical hourly wage worker twenty-six hours, but a piece-rate worker only nineteen hours, with no significant difference in pruning quality.28
THE WINE FIRM AS AN ECONOMIC ENTITY
A wine firm exists as an economic entity when it makes decisions related to wine production and sales. These decisions concern the organization and coordination of grape growing, wine production, and wine distribution; the types of wine products to offer consumers; and the quantities, qualities, and prices of those products. In making these choices, a wine firm must decide which tasks to outsource and which to perform within the firm. When activities are performed in-house, it must choose the amounts of labor services, capital equipment, and other inputs to use, and how to direct, supervise, and monitor the performance of hired employees so that the tasks are carried out in the desired manner. The decisions a wine firm makes as an economic entity depend in large part on whether the owner is motivated by the goal of maximizing profits, the extent to which the owner has nonprofit objectives, the constraints imposed by government regulation, the current state of technology, and the market environment.
Objectives
A standard assumption in economics is that the primary objective of a firm is to maximize profit. Profit is the amount of sales revenue a firm receives over and above all costs. So why does a particular wine firm choose to grow organic grapes, harvest them by hand, ferment the must in a stainless steel vessel, mature the wine for two years in oak barrels, bottle the wine on a semi-automatic bottling line, and sell 1,000 cases of the wine to consumers through three different distributors in ten states at a price of $20 per bottle? The motivation for each of these decisions is to maximize the difference between the revenue the firm receives from selling this wine and the cost of producing and distributing it.
A cogent argument can be made that profit maximization is a reasonable approximation of the objective of a large wine firm that is legally organized as a public corporation, such as Constellation, Treasury Wine Estates, and Diageo. The owners of a large public corporation are tens of thousands of stockholders. In its fiduciary role, the board of directors hires managers to make decisions in the best interest of the stockholders. To do this, managers should make choices that maximize stockholders’ utility. Because utility depends indirectly on wealth, managers can act in the best interest of stockholders by making decisions that maximize profit.29
As discussed previously, all but six firms in the U.S. wine industry are privately owned and legally organized as proprietorships, partnerships, limited liability companies, and private corporations. In the vast majority of these wine firms, the owners are also active managers who make most or all of the significant decisions for the firm. This facet of the internal organization of a private firm is fundamentally different from that of a public corporation, where the owners delegate decision-making authority to professional managers, separating those who own the firm from those who control its operations. Is profit maximization a reasonable approximation of the objective of privately owned wine firms in which the same individuals or family members both own and control the firm?
At first glance, it would appear that privately owned wine firms have a stronger motivation to maximize profit than public corporations. It is reasonable to assume that the owners of a private wine firm want to maximize utility. Suppose all goods that yield utility to the owner as a consumer can be purchased in the marketplace. Because profits from the wine firm contribute directly to the owner’s income, or possibly constitute his entire income, to maximize utility, he must in that case maximize profit. However, suppose the owner derives utility from a good for which a market does not exist; it can only be obtained by owning a wine firm. The enjoyment from this type of nonmarket good can be sourced within the firm by an owner who is willing to sacrifice profit. In this case, the assumption of profit maximization may not be a reasonable approximation of the objective of the wine firm; the wine firm may well have nonprofit objectives related to the owner’s desire to obtain utility from one or more goods that cannot be purchased in the marketplace.
An example will help to clarify the idea of a nonmarket good. Assume a wine firm owner has a preference for employing family members at the winery that is separate from their contribution to profit. Let us call this nonmarket good nepotism. Suppose nepotism were offered for sale on a market at a price of $100 per week. To maximize utility, the owner would maximize profits from the wine firm and use this money to purchase the utility-maximizing amount of nepotism and other market goods. However, because a market does not exist for nepotism, the owner must source it within the firm. Assume that the owner can employ either a family member or a non-family-member for a particular winemaking task. Suppose that the family member would contribute $500 per week to profit; the non-family-member would make a larger weekly contribution of $600. If the owner chooses to employ the family member, then he sacrifices $100 per week in profit for the utility derived from nepotism. Conceptually, there is no difference between making the profit-maximizing choice of hiring the more productive non-family-member and using the extra $100 in profit to buy nepotism on a market, if one existed, and “purchasing” nepotism within the firm by employing the less productive family member and sacrificing $100 of profit.
Anecdotal evidence and surveys of the attitudes of owners of private wine firms suggest that a number of nonmarket goods that may give rise to nonprofit objectives. Many wine firm owners appear to derive substantial utility from the quality of their wine independent of the effect of wine quality on profit. Some owners may view winemaking as an artistic expression, and therefore value the process of producing a high-quality wine that is tantamount to a beautiful painting. Stories of such artisanal wineries abound in the wine media. Others may seek the status and prestige a high-quality wine affords them among their peers, wine critics, or wine aficionados, even if it comes at the expense of personal wealth. Numerous stories appear in the wine press on a regular basis of the latest rich lawyer, venture capitalist, wealthy investor, or real estate magnate who paid an exorbitant price for vineyard land to start a boutique winery with the goal of producing the next “cult wine” that receives high scores from wine critics and accolades from the wine community.30 Making money from the winery seems to be inconsequential to these owners. Many of the choices made by wine firms related to the trade-off between quality and cost discussed in chapters 4 and 6, such as cluster trimming, manual pruning and harvesting, and preferring oak barrels to cheaper alternative oak treatments, are consistent with a willingness to trade-off profit for quality. The prevailing evidence suggests that for many of these choices, the increase in quality may well come at the expense of making less money. For some owners, winemaking philosophy and wine style may be a source of utility. A proprietor may have a strong preference for making wine in an Old World style with subtle nonfruit flavors that reflect the location where the grapes are grown, even though he could make more money offering generic, New World, international-style wine products characterized by intense fruit and oak flavors for which there is greater consumer demand. Another potential nonmarket good that has received much attention involves the lifestyle of a wine proprietor. Many proprietors seem to get much enjoyment from owning an idyllic winery overlooking a beautiful vineyard and participating in tending the land and making the wine, even though they could generate greater profit by purchasing grapes from an independent grower and contracting with a custom-crush producer to make wine, or investing their resources in a different line of business. Other aspects of lifestyle that proprietors may value include socializing with others who share a love of wine, living a rural lifestyle, being one’s own boss, and favoring family members and relatives.
A survey of 184 California wine firms provides some empirical support for the existence of nonprofit motives in the wine industry.31 Almost 80 percent of owners surveyed indicated they would be unlikely to sell their wineries if they could make more money by investing the proceeds in the stock market. About 40 percent said they would be willing to lose money to improve the quality of their wine products. More than half stated that love of wine and the winemaker’s lifestyle were a motivation for owning a wine firm. Almost all of these owners said they wanted to cover their costs and earn some profit. Together these survey responses suggest that while almost all owners want to make some profit, they are not necessarily motivated by earning maximum profit. Many are willing to trade off a certain amount of profit for other sources of utility that can only be obtained through ownership of a wine firm.
Given the above arguments, anecdotal evidence, and survey evidence, it seems reasonable to conclude that the wine industry consists of a mix of both profit-maximizing firms whose primary objective is to make as much money as they can for the owners, and firms with nonprofit objectives whose owners willingly sacrifice profit for firm-specific nonmarket goods such as wine quality and lifestyle. However, is profit-maximizing behavior necessary for long-run survival in a competitive environment like the wine industry, with over 7,000 firms? Are firms with owners who have nonprofit motives jettisoned from the market over time?
Consider the standard “survival of the fittest” argument, which has a long history in economics. Economists distinguish between accounting profit, normal profit, and economic profit. Accounting profit is the difference between a firm’s sales revenue and business expenses. Normal profit is the amount of money the owners of a firm could make if they used the resources currently invested in the firm in their next best areas of employment. Economic profit is the difference between accounting profit and normal profit.32 Positive economic profit provides an economic incentive for new firms to enter an industry. Negative economic profit is an incentive for firms to leave an industry. In the long run, the forces of competition eliminate economic profit. The only firms that can survive in an industry are those that make a normal profit. Because profit-maximizing firms are more efficient and produce output at a lower cost than firms with nonprofit motives, only profit-maximizing firms can earn a normal profit and remain viable.
A simple example will help to clarify the logic of the survival argument and allow us to assess whether it is applicable to the wine industry. Consider two wine firms: a profit-maximizing firm (P), and a non-profit-maximizing firm (N) that sacrifices profit to nepotism. To keep the example free of cumbersome detail, assume that the only resource the owner provides to the firm is his own time. Normal profit is then the amount of money the owner could make if he shut down the firm and devoted his time to the next best employment opportunity. Assume that this opportunity is working for another winery as a cellar manager earning $1,000 per week. According to the survival of the fittest argument, if a firm does not earn an accounting profit of at least $1,000, the owner will choose to leave the industry and take the more lucrative employment opportunity. Now assume that P hires more productive nonfamily labor; N engages in nepotism and employs less-productive family members. As a result, the cost of producing wine is $100 per week higher for N than for P, and P therefore earns an accounting profit of $1,000, while N’s accounting profit is only $900. P is making a normal profit and hence will choose to remain in the industry. On the other hand, N will choose to exit the industry because accounting profit is less than normal profit and the owner can make more money working as a cellar manager.
Why might this survival of the fittest argument not apply to the wine industry? It assumes that markets exist for all goods that provide utility to the owner as a consumer, including nonmarket goods such as nepotism. However, because a market does not exist for nepotism, the owner of N can and will choose to remain in the wine industry and sacrifice $100 of accounting profit for the enjoyment of employing less-productive family members, even though he is earning less than a normal profit and could make $100 more by opting to work as a cellar manager. Clearly N is able to incur the higher cost of nepotism and survive competition from lower-cost P, because N still covers all business expenses of producing wine and makes an accounting profit of $900. The owner of N maximizes his utility by giving up $100 of accounting profit to purchase nepotism and using the $900 of accounting profit to purchase market goods in his role as a consumer. Nevertheless, N faces a cash-flow constraint. If accounting profit is negative, then N does not generate enough sales revenue to cover business expenses, and the owner must therefore either make up the shortfall from other sources, such as personal wealth, or declare bankruptcy and be forced to leave the industry.
To conclude, the survival of the fittest argument is not applicable to the wine industry. Wine firms with both profit and nonprofit motives can survive and thrive in the long run. While it is not possible to directly observe owner and manager motives, I speculate that profit maximization is a reasonable approximation for the relatively small number of large wine firms organized as public corporations, private corporations, and limited liability companies that account for 80 to 90 percent of the wine produced in the United States, even though a number of these, such as Gallo, are owned, controlled, and managed by family members. I also conjecture that a large proportion of the 7,000+ smaller wine firms, many of which are legally organized as proprietorships and partnerships, have nonprofit motives that may have a significant effect on their production and sales decisions and induce them to behave differently from profit maximizers.
When making decisions, the set of alternatives from which all wine firms are able to choose regardless of their objectives is limited by available grape-growing, winemaking, and wine-distribution technology; the characteristics of the market environment in which they operate; and regulatory restrictions imposed by government. The next three subsections discuss these constraints and how they circumscribe wine firms’ choices.
Technology
Wine technology is the current state of knowledge about how to grow grapes, and produce and distribute wine. This knowledge is often embodied in capital equipment such as mechanical harvesters and pruners, rotofermenters, pneumatic grape presses, and temperature-controlled trucks and ships for transporting bulk and packaged wine. However, technology is also embodied in individuals who grow grapes and make wine in the form of human capital from scientific knowledge, much of which has been produced and disseminated by universities. The current state of technology determines the methods of production that are available to a wine firm to grow grapes, produce wine, and distribute wine.33 Technology is a constraint on the decisions of a wine firm because it limits the feasible methods of production from which it is able to choose.
Technology is an important determinant of a wine firm’s cost of production. The cost of producing a given level of output depends upon the technologically feasible methods of production available to a wine firm and the prices it must pay for inputs. A wine firm whose objective is to maximize profit will always choose the least-cost method of producing its desired quantity and quality of output since this is a necessary condition for maximizing the difference between revenue and cost. However, a utility-maximizing wine firm whose owner derives enjoyment from some aspect of the production process will not necessarily choose the cost-minimizing method of production. For example, an owner who derives utility from vineyard land may choose a feasible method of production that has more than the cost-minimizing amount of this input. An owner that experiences utility from a deeply rooted winemaking tradition may choose a method of production that does not minimize the cost of producing wine. In these instances, the utility the owner derives from the higher-cost method of production comes at the expense of profit the wine firm could have made.
In most industries, advances in technology allow firms to produce more output with the same amounts of inputs, or the same level of output employing fewer inputs. These are called cost-decreasing technological advancements, since they result in an increase in technical efficiency and productivity, and therefore lower the cost of producing a given amount of output. However, some types of advances in technology may introduce feasible methods of production that reduce cost, but also lower grape or wine quality. Exactly which technologies and methods of production fall into this category is often the subject of vociferous debate among wine professionals. This is because it is typically much easier to measure the effect of a new technology on cost than on quality. The owner of a utility-maximizing wine firm that cares about wine quality may choose not to adopt a cost-saving technology if he believes that this entails trading off quality and personal satisfaction for the increased profit the new technology will bring. The owner of a profit-maximizing wine firm will adopt the new technology if he believes the reduction in cost exceeds the loss of revenue from selling lower-quality products.
Market Environment
Technology limits input and production choices. The economic environment in which a wine firm operates constrains its output, price, quality, and selling decisions. Economists call this environment market structure. This section discusses some important characteristics of the structure of the wine industry and how this environment constrains firms’ choices. These attributes include the number and size distribution of domestic wine firms and buyers, import competition, the nature of the wine product, barriers to the entry of new wine firms, and the presence of conglomerate wine firms.
The number and size distribution of firms in an industry affects the competitive structure of a market. A characteristic of a competitive industry is the existence of a large number of firms of roughly equal size. A wine firm that operates in a highly competitive market has little discretion in choosing the price of its wine products and is compelled to accept the going market price. While the wine industry has more than 7,000 firms, they range in size from gigantic Gallo with a market share exceeding 20 percent to small boutique producers with market shares less than one one-thousandth of one percent. Because the four largest domestic producers account for more than half of case sales, many would describe this market environment as a highly concentrated oligopoly. However, it is more appropriate to view the wine industry as composed of several different segments occupied by firms producing commodity, premium, and luxury wine products that differ in terms of perceived quality and price. The lower-quality commodity segment is dominated by a handful of the largest firms like Gallo, The Wine Group, Bronco Wine Company, and Constellation; a relatively large number of small boutique firms compete in the high-quality luxury segment. The premium segment is populated by many medium-sized firms, a substantial number of small firms, and relatively few large firms. The environment that characterizes each of these segments imposes different constraints on price, output, quality, and selling decisions.
Closely related to the number of firms in the domestic industry is the extent of import competition. Imported wine products account for about one-third of wine sales in the United States. In addition, in 2010, domestic producers imported fifty million gallons of bulk wine to bottle and sell under their own brand names and use as a blending component in other brands.34 The choices that domestic wine firms are able to make in the commodity, premium, and luxury segments of the market may be limited by import competition. However, availability of imported wine may also expand opportunities for new wine brand offerings, as well as the characteristics of existing brands. The Wine Group’s Franzia brand Chardonnay and Merlot wine products, two of the largest bag-in-box wines sold in the United States, are produced with bulk wine imported from abroad. Today, many domestic wine firms view purchased grapes and imported bulk wine as close substitutes when producing specific products, which increases their winemaking choices. When domestic grape prices increase, wine firms can readily substitute relatively less expensive imported bulk wine for wine produced from purchased fruit in making blended wine products.
The number and size distribution of buyers is also an important characteristic of market structure. From a wine firm’s perspective, it is useful to identify three types of wine buyers: consumers, retailers, and distributors. Wine firms sell their products to about 100 million consumers in the United States. Ninety percent of this wine is sold through distributors; only 10 percent is sold directly to consumers and retailers. Since the 1990s, the number of wine firms has more than doubled, while the number of distributors has declined by more than 80 percent. Today over 7,000 wine firms produce more than 15,000 wine products each year, but must compete to sell them through fewer than 700 distributors. The largest twenty distributors have a combined market share of over 75 percent, and the top five account for more than 50 percent of purchases from wine firms. As the distributor segment of the wine market continues to become more concentrated, it is increasingly difficult for many firms, particularly smaller ones, to find wholesalers willing to carry and promote their products. To increase profit margins, many distributors have eliminated brands of medium-sized and small wineries with slow inventory turnover rates in favor of the high-volume brands of large producers such as Gallo, Kendall-Jackson, and Ste. Michelle Wine Estates. Others have limited the marketing support they provide for many of the wines they carry. This places constraints on the selling choices of wine firms and compels many to promote and market their wines themselves, or distribute their products directly to consumers.
A third prominent characteristic of industry structure is the nature of the good sold on the market. Firms in an industry may produce either identical or differentiated products. In some markets, such as agricultural goods and steel, buyers perceive the products of different firms to be perfect substitutes. In this type of market environment, all firms receive the same price for their products, and branding a product is not a viable option. However, in the wine industry, consumers perceive the products of different wine firms to be imperfect substitutes and develop a preference for the products of certain firms. As a result, if a firm increases the price of a wine product it sells above that of its competitors, it may lose some but not all of its customers; some of its customers still prefer the particular characteristics of the wine product it is selling. This significantly increases the range of choices open to a wine firm. It has more leeway in setting price and can respond to changing market conditions by altering the characteristics and quality of its product. Branding its product through advertising and other promotional activities is also an option.
Consumers may perceive that the sensory characteristics of wine products differ across firms. However, wine products may also be differentiated in ways not related to their sensory characteristics. Many wine firms attempt to create a brand image so that consumers think its products are different from those of other firms, even if this difference is imagined rather than real. They may do this by choice of brand name, bottle and label design, advertising, and the types of retail outlets where they choose to sell their products. A wine firm may choose to undertake promotional activities to brand a product as a luxury wine, even though it has the sensory characteristics of a premium wine, to create a perception of cachet among consumers. A prestigious brand image can give a wine firm significant freedom to charge a high price without sacrificing the amount of the product it sells. A status conscious consumer may well be willing to pay $1,000 for a bottle of 2009 Screaming Eagle Cabernet Sauvignon, even if wine critics conclude that a $70 bottle of 2009 Pride Cabernet Sauvignon has more favorable sensory characteristics, because Screaming Eagle has higher “cachet value.” Another way products are often differentiated is by wine-related services provided by a wine firm. Most wine firms have tasting rooms and sell their wine products to wine-club members and others who submit orders by phone or on a winery website. Some wine firms have well-trained staffs and provide excellent service to consumers in the tasting room and to those who purchase wine by mail.
Barriers to entry are a fourth important characteristic of industry structure. An entry barrier is anything that makes it difficult or impossible for a new firm to enter an industry. All else being equal, the lower the barriers to entry, the greater the number of firms we would expect to find in the industry, and therefore the more competitive the market. Several types of entry barriers exist that affect the ability of new firms to enter the commodity, premium, and luxury segments of the wine market. The commodity segment is characterized by economies of large-scale production. To achieve low unit costs of producing commodity wine, a firm must produce a large volume of it. It would be difficult for a new wine firm to compete with the few existing large producers in this segment of the market, like Gallo, The Wine Group, and Bronco Wine Company, which produce millions of cases per year and thus enjoy low unit costs. This is because the new firm must either enter the commodity segment as a small-scale, high-cost producer, or raise the large amount of money necessary to enter at the efficient scale. It has been estimated that the investment required for a winery with the capacity to produce 500,000 cases per year, which does not fully realize all economies of scale, is about $35 million. Even if the new firm raised this large amount of money and entered at an efficient scale, the consequent substantial increase in the supply of wine would lower price and likely result in losses for both the incumbents and the entrant. The premium and luxury segments of the wine market achieve low unit costs with a smaller output, and they therefore have lower entry barriers. Estimates suggest that the investment required here for a 2,000-case wine facility is about $600,000.35 These costs can largely be avoided by entering as a virtual wine firm and contracting with a custom-crush producer. In fact, this is the strategy that many entrants choose to enter the premium and luxury segments of the market.
A second type of entry barrier germane to the wine industry concerns the absolute cost disadvantage of an entrant that results from the limited amount of vineyard land capable of growing high-quality grapes. To enter the luxury segment of the wine market and successfully compete with incumbent producers, an entrant may require high-quality grapes. Vineyard land capable of producing these grapes is in relatively fixed supply and has increased dramatically in price over the past decade. For instance, in Napa Valley, California the highest-quality vineyard land costs as much as $300,000 per acre, and grapes sourced from these vineyards can command prices of as high as $25,000 per ton. Luxury wine producers who already own high-quality vineyard land have a significant absolute cost advantage over potential entrants, which may preclude new firms from entering the luxury segment of the wine market.
A third type of entry barrier involves product differentiation. Wine firms in the commodity segment of the market have established brand names that many consumers associate with availability, consistency, and low price point quality. They spend a large amount of money on advertising and other promotional activities to maintain their brand images and loyalty. A new entrant is at a disadvantage because it must somehow persuade consumers that the new wine it brings to the market is preferable to existing commodity wines. To induce consumers to try its product, it may have to charge a lower price than incumbent firms and make substantial advertising and promotional expenditures. This may be a consideration that dissuades new firms from attempting to enter the commodity segment of the wine market. However, product differentiation may work to the advantage of firms attempting to enter the premium or luxury segments of the market. By making a wine with slightly different sensory characteristics than existing firms and promoting this product with an interesting story that catches the attention of consumers, the owner may be able to find a niche in the market and operate a small-scale winery.
The size distribution of firms in an industry can be easily quantified by gathering available data and calculating a concentration ratio. The existence and height of entry barriers for the different segments of the wine market is much more difficult to measure. However casual observation suggests that entry barriers are very high for the commodity wine segment and much lower for the premium and luxury wine segments. During the past decade very few firms have entered the commodity segment, while a large number of new firms have entered (and exited) the premium and luxury segments of the market.
The final characteristic of market structure that is relevant to the wine industry involves the existence of large conglomerate firms. A wine conglomerate is defined as a large corporation that produces and sells products in the market for wine as well as one or more other product markets. Under this definition, four large conglomerate firms currently have a presence in the U.S. wine market and account for about 30 percent of case sales.36 In terms of revenue, Diageo is the largest conglomerate, followed by the Altria Group, Constellation Brands, and Brown-Forman Corporation. These conglomerates have annual revenues ranging from about $3 to $16 billion. Constellation began as a wine producer and diversified into the spirits and beer markets; Diageo and Brown-Forman originally produced spirits and extended their activities into wine during the decade of the 1990s.37 The Altria Group, a large producer of tobacco products, entered the wine market in 2009 when it acquired UST, a manufacturer of smokeless tobacco products that owned Ste. Michele Wine Estates. Constellation is the only conglomerate for which wine is the most important source of sales revenue. The presence of conglomerates can affect competition in the wine market independent of the number and size distributions of firms in the industry. These firms might use profits obtained from products other than wine to gain a competitive advantage in the wine market by charging lower prices for wine products than rivals, some of whom may then be forced from the market. Economies of scale and scope gleaned by large conglomerates may also place smaller, undiversified wine firms at a disadvantage. Large distributors, most of whom deal in spirits as well as wine products, may give priority to the products of diversified wine and spirits conglomerates, making it more difficult for other wine producers to market and sell their products.
Government Regulation
Wine firm choices are also constrained by the system of federal, state, and local laws and regulations that apply to the production and sale of wine. Compared to other countries, wine laws in the United States place relatively few restrictions on grape growing and wine production, but significantly more restrictions on wine distribution.
In European nations such as France, Germany, and Italy, wine laws and regulations often impose substantial restrictions on grape growers’ choices in the form of permissible grape varieties, maximum grape yield, and viticultural practices, such as allowable pruning techniques and trellis systems. Wine producers typically face legal restrictions on their choice of grape varieties, alcohol level, acid, sugar, fining agents, maturation time, and in some regions the earliest date at which a wine can be sold. Most European wine regulations apply to quality wines, as opposed to ordinary table wines, and compel wine firms to make choices that are consistent with traditional winegrowing methods and techniques. Grape growers and wine producers in the United States have much more freedom when making these sorts of choices. Regulatory constraints on growers are typically in the form of land-use regulations and laws governing water quality, waste management, and endangered species. While some states have laws that prohibit adding sugar or acid to wine, and federal regulations specify maximum permissible sulfite levels, relatively few regulations govern the production of wine, and those that exist are typically nonbinding. As discussed in chapter 8, the most substantial legal constraints on wine firms’ choices are state laws and regulations governing the distribution and sale of wine.