10
Wine-Firm Behavior
A wine firm is a legal entity that organizes and coordinates the production and sale of wine. To do this, it must make a number of economic decisions that are limited by available technology, market environment, and government regulations. Collectively, these constrained decisions determine how a wine firm will behave. The focus of this chapter is on two facets of wine-firm behavior. The first involves wine quality and price. How do wine firms choose the price and quality of their products and convey information about quality to consumers? The second is the sourcing decision. How do wine firms choose which tasks to perform within the firm and which to contract to other firms in the marketplace? What do these price, quality, and sourcing decisions imply about wine-firm behavior? Before proceeding, a caveat is in order. The literature on decision making by firms contains a number of alternative theories and perspectives, so providing an explanation of wine-firm behavior is not a simple matter. The goal of this chapter is to draw from different strains of the literature to provide some perspective on why wine firms may behave the way they do in organizing and coordinating the tasks required to produce and sell wine to consumers and choosing the price and quality of their wine products.1
ASYMMETRIC INFORMATION AND WINE-FIRM QUALITY BEHAVIOR
Wine firms have better information than consumers about the characteristics of the wine they sell. Because consumers cannot assess the quality of wine before they consume it, the decision to purchase a particular wine involves uncertainty and risk. If wine firms cannot find a way to convey quality information to consumers, then low-quality products may come to dominate the wine market. This outcome is predicted by the Nobel laureate George Akerlof’s adverse-selection “lemons theory.” The word lemon refers to defective automobiles sold on the used car market, which Akerlof used to illustrate his theory.2
Used Cars and Wine Products
Following Akerlof, consider the market for used cars. Suppose owners of used cars offer two types of automobiles for sale: good cars and lemons. Assume individuals who desire to buy a used car would be willing to pay $12,000 for a good car, but only $6,000 for a lemon. However, only the sellers know whether the cars offered for sale are reliable or unreliable. Because buyers lack information on quality, they know the cars they are purchasing may be lemons. Suppose they believe that there is a 50 percent chance of getting an unreliable car. Given the uncertain quality of used cars, they are only willing to pay $9,000, which reflects the risk of purchasing a lemon. Lemon owners are happy to get $9,000 for an unsatisfactory car worth much less. Owners planning to sell good cars are frustrated because the price they can get is below their true value. This discourages owners of good cars and encourages owners of lemons to offer them for sale. As a result, fewer reliable automobiles and more lemons are supplied on the used car market. Over time, the price and volume of used car transactions fall, because a larger proportion are unreliable. When this dynamic process ends, most of the small number of used cars bought and sold will be relatively low-priced lemons.
Given that producers have much better information than consumers about the quality of the wine they offer for sale, why isn’t the wine market a relatively small market dominated by wine products that are “lemons”? Why are consumers willing to pay a relatively high price for a variety of wine products of uncertain quality? Wine firms that produce higher-quality products have an economic incentive to convey this information to consumers. The perceived risk of buying a “good wine” of uncertain quality decreases as the amount of information that consumers find useful in evaluating the quality of the wine increases. But how do wine firms convey information that consumers would find valuable in assessing wine quality? They do this by building a reputation for producing wine of a given quality and providing signals or indicators to consumers to communicate this information. By behaving this way, wine firms that produce higher-quality products can distinguish them from lower-quality products and sell them at a higher price. Wine critics also have an economic incentive to specialize in evaluating the quality of wine products and providing this information to consumers, often in the form of wine scores. Consumers are willing to pay for information provided by credible wine critics to reduce the uncertainty of wine buying. In this way, the wine market is separated into commodity, premium, and luxury segments by quality and price. Wine firms then direct signals about their products to the appropriate segment of the market.
Wine-Firm Quality Signals
Wine firms can use several types of signals to indicate quality. One form of signaling involves reputation. To establish a reputation, a wine firm can take necessary actions to produce a wine of above average or superior quality from vintage to vintage. Consumers who initially buy this wine and discover that it is good make repeat purchases. Information on the quality of the wine spreads as these individuals and retailers recommend it to others. The wine firm’s reputation builds gradually as more and more consumers learn about its product by word of mouth.
A potential shortcoming of relying exclusively on reputation based on the firm’s past performance to signal quality is that it may be a slow process and take many years. This is particularly true in the wine market, where consumers have thousands of wine products from which to choose. A more efficient way to build a reputation and signal quality may be to establish a brand name. A wine firm can invest in brand-name reputation by advertising, label and bottle design, newsletters, websites, and other tasks. By doing this, it makes a commitment to produce wine products of a given quality. If the wine firm does not deliver on the quality promise, then consumers will not make repeat purchases, and its investment in the brand name will be a waste of money. If the wine firm does honor its quality commitment, then consumers will associate the brand name with the promised level of quality and price.
Many wine drinkers come to rely heavily on established brand names that honor their quality commitment. As a result, brand name itself is an intangible asset with market value. In some cases, the market value of a brand name may even exceed the value of the real assets a wine firm owns, such as the winery production plant and vineyards. Today, wine firms regularly buy and sell wine brands as a stand-alone asset, independent of wineries, the services of winemaking personnel, or vineyards. A recent transaction provides an example. Prior to 2007, the Davis Bynum wine firm produced five single-varietal wine products—Pinot noir, Chardonnay, Zinfandel, Sauvignon blanc, and Merlot—and sold them under the Davis Bynum brand name. About 8,000 cases of these products were produced each year in a Davis Bynum–owned winery from both purchased grapes and grapes grown in a Davis Bynum–owned vineyard. In 2007, the Rodney Strong wine firm purchased the Davis Bynum wine brand and the existing inventory of five wine products, but not the winery or vineyard. Rodney Strong now produces the Davis Bynum Pinot noir and Chardonnay wines in its own production facility and sells them under the Davis Bynum brand name.3 The value of the Davis Bynum brand name depends in large part on the degree to which Rodney Strong can maintain the quality and reputation of the two wines formerly produced in another winery by another winemaker with grapes possibly sourced from different vineyards.
A wine firm can also signal the quality of its products by sending a sample to a publication such as The Wine Spectator or The Wine Advocate to be evaluated and scored. The score given by a prominent critic can be a very powerful signal of wine quality and help to establish the reputation of a product very quickly. The risk is that the wine may receive a score below the actual quality level and adversely affect the firm’s reputation and brand name. Anecdotes abound of how the critic Robert Parker has made a wine firm’s reputation overnight. For instance, Elin McCoy, in her book The Emperor of Wine, tells the story of Sine Qua Non, a small startup winery whose products were virtually unknown to consumers. It was producing about 100 cases of wine per year in a rented warehouse in Southern California when the proprietor sent a bottle of its wine to Robert Parker who gave it a score of 95. The day after the next issue of Parker’s newsletter The Wine Advocate was distributed, which included a description and score of the wine product, Sine Qua Non received a plethora of telephone orders from consumers worldwide. Subsequent high scores and consumer demand firmly established the quality reputation of this previously unknown winery, and allowed it to charge high prices for its high-quality products.4
Other quality signals a wine firm may use include wine tourism and information provided on a wine label. Wine tourism brings consumers to a winery tasting room to sample its products and evaluate quality. Consumers may make repeat purchases of products whose quality is commensurate with price and spread the word to others, which helps to build a wine firm’s reputation. A variety of information related to wine quality can be given on the label. This includes a description of the smell and taste of the wine, the location where the grapes were grown, and winemaking techniques. For example, grapes sourced from a location with a reputation for high quality, such as the To Kalon vineyard in Napa Valley, and maturation of the wine in costly new French oak barrels may signal a high-quality wine product to consumers.
MARKET STRUCTURE AND WINE-FIRM PRICE AND QUALITY BEHAVIOR
The prices and qualities a wine firm chooses for its products depend upon the objectives of the owners or managers and the market environment in which it operates. As discussed previously, the wine industry can be separated into commodity, premium, and luxury segments. These submarkets have different structural characteristics and are populated by wine firms with different objectives.
Price and Quality Behavior in the Commodity-Wine Submarket
The commodity segment of the wine industry resembles an oligopoly dominated by a small number of large producers such as Gallo, The Wine Group, Constellation, Trinchero Family Estates, and the Bronco Wine Company, which sell well-known wine brands like Carolo Rossi, Franzia, Taylor California Cellars, Sutter Home, and Charles Shaw. These firms take full advantage of economies of scale, have established brand names, and spend a large amount of money to maintain their brand images. Economies of large-scale production and brand loyalty serve as barriers that make it very difficult for new wine firms to enter the commodity submarket. It is reasonable to assume that the large firms occupying this segment of the market maximize profit. Each firm is acutely aware that if it changes the price or characteristics of its commodity-wine products, this will affect its rivals, which may respond by altering their own price and quality decisions. As a result, when choosing the profit-maximizing price and qualities for a commodity wine, each firm must predict how other firms will react.
In this environment, characterized by a high degree of perceived mutual interdependence, firms may exhibit a wide range of behavior, and a large number of economic theories have therefore been developed to explain how firms make price and quality choices. While the data and studies necessary to determine which of these theories offers the best explanation of firm behavior in the commodity submarket do not currently exist, a few observations related to price and quality decisions are germane.
To maximize profit, firms would seem to have a strong economic incentive to cooperate in setting the prices of their commodity wines. By cooperating and avoiding potentially mutually destructive price competition, they can act as joint monopolists, charge higher prices, share the commodity market, and make greater profits than they would if they behaved as rivals. The most effective way to cooperate is to make a formal agreement as a cartel. However, a cartel agreement is not legally enforceable and even worse is illegal under the Sherman Antitrust Act of 1890. Any such agreement must be surreptitious. While firms in many oligopolistic industries do attempt to make and enforce secret cartel agreements from time to time, the Justice Department has never brought a price-fixing case against firms in the wine industry and there is no anecdotal evidence that large wine firms have ever attempted to collude to fix prices. A more subtle and legal way for wine firms to cooperate is by engaging in tacit collusion. This involves coordinating firms’ behavior by developing a method to indirectly communicate pricing decisions to one another. A common type of tacit collusion observed from time to time by firms in the automobile, steel, airline, cigarette, beer, and breakfast-cereal industries is price leadership. One firm emerges as the price leader, such as Anheuser-Busch, and makes pricing decisions for all firms in the industry. Other firms implicitly concur by setting their prices in line with the price leader, without making a formal agreement to do so. By behaving this way, firms can avoid price competition. In this type of tacit agreement, the price leader is typically the largest firm in the industry or the one that has been in business the longest. In the wine industry, this role could be performed by Gallo. However, once again there is no compelling evidence that large wine firms tacitly consent to a price-leadership arrangement.
Why don’t wine firms in the commodity submarket attempt to explicitly or tacitly collude in making pricing decisions? One possible explanation is that the economic incentive to do so is not sufficiently strong. Large wine producers sell a variety of differentiated wine products on the commodity submarket. If one firm, such as Gallo, drops price, this may not have a big effect on the market shares of other firms, such as The Wine Group and Constellation, that sell products consumers perceive as imperfect substitutes. Differentiated products reduce the degree of interdependence among the pricing decisions of different firms, and therefore the perceived benefit of taking actions to coordinate these decisions. What is more, finding a mutually agreeable price structure for a variety of differentiated products is complex and difficult, and it may therefore not be worth it to large wine firms to attempt to coordinate pricing decisions.
Even though large wine firms do not appear to attempt to coordinate pricing decisions through a surreptitious cartel agreement or a tacit price-leadership arrangement, commodity-wine prices are relatively rigid, suggesting that these firms avoid significant price competition. Each firm likely recognizes that attempting to increase market share by aggressively cutting the prices of its commodity products would likely be ineffective, inasmuch as this would elicit quick matching price reductions by rivals. Moreover, this type of pricing behavior might well degenerate into a price war and substantially reduce profits for all the firms. Large wine firms are more inclined to compete by introducing new commodity wines or brands at a given price point with characteristics that better satisfy consumer wants than those currently on the market, and building the reputation of existing brands. This type of nonprice competition is not as easily matched by rivals as a price cut. Introduction of a successful new brand or an improvement in the image of an existing brand can result in a substantial increase in profits. For example, Constellation introduced twenty new wine products in 2011, with several brands such as Simply Naked and Primal Roots selling at a price point of less than $10 per 750 ml bottle. The Simply Naked brand, which attempts to satisfy consumer preferences for crisp, fruit-forward, unoaked wine, sold about 180,000 cases during the first six months after its debut.5
Price and Quality Behavior in the Premium and Luxury Wine Submarket
The premium and luxury submarket more closely approximates a market environment called monopolistic competition, with characteristics of both a competitive and monopolistic industry. As in a competitive market, there are thousands of firms, most of which are small or medium-sized. Entry barriers are low, and it is relatively easy for new firms to enter this submarket as either a bricks-and-mortar or virtual wine producer. However, because firms sell wine products that have different perceived characteristics, consumers make buying decisions by comparing the qualities of products as well as price, so each firm has a degree of monopoly power in setting its price. Wine firms that sell products in this submarket act independently and may have either profit or nonprofit objectives.
A study by Fiona Scott Morton and Joel Podolny (2002) analyzes the price and quality behavior of wine firms that choose to operate in the premium and luxury submarket. To do this, they formulate a theory of wine-firm behavior and test the predictions it yields with empirical data. Their theory allows the premium and luxury submarket to be inhabited by both profit-maximizing and utility-maximizing wine firms. Profit-maximizing owners care only about making money. Utility-maximizing owners are assumed to derive utility from making good wine as well as profit. They may also derive utility from other types of nonmarket goods, such as those related to wine lifestyle and personal involvement in the winemaking process. All wine-firm owners are rational and increase wine quality as long as marginal benefit exceeds marginal cost. For profit-maximizing owners, the marginal benefit is the contribution to revenue a higher-quality wine will generate. The marginal benefit for a utility-maximizing firm includes the enjoyment the owner experiences from improving wine quality in addition to the increment in revenue. Those utility-maximizing proprietors who derive satisfaction from nonmarket goods that can only be obtained by owning a wine firm increase their consumption as long as the marginal benefit, measured by the additional enjoyment these tasks bring, exceeds the marginal cost resulting from the concomitant reduction in winemaking efficiency. Wine firms produce differentiated products, and therefore face a downward-sloping demand curve. Further, it is assumed that the ability to produce wine differs among owners when they initially enter the wine industry, which results in differences in the marginal cost of wine production. However, the more experience an owner has, the more he or she learns about efficient winemaking techniques.
The theory yields three important predictions. First, utility-maximizing proprietors are willing to trade off profit for the opportunity to produce high-quality wine, and therefore need to make less money than profit-maximizing proprietors. To enter the wine industry and remain viable, profit-maximizing owners must make an accounting profit at least as large as the money payments forgone from not using their resources in the next best area of employment. Utility-maximizing owners are willing to accept less than a normal profit, and some may choose to enter the wine industry even if they expect to make little or no accounting profit, provided they can afford to subsidize any losses they might incur. Because they require less profit and care about making high-quality wine, more utility-maximizing firms than profit-maximizing firms will inhabit the upper end of the premium segment and the luxury segment of the market and will drive some profit-maximizers out of the wine market altogether. The profit-maximizing wine firms that remain in the market will tend to produce products at the lower end of the premium segment.
The second prediction is that utility-maximizing wine firms will have lower average ability and higher marginal costs than profit-maximizing wine firms and charge higher prices for their products. They have lower average ability since they require less profit to enter the industry. They have higher marginal cost for two reasons: first, they have lower average winemaking ability, and second some are willing to accept higher cost in return for the utility of nonmarket goods associated with grape growing and wine producing. Finally, because they have higher marginal cost and face a downward-sloping demand curve for their wine, they will charge higher prices.
The third prediction is that the marginal cost of producing wine will decrease the longer a proprietor operates in the industry. The more experience an owner has making wine, the more he or she learns about the winemaking process. This results in increased efficiency and lower costs.
To test these predictions, Scott Morton and Podolny use data on a sample of 184 California wine firms for the period 1980 to 1990. Based on answers to a number of survey questions, they construct variables that measure the strength of firm owners’ nonprofit and profit objectives. They proceed to analyze the relationship between these variables and measures of wine quality and price, controlling for potential confounding factors. Their results suggest that proprietors with stronger nonprofit motives produce higher-quality wine and tend to operate exclusively in the luxury segment of the market. These proprietors are typically unwilling to include lower-quality premium wine in the portfolio of products they sell. Proprietors motivated by profit produce predominately lower-quality premium products. Those who also produce some luxury wines often don’t make money on these products, but this helps to build a reputation for quality that allows them to charge higher prices for their premium wines. Wine firms whose owners are motivated by nonprofit objectives also tend to charge a higher price for a wine product of given quality than firms whose goal is to make money. This is consistent with the theoretical prediction that utility-maximizing proprietors have higher marginal costs than profit-maximizers. All wine firms lower the prices they charge for wine products of a given quality the longer the owners are in business, but the reduction in price is more rapid for utility-maximizers than for profit-maximizers. This is predicted by the theory of wine-firm behavior and reflects learning by doing and higher initial costs for utility-maximizers who enter the industry with lower average winemaking ability.
The theory and empirical findings of Scott Morton and Podolny imply that the luxury segment of the wine market will be largely populated by utility-maximizing wine firms that enjoy producing high-quality wine and are willing to trade off profits for the opportunity to do so. Relatively inexperienced utility-maximizing proprietors will charge higher prices for products of equal quality than the few profit-maximizing competitors who produce luxury wines, but this price difference will disappear over time as utility-maximizers gain more winemaking experience that results in increased efficiency and lower cost. Even though they are able to produce luxury wine at a lower marginal cost, most profit-maximizing firms choose not to sell these products. Utility-maximizing firms that are willing to accept less than a normal profit and may even use personal wealth to subsidize grape-growing and winemaking operations are willing to pay inordinately high prices for the best vineyard land, highest-quality grapes, most talented winemaking consultants, and other inputs used to produce luxury wines. This makes it unprofitable for most profit-maximizing wine firms to operate in the luxury segment, and they therefore tend to populate the premium segment. The existence of utility-maximizing proprietors who get personal satisfaction from producing high-quality wine suggests the types of luxury wine products offered for sale by these firms depend upon the tastes and preferences of proprietors as well as consumers.
SOURCING BEHAVIOR
The wine firm’s sourcing decision refers to the choice of insourcing or outsourcing a task related to grape growing, wine production, or wine distribution. To insource a task is to perform it within the firm. To outsource a task is to contract with another firm in the marketplace to perform it.
To analyze the sourcing decision, it is assumed that the wine firm may have either profit or nonprofit objectives. The owners or managers make rational decisions, weigh the benefit and cost of insourcing or outsourcing a task, and choose the alternative for which the benefit exceeds the cost. The benefit and cost of insourcing or outsourcing a task are reciprocal: the benefit of insourcing is the opportunity cost of outsourcing; the opportunity cost of insourcing is the benefit of outsourcing. For example, suppose the search and contracting cost a wine firm would incur if it purchased grapes from an independent vineyard is $20,000. This transaction cost is a cost of outsourcing grape production. If the wine firm performs this task internally and grows its own grapes, it can save $20,000 in transaction costs. This is a benefit of insourcing. Continuing this example, suppose the cost of producing grapes within the firm is $75,000 and the price of purchasing the same amount of grapes from the independent vineyard is $50,000. The $25,000 difference between the internal production cost and external acquisition price is a cost of insourcing and a benefit of outsourcing. If transaction and production costs are the only two factors that affect the benefit and cost of sourcing grapes, the wine firm will choose to outsource this task, because the benefit of insourcing the grape input ($20,000) is less than the cost ($25,000), or alternatively the benefit of outsourcing the grape input ($25,000) exceeds the cost ($20,000).
A useful way to think about the sourcing decision is in terms of the following conceptual framework. Suppose that twenty-five technically separable tasks are required to produce and sell wine. A rational wine firm would evaluate the benefit and cost of performing each of these tasks within the firm. It would then order these twenty-five tasks in terms of their net benefits and internalize all of those with positive net benefits, starting with the highest and proceeding down to the lowest. Tasks with negative insourcing net benefits, and therefore positive outsourcing net benefits, would be contracted out to other firms in the marketplace. The benefits and costs of insourcing differ across firms, and wine firms will therefore differ in terms of their sourcing decisions. Factors affecting benefits and costs may also change over time and induce a wine firm to outsource tasks previously insourced or insource tasks heretofore outsourced.
As noted previously, a typical wine firm produces two or more wine products and sells them under one or more brand names. The wine firm must make sourcing decisions about the tasks required for each product. Given its evaluation of benefits and costs, it may choose to insource a task for one product and outsource the same task for another product. For example, a wine firm may choose to insource grape growing and wine production for a luxury wine, while at the same time outsource these tasks for a premium or commodity wine. This gives rise to the possibility that some tasks may simultaneously be insourced and outsourced.
Four important factors affect the benefits and costs of insourcing and outsourcing, and therefore provide a wine firm with economic incentives to organize and coordinate wine production and distribution tasks in a particular manner. These are transaction costs, production costs, product quality, and nonmarket goods.
Transaction Costs
As discussed in the previous chapter, transaction costs are the costs of searching for a party with which to make an exchange in the marketplace, and negotiating and enforcing the contract that specifies the terms of the exchange. The higher the transaction costs of a task, the greater the benefit (cost) of insourcing (outsourcing) it, and therefore the stronger the financial incentive for the firm to perform the task itself. Two important attributes of a market exchange that affect transaction costs are uncertainty and asset specificity. Transactions involving more specialized assets and more uncertain conditions have higher contracting and transaction costs largely because of the potential for opportunistic behavior.6
Uncertainty, or imperfect information, is a characteristic of all transactions. No contract between a wine firm and another party, such as a grape grower, a custom-crush producer, or a distributor, can specify every possible contingency related to a market transaction. The more contingencies associated with a transaction, the higher the contracting costs. This is because more contingencies make a contract more difficult and costly to negotiate and enforce. Much time and money is spent attempting to identify various contingencies that may arise and describe how they are to be resolved. Contingencies not specified in the contract may occur that result in opportunistic behavior and high enforcement costs, or lead the wine firm and the other party to engage in a costly renegotiation of the contract, possibly a number of times over its life. Another type of uncertainty involves measuring and evaluating the good or service being exchanged in the transaction, such as grapes or bulk wine. The more difficult it is to assess the characteristics of a good or service, the more difficult and costly it is to negotiate price and other terms of an agreement and enforce a contract should disputes arise. This is particularly important in wine market transactions since the quality of the grape input and wine product may be difficult to measure and evaluate. As discussed in the previous chapter, the party with whom a wine firm transacts to outsource a task may have better information about the quality of the good or service it is providing and the effort put forth in carrying out the agreement resulting in potential adverse selection and moral-hazard problems. To minimize this type of opportunistic behavior, complex and costly contracts may be necessary. Too many contingencies might even make it impossible for a wine firm to negotiate an agreement with another party to outsource a task, and handling it within the firm may therefore be the only viable option.
Transaction costs of outsourcing grape growing and wine production tasks stem largely from uncertainty and asymmetric information, and may be substantial. Grape quality can be difficult to assess. It depends upon measurable characteristics like sugar and acidity, and nonmeasurable characteristics related to physiological maturity and other flavor-related considerations. Growers generally have better information than wine firms on their ability to produce quality grapes and the effort they expend to do so. The quality of grapes used to produce lower-priced commodity wines is adequately measured by sugar content at harvest time.7 As a result, relatively simple contracts can be written that include penalties or bonuses for sugar content to ensure the desired level of quality and minimize adverse selection and moral-hazard problems. These contracts are relatively easy to negotiate and enforce and the transaction costs of outsourcing grapes for commodity wines is therefore relatively low. However, measuring the quality of grapes used in the production of premium and luxury wines is much more difficult, since physiological and flavor-related characteristics desired by wine firms are difficult to measure at harvest. To ensure quality and minimize problems of adverse selection and moral hazard, relatively sophisticated contracts that account for more contingencies are required. They may include a number of viticultural provisions and monitoring devices that are more difficult to negotiate and enforce. Contingencies not covered by the contract can result in costly disputes and contract renegotiation. As a result, the transaction costs of outsourcing grapes for premium and luxury wines can be relatively high giving a wine firm a financial incentive to insource these grapes.
Outsourcing wine production also entails considerable uncertainty and asymmetric information. Wine quality is uncertain and imperfectly measured. A finished wine product deemed adequate by a custom producer may not satisfy the quality standards of the contracting wine firm. The wine firm and custom producer must agree on what characteristics measure quality and who determines if these characteristics are satisfied. Failure to do so may open the door to a serious dispute. Other contingencies may also occur. For instance, wine quality may be compromised by a poor vintage or other factors beyond the control of the custom producer. Disputes may arise if these issues are not resolved. Moreover, a wine firm cannot perfectly observe the effort put forth by custom producers, many of which also make their own wine products. These custom producers may take better care of their own products than those of their clients, and custom contractors whose effort cannot be measured may shirk and produce a wine of lower than expected quality. Custom producers may not adequately implement the client’s winemaking instructions, and therefore fail to achieve the desired wine style. Contracts that do not address these sorts of contingencies may result in irreconcilable disputes and costly litigation. Writing contracts that cover many of these contingencies can be difficult, and they can be costly to negotiate and enforce. Because of this, outsourcing wine production tasks may entail relatively high transaction costs, particularly for higher-quality premium and luxury wines.
Most transactions between a wine firm and another party involve one or more assets that are required to carry out the exchange. For example, a transaction between a wine firm and a custom-crush producer to exchange money for a wine product requires the use of the plant and equipment assets of the custom producer. A transaction between a wine firm and a grape grower to exchange money for grapes involves the assets used to produce grapes, such as vineyard land, trellises, an irrigation system, and so on. A transaction between a wine firm and a winemaking consultant to exchange money for winemaking services includes the knowledge of the winemaker needed to make the wine, which is called a human-capital asset. When a wine firm or another party invests in an asset that is specialized to a transaction, this is called asset specificity. The degree of asset specificity can be measured by the difference between the cost of investing in the asset for this particular transaction and its value in its next best alternative use: the greater this difference, the more specific the asset is to this transaction.
As an example, consider the following transaction. A manufacturer invests $1 million in equipment designed to produce wine bottles with a unique shape and size for a wine firm. Because this equipment is used to make a highly specialized product that only this wine firm needs, it cannot be used to produce bottles for any other firm, and the next best use of the equipment is therefore as scrap metal with a value of $10,000. The substantial difference between the value of the equipment in its current use and its value in its next best alternative use indicates that this asset has a high degree of specificity. The higher the degree of asset specificity involved in a transaction, the higher the contract and transaction costs. Why? Continuing the previous example, once the contract is signed and the investment is made in the bottling equipment, the manufacturer and wine firm have limited alternatives. The manufacturer is the only producer of the unique bottle design for the wine firm. The wine firm is the only demander of this particular type of bottle from the manufacturer. This creates an incentive for opportunistic behavior by both the wine firm and manufacturer. The wine firm may renege on the contract and try to use its position as the only potential source of demand for the bottles to negotiate a lower price than the one it originally agreed to pay. The bottle manufacturer may renege on the contract and try to use its status as the only source of supply to negotiate a higher price. To protect each party from opportunistic behavior by the other, the contract must have complex terms that are very costly to negotiate and enforce, resulting in high transaction costs.
Asset specificity may help to explain why Gallo produces its own wine bottles. Gallo has manufactured wine bottles since 1957. It currently produces 2.5 million bottles per day with an assortment of molds capable of producing over 100 different bottle design and color combinations.8 If outsourced, the specialized assets required for the variety of bottle designs that Gallo desires would likely entail high transaction costs, which is reduced by internalizing bottle production. Asset specificity may also provide an incentive for wine firms to produce high-quality grapes for luxury wine products from estate-grown grapes, but contract with independent vineyards for grapes of lesser quality for premium or commodity wines. High-quality grapes with a specific bundle of characteristics that a wine firm desires to make a luxury wine may necessitate an investment in a specific type of vineyard land and equipment, giving rise to relatively high transaction costs. Lower transaction costs are incurred when contracting with an independent vineyard that uses less specialized assets to produce grapes with acceptable characteristics for lower-quality wines.
Production Costs
The costs of performing a task are termed production costs. When the cost of performing a given task within a firm is lower (higher) than the cost of contracting in the marketplace to have it done externally, this results in an insourcing benefit (cost) and an outsourcing cost (benefit). The greater the benefit (cost) of relatively lower (higher) production cost within the firm, the stronger the financial incentive for the firm to insource (outsource) the task. The most important factors affecting relative production costs are economies and diseconomies of scale and scope and wine-firm capabilities.
It is typically the case that when the scale of production increases, the average (unit) cost of output declines, at least up to a point. This phenomenon, called economies of scale, is an important factor affecting the cost of performing tasks. Economies of scale in the wine industry can occur either at the winery plant or firm level, and may characterize some tasks a firm performs but not others. For example, it has been estimated that the average cost of producing premium wine in a single winery production plant falls as output increases up to and beyond 500,000 cases per year. The estimates indicate the unit cost of producing a case of wine decreases by 40 percent as the scale of production increases from a relatively small plant capable of producing 10,000 cases per year to a much larger plant with a 500,000-case production capacity.9
There are technological, specialization, and financial reasons for economies of scale. To undertake a task, a firm must typically invest in certain types of assets. The cost of these assets does not vary with the amount of the activity produced. This results in a reduction in unit cost as output expands. For example, to produce wine, a firm typically purchases a building and the equipment it needs to crush, press, ferment, mature, bottle, and store wine. It has been estimated that the initial cost of plant and equipment for a winery with an annual production capacity of 10,000 cases of wine is about $1.6 million, with annual fixed costs of $230,000.10 Suppose the average cost of grapes, labor services, and other variable inputs required to vary output in this winery is $40 per case. If this plant produces 2,000 cases per year, then average fixed cost is $115, average variable cost is $40, and unit cost is $155. If annual production is increased to 4,000 cases, then average fixed cost is $57.50, average variable cost is $40, and unit cost is $97.50. The more cases of wine produced in this building with this equipment, the lower the average cost per case as these large fixed costs are spread over more cases. Also, for technical reasons, the initial cost of purchasing the building and equipment for a larger winemaking plant is proportionately less than for a smaller plant. The investment required for a winery capable of producing 50,000 cases of wine per year is not five times as much as one that has an annual capacity of 10,000 cases, since it does not require five times as much building space, and so on. It has been estimated that the setup cost for a 50,000-case winery of $4.9 million is only three times as much as the $1.6 million investment requirement for a 10,000-case winery, resulting in a lower unit cost for the larger plant. Growing grapes also involves an initial investment in such assets as land, trellises, an irrigation system, tractors, pruners, and a harvester, and a larger vineyard operation can therefore reduce unit cost by spreading overhead and benefiting from the proportionately lower investment cost of a larger scale of production.
A second reason for economies of scale involves specialization of labor. By expanding the scale of a task, workers can specialize and develop an expertise in performing different tasks. As a result, worker productivity rises and unit cost falls. For example, in a small winery with an annual production of 1,000 cases, two or three workers may be required to divide their time among a variety of wine production tasks. In a large winery, workers can specialize in different areas of the production process, such as sorting and crushing grapes, fermenting the must, blending the wine, chemical analysis of the wine, and wine bottling. Specialized workers develop a high degree of proficiency in different tasks. This increases productivity and lowers unit cost. Increased efficiency from specialization also occurs in grape growing and wine distribution.
Performing a task at a larger scale of production may also allow a firm to use specialized equipment that would not be feasible at a smaller scale. This equipment enables the production process to be more highly automated, which increases labor productivity and lowers unit cost. For instance, the Trinchero Family Estates wine firm recently invested $200 million in a new winery near Lodi, California, with the capacity to produce more than six million cases of wine per year. The large scale of this winery allowed Trinchero to install specialized equipment to automate the production process and minimize the amount of labor required. The facility has a test station that automatically takes samples of grape juice to measure sugar content. Grapes are pressed by eighteen machines with automatic grape-filling capacity. Red grapes are fermented in self-cleaning, computerized, stainless steel tanks with a 175-ton capacity and automatic “cap punching” technology. The winemaker is able to program the fermenter to achieve the desired wine style. The plant has the capacity to store more than 30 million gallons of wine in 391 temperature-controlled stainless-steel tanks of varied size, some holding as much as 360,000 gallons. Juice, must, and wine are automatically moved from station to station through conveyor and pump-driven stainless-steel pipes. This minimizes the amount of labor required to perform this function.11 These sorts of productivity-enhancing machines and technologies, which lower the unit cost of producing wine, would not be feasible in a small or medium-sized plant. Large-scale commercial vineyards can also reduce the unit cost of grape production by taking advantage of specialized equipment. For example Beckstoffer Vineyards, the largest commercial grape grower in Northern California, with more than 3,000 acres of vineyard land, employs productivity-enhancing equipment such as automated irrigation systems, machine harvesters, weather-monitoring equipment, computer technology that monitors grape maturity and harvest, and specialized software that measures labor productivity.12 This type of equipment is not feasible for the small-scale vineyards with 5 to 10 acres of vineyard land that comprise more than 50 percent of grape growers in the United States.
Organizing a task on a larger scale can also result in cost savings from lower input prices. A firm may be able to obtain quantity discounts if it purchases large amounts of material inputs. For example, when the 43-million case producer Constellation Wines U.S. purchased the 400,000-case Blackstone winery, it reduced Blackstone’s annual bottle cost by $800,000.13
Economies of scope occurs when two or more products can be produced at a lower cost by a single plant or firm than if each of these products were produced by a separate plant or firm. The most important reason for economies of scope is that the different products employ common inputs. For example, suppose two vineyards grow different grape varieties, one Chardonnay and the other Cabernet Sauvignon. Each vineyard can be harvested with the same mechanical grape picker. The cost of harvesting the two vineyards for a single firm that owns a mechanical harvester is less than cost of two separate firms harvesting these vineyards, each with its own mechanical grape picker. This is because a single firm can spread the fixed cost of the grape harvester over the two grape products. Economies of scope often arise in the production and distribution of different wine products and products related to wine, such as spirits and beer. Here a variety of common inputs may exist. The same plant and equipment can be used to produce different wine brands and products. A winery with excess capacity can produce multiple wine brands at a lower cost than if each brand were produced with the same equipment in a different winery, possibly by a different wine firm. A sales force that sells wine, spirits, and beer may have a lower cost than if each of these products were sold by a separate sales force. The same salesperson can sell more than one wine brand or alcoholic beverage to a distributor or retailer. Distributors and retailers may prefer to deal with one wine firm for all of their wine needs, rather than multiple firms, if the single firm has a wide variety of wines. The input that is shared among different products does not have to be a physical asset; it can also be a knowledge input. Information about one wine brand might help to reduce the cost or improve the quality of another brand. A wine firm that produces multiple products can share grape-growing and winemaking information and expertise across all of these products. Having an expertise in selling spirits may enable a firm to market wine more efficiently. In these situations, it is more costly to produce and sell products separately, because the knowledge input would need to be duplicated for each product.
Economies of scale and scope are not mutually exclusive. A firm that sells many wine products can specialize tasks by plant, such as bottling and blending, to achieve cost savings from economies of scale, while at the same time spreading the cost of common inputs like sales force, knowledge, and shared information across products.
It is possible to glean the benefit of lower production cost from economies of scale and scope by either insourcing or outsourcing a task. For instance, as we have seen, estimates suggest that a wine firm can decrease the unit cost of producing wine by 40 percent if it increases the size of its winery from a plant producing 10,000 to one producing 500,000 cases per year. This cost savings a wine firm would realize is a benefit of becoming larger and insourcing more wine. But what if the demand for its product does not justify this larger scale of operation or it faces constraints in distributing a greater volume of wine? A custom-crush producer that specializes in producing wine products for a number of client firms can enjoy the same economies of scale, and the relatively low unit cost of production can be passed on to client firms in the form of a lower price. As a result, the acquisition price of purchasing 10,000 cases of wine from the custom producer may be lower than producing this wine internally. If so, then the wine firm would have an economic incentive to outsource production. The custom producer might also enjoy additional cost savings from economies of scope that are reflected in price. The custom producer’s facility and equipment can be used to produce multiple wine brands for clients and fully utilize plant capacity. The specialized knowledge of the custom producer in sourcing grapes, producing wine, and possibly marketing wine can be spread over multiple products and clients.
A supplier that specializes in performing grape-growing, wine-production, or wine-distribution tasks for a number of smaller wine firms may be able to operate on a larger scale or scope than each individual wine firm performing these tasks internally. If the cost savings to the supplier firm from economies of scale or scope translate into a lower acquisition price for a wine firm than the unit cost of performing a task in-house, this gives the wine firm an economic incentive to outsource the task. However, if only one or a few large specialized firms perform task, such a supplier may use its monopoly power to charge a relatively high price. This may weaken or eliminate the incentive for a wine firm to outsource.
Large wine firms often realize substantial cost savings from economies of scale and scope by performing tasks in-house, while smaller firms exploit these cost savings through outsourcing. Large firms like Gallo, Constellation, Bronco Wine Company, and Trinchero Family Estates realize economies of scale in grape growing, wine production, and wine distribution from ownership of thousands of acres of vineyards; large-scale or multiple wineries that produce millions of cases of wine each year; specialization of tasks such as blending, bottling, and, for Gallo, bottle production; large volume purchases of equipment, grapes, packaging materials, and other inputs; and large sales forces. These large producers also achieve economies of scope by producing a large number of wine products, with several selling fifty or more different wine brands. Some large wine firms are organized as wine groups. They own a diversified portfolio of wineries that produce different wine brands and sell products in different segments of the market at different price points. Each winery is allowed to act as an independent entity in making product and production choices. Cost savings from economies of scale are obtained through centralized input purchasing, and economies of scope from marketing and selling the firm’s portfolio of products. The firm can offer large distributors and retailers a variety of wine products, which reduces marketing cost and allows smaller volume brands to compete for retail shelf space and expand sales. Distributors and retailers benefit from the ability to purchase many of their wine products from a single wine firm rather than multiple firms.
Many small wine firms achieve the benefits of economies of scale and scope by outsourcing wine production to custom-crush producers. Twenty years ago, there were relatively few of these and most were wine firms willing to contract out production only in periods when they developed excess capacity. Today, a relatively large number of specialized custom producers exist. Many of these have fifty or more clients. Small wine firms that contract with custom producers are able to realize economies of scale and scope indirectly by paying a lower price for a wine than the cost of producing it in their own winery. The custom producer is often able to benefit from volume discounts on inputs that can be passed on to clients. The cost of expensive equipment and technology such as sorting tables, crushers, fermentation tanks, filtration systems, and bottling lines is spread across a number of client firms. For some small wine firms, purchasing this equipment would be prohibitively expensive. A wine firm can use the knowledge of the custom producer and information shared by other clients when producing its product. Some small wine firms realize cost savings from economies of scope by producing their wines in an alternating-proprietor winery. This allows them to spread the fixed costs of the building and equipment over several wine firms, which share the facility and fully utilize the winery.
Small wine firms can also indirectly exploit the cost advantages of economies of scale and scope in grape growing by contracting with a large commercial vineyard. For example, the large independent grape grower Beckstoffer Vineyards sells grapes under contract to more than fifty small-to-medium-sized wine firms. Grapes are grown on different blocks of vineyard land for different wine firms. The fixed cost of productivity-enhancing high-tech equipment such as automated irrigation systems, mechanical harvesters and pruners, weather-monitoring equipment, and GPS technology is spread over the large number of contracting wine firms. These firms would experience high average fixed costs and therefore units costs, or not be able to afford to invest in this type of equipment at all, if they produced grapes in-house in a vineyard the size of their Beckstoffer block. Beckstoffer’s expertise in growing high-quality grapes cost-effectively is shared by the contracting wine firms, allowing them indirectly to realize economies of scope from this information input.
When the scale of a plant or firm that performs a task or set of tasks continues to grow and surpasses some particularly size, average cost may rise with greater production. This phenomenon is called diseconomies of scale. The major reason for diseconomies of scale is the difficulty of efficiently managing a large-scale operation. For example, in a small winery, the winemaker is also the cellar master, who oversees relatively few cellar workers and makes all the important decisions about wine production. It is easy for the winemaker to obtain the information he or she needs by directly observing winemaking tasks and communicating with workers. This permits implementation of effective, efficient decisions. Also, in a small winery cellar workers may be more committed to their job, and it is easier to monitor their performance to minimize shirking and maximize productivity. As the scale of the winery operation increases, the head winemaker has to delegate responsibility and authority to lower level employees. A medium-sized or large winery typically has one or more assistant winemakers involved in implementing the wine production plan, and cellar masters who supervise and manage a relatively large group of cellar workers and lab assistants. Because of the different levels of management and employees, the head winemaker is farther removed from the actual winemaking process. Information must be transmitted among cellar workers, cellar masters, assistant winemakers, and the head winemaker. Problems with communication may result in inaccurate information and misunderstood instructions. Decision-making at different levels makes it more difficult to coordinate wine production. Red tape and paperwork increase. Cellar workers may feel less committed to the winemaking process and, because they are a members of a large team, take the opportunity to shirk, provide less work effort, and take on-the-job leisure. As a result, more supervisors may be needed to monitor workers and maintain productivity. Management and supervision problems of this type contribute to increasing average cost when the scale of a task becomes too large to control and coordinate in an efficient manner. These sorts of management difficulties may well be amplified in a large wine firm that does much of its own grape growing, wine production, and wine distribution. Top management must control and coordinate a wide variety of tasks. As more tasks are carried out internally, planning, coordination, and administration within the firm become increasingly complex and difficult, and the marginal cost of insourcing additional tasks therefore rises. This provides the wine firm with an increasingly stronger incentive to outsource tasks.
Large wine firms may be motivated to outsource grape and wine production to avoid rising costs associated with diseconomies of scale. None of the largest wine firms in the United States grow all of their own grapes or produce all of their own wine. For example, it has been estimated that Gallo produces about 10 percent of its annual million-ton grape input requirement internally on 15,000 acres of vineyard land that it owns and contracts with independent growers for the remaining 90 percent. One possible explanation is that by contracting with a number of grape growers, each of which is big enough to achieve economies of scale, it can indirectly enjoy the cost savings that grape-growing scale brings and avoid the managerial inefficiencies and higher production cost of growing most or all of the grapes it needs in its own mammoth vineyard operation.
The wine firm’s capabilities are another factor affecting production cost. Wine firms and the suppliers with which they might potentially contract may differ in their ability to perform various tasks cost-effectively. This may result in differences in the cost of performing a given task, and therefore motivate the sourcing decision.14 The benefit of insourcing a task is higher for those that a firm is capable of performing more efficiently or for some other reason at a relatively lower cost. Firm capabilities may differ because of different endowments of resources such as the knowledge and skills of owners and employees, capital equipment, and land. Individuals within a wine firm may have knowledge and skills that are specific to producing and selling wine. For example, by reason of experience, education, or natural ability, an owner may be particularly competent in growing grapes, producing wine, or marketing and distributing it. This expertise may be based on tacit knowledge acquired from observation and practice, as in blending wine, and thus not be easily transferrable to other individuals.15 In any case, it may enable the firm to perform specific tasks efficiently and provide an incentive to insource them. Finally, ownership of the capital equipment or land necessary to perform a given task cost-effectively clearly also increases the benefit of insourcing and the cost of outsourcing it.
Consider the following example. Two wine firms desire to produce 10,000 cases of premium wine per year. The investment required to build and equip a winery with this capacity is $1.6 million.16 The proprietor of Firm A inherited a winemaking facility with the capacity to produce this quantity of wine. He also gained significant winemaking experience, knowledge, and skill from being raised in a family that owned a wine firm. The proprietor of Firm B does not own the plant and equipment necessary to produce wine. Having worked for marketing firms, he has expertise in selling wine, but he knows relatively little about winemaking. If Firm A chooses to insource wine production, it will have a variable cost of $544,000 plus an annual fixed cost of $16,000 for property taxes, insurance, and maintenance, making its total cost $560,000, or $56 per case. Variable cost reflects the price of grapes, packaging, utilities, and other variable inputs, and the ability of the proprietor to use efficient winemaking techniques. For Firm B, the annual fixed cost of producing 10,000 cases of wine is substantially higher. Like Firm A, it must spend $16,000 per year on insurance, property taxes, and maintenance, but it must also raise $1.6 million to purchase a winery. This adds an additional $207,000 to its fixed cost. The annual fixed cost for Firm B would therefore be $223,000. Given Firm B’s lack of expertise in cost-effective winemaking, it would have a higher variable cost of $600,000, reflecting the use of less-efficient methods of production. The total cost of internal wine production for Firm B of $823,000, or $82.23 per case, reflects its higher fixed and variable costs. The production cost advantage Firm A enjoys is the result of its endowment of capital equipment and the winemaking knowledge and skills of the proprietor. Now, suppose that both firms are able to contract with a custom-crush producer who charges $70 per case of wine. Firm A would get a production cost benefit from insourcing and Firm B from outsourcing wine production. Firm B may also get an additional benefit from outsourcing production, because it enables the owner to forgo the task of raising $1.6 million to build a winery. For many would-be winemakers, obtaining the large amount of money required to purchase a winery may be difficult or prohibitively expensive. However, because Firm B is endowed with knowledge and skills in marketing and distributing wine, it has an incentive to perform sales tasks internally. Firm A has an incentive to outsource marketing and sales, since it has no specialized knowledge or skills in that area and therefore gets a production cost benefit by contracting those tasks out.
Firm capabilities may be an important factor influencing the sourcing decisions of a variety of wine firms. Several examples help to illustrate this notion. The Teatown wine firm, located in Hudson, New York, calls itself a virtual winery and sells several different wine products in more than fifteen states. It owns neither vineyards nor a winery. Before starting the firm, the proprietor had more than fifteen years of experience as a restaurant wine buyer and working for wine distributors. This prior experience, along with relationships he developed with grape growers, winemakers, and wine firms, provided him with expertise in purchasing bulk and finished wine and marketing it to distributors and restaurants. Based on the proprietor’s knowledge, these tasks are thus performed within the firm. Grape growing and wine production, areas in which the proprietor lacks knowledge, skills, and capital equipment, are outsourced to California wine firms, and the products are sold as Napa Valley Chardonnay and Merlot wine.17
Cameron Hughes is described by many as a negociant. When he was growing up, his father worked in wine sales. He spent several years as a wine broker, acquired substantial knowledge about the bulk wine market, and made the connections necessary to make cost-effective transactions in bulk and surplus bottled wine. Hughes eventually started the Cameron Hughes Wine firm, which draws on his knowledge of the bulk-wine market and sales, along with the skills of the winemaker Sam Spencer, who has expertise in tasting and blending wines, to purchase high-quality bulk and surplus bottled wine at low cost and sell it under the Cameron Hughes label at bargain prices. Cameron Hughes Wine sells its products on a website and through large retailers nationwide like Costco, Sam’s Club, Kroger, and Safeway.18
The wine critic Robert Parker calls David Abreu a “superstar viticulturist” with extraordinary grape-growing knowledge and skills. He owns the David Abreu Vineyard Management Company and manages vineyards under contract for many well-known wine firms in California whose wines consistently receive high scores from the critics. The high quality of these wines is often attributed to Abreu’s expertise in growing high-quality fruit. Abreu also grows grapes on about seventy acres of vineyard land he owns and uses some of this fruit to produce wine that he sells under his own Abreu label. As the proprietor of a wine firm, Abreu uses his expertise in vineyard management to produce his own grapes, but outsources the production and distribution of his annual output of about 500 cases of wine.19
Large wine firms like Gallo and Castle Rock Winery also have particular capabilities that affect the benefits and costs of the sourcing decision. In addition to Gallo’s large endowment of winemaking plant and equipment, it has an expertise in the application of advanced cost-reducing technology that yields large benefits. Gallo has implemented technology to automate its bottle-manufacturing facility to minimize production costs. The Gallo Wine Manager System provides its winemaking team with information on the cost of producing wines of varying styles. Gallo’s regional distribution centers are equipped with a recently installed innovative and efficient inventory management system that has doubled warehouse productivity. It has sophisticated software that provides distributors and retailers with information on Gallo products and their availability. The Gallo Technology Center continues to develop and apply new cost-minimizing technologies on an ongoing basis.20 As noted previously, the Castle Rock Winery is the twenty-sixth largest wine firm in the United States, but contracts out all grape growing and wine production. Marketing, sales, and development tasks are performed within the firm by a relatively small number of individuals who have expertise in these areas.
Product Quality
The discussion so far has focused on the effect of cost on the sourcing decision. All else being equal, the higher the transaction cost and the lower internal production cost, the stronger the incentive is to perform a task within the firm. However, in the wine industry, product quality is also an important factor affecting the benefits and costs of sourcing. Maintaining consistent wine quality may be instrumental in building or protecting a wine firm’s reputation and brand loyalty for its products, so that customers are less likely to switch to products of other firms. Improving wine quality may allow a firm to charge a higher price, generate more revenue, and increase prestige, all of which may benefit the owners through either greater profit, increased utility, or both. The quality of wine products depends upon grape growing and winemaking, which can be performed either within the firm or outsourced. When the contribution to wine quality of a task performed within the firm is greater (smaller) than when it is outsourced, this results in an insourcing benefit (cost) and an outsourcing cost (benefit).
One possible factor contributing to wine quality is the degree of control a wine firm has over a task. Industry participants often maintain that an important benefit from insourcing grape growing and winemaking tasks is that a wine firm has maximum control of them. This ensures the supply of important inputs and allows it to make decisions necessary to protect or improve wine quality. Purchasing grapes from independent vineyards on the spot market may be unreliable. The availability and quality of fruit may be uncertain and may vary from vineyard to vineyard and from one year to the next. A wine firm and grower must carefully coordinate the timing of the harvesting and delivery of grapes, because they are perishable, and failure to do so can have an adverse effect on wine quality. A wine firm can gain more control over the outsourcing of grapes by entering into a long-term contract with a grower. However, as discussed previously, a contract cannot specify all possible contingencies, and adverse selection and moral-hazard problems may preclude it from achieving the desired level of input quality. Some commercial vineyards allow contracting wine firms to opt for greater control over grape-growing decisions by paying per acre of land farmed, rather than per ton of grapes produced, and be actively involved in managing their vineyard blocks. However, by producing grapes in its own vineyards, a wine firm achieves maximum control and is assured of a timely supply of grapes that are more likely to have attributes that satisfy its quality standards.
Lack of control when outsourcing winemaking tasks may also compromise wine quality. In a typical custom-crush arrangement, the contracting wine firm specifies a wine style and possibly winemaking instructions. The custom producer uses its own judgment to achieve the desired wine style, and in so doing may make inappropriate decisions because of lack of communication or moral-hazard problems. Many custom producers have hundreds of clients and high staff turnover, which can result in winemaking chaos. To increase quality control, many wine firms have their own winemakers or contract with a winemaking consultant to oversee the winemaking process. Some custom producers encourage or even require this practice, while others prohibit it. Producing wine internally allows a wine firm to avoid these problems and gives it more control over quality.
Firm capabilities may also have a significant effect on wine quality and therefore the sourcing decision. The benefit of insourcing is higher for those tasks for which a wine firm is capable of making a greater contribution to wine quality. Wine firms and suppliers may differ in their ability to deliver quality because of differences in resource endowments. Arguably, the most important resources affecting wine quality are the quality of vineyard land and the skills of the vineyard manager and winemaker. Vineyard land with climate, soil, and landscape characteristics capable of producing high-quality grapes is in relatively fixed supply, and much of this land has been owned by the same wine firms and independent growers for decades. Firms with an endowment of high-quality land have a stronger incentive to insource grape growing than those who do not. For example, the To Kalon vineyard in Napa Valley, California, originally planted in 1868, is part-owned by Constellation’s Robert Mondavi Winery and part-owned by the independent grape grower Beckstoffer Vineyards. It is acknowledged by many to yield the best red wine grapes in the United States. Constellation insources most of the grapes for its Mondavi Cabernet Sauvignon from its To Kalon acreage. Other producers of high-quality wines that do not have an endowment of vineyard land of comparable quality, such as Schrader Cellars, outsource grapes from To Kalon by contracting with Beckstoffer.
A wine firm that desires to produce high-quality wine and has a highly skilled winemaker realizes greater benefits from producing wine in-house than contracting out for winemaking services, while one with a winemaker of average skill may be motivated to outsource some of its wine products or contract with a winemaking consultant. Today, an active market exists in winemaking consulting. Many of these consultants, such as Helen Turley, Heidi Barrett Peterson, Michel Rolland, Paul Hobbs, and Philippe Melka, are considered to be superstar winemakers of exceptional ability. They have been instrumental in greatly enhancing the reputation of many wine firms that produce high-quality wine. Many of the top winemakers produce wine under their own label and provide consulting services to other wine firms. Some of these, called flying winemakers, provide global consulting services. The French winemaker and enologist Michel Rolland works as a consultant for more than 100 wine firms in the United States, France, Chile, Argentina, and a number of other countries.21 A similarly active market exists in vineyard management and consulting services with superstar grape growers like David Abreu.
Nonmarket Goods
The higher the transaction cost, the lower the internal production cost, and the greater the contribution to quality of performing a task in-house, the more likely a profit-maximizing wine firm is to realize net benefits from insourcing it. This is because net benefits for a profit-maximizing wine firm are measured by the difference between the marginal revenue and marginal cost of a task. Performing tasks within the firm that increase revenue by enhancing quality and reducing cost by not outsourcing contribute to the goal of making as much money as possible for the owners. However, for a utility-maximizing wine firm, the cost-benefit calculus of sourcing includes an additional consideration: the value to the owners of an activity related to a nonmarket good such as wine quality, lifestyle, or nepotism. An owner may derive an insourcing benefit from growing grapes in a self-owned vineyard or producing wine in a self-owned winery because he derives utility from the contribution these activities make to his desired lifestyle. Conversely, he may derive an outsourcing benefit from contracting with a superstar winemaking consultant to assist with or make winemaking decisions because he derives utility from the contribution this makes to his goal of producing a high-quality wine, independent of the effect on wine-firm revenue.