Product Suppliers
FA L L 2 0 0 8
Wholesale-Distributors
Dispelling the Myths of the Three-Tier Distribution System
Product Retailers Prepared by: PROFESSOR DAVID S. SIBLEY* John Michael Stuart Centennial Professor of Economics, University of Texas at Austin PA DMA NAB HAN SRIN AGESH ** Principal, ERS Group
Contents
Executive Summary I. Introduction II. Distribution Overview: The Three-Tier System - Benefits, Value and Choice A. The Purchasing Environment of Wine and Spirits: Variations in Product Characteristics and Individual Taste Create Marketing Challenges B. The Third Tier: Wine and Spirits Retailing C. The Second Tier: Wine and Spirits Wholesalers 1. Wholesaler Logistics Promote Efficient Delivery 2. Beyond Logistics: Marketing Savvy i. Value Added: Specialized Knowledge and Understanding of Local Markets ii. Wholesaler Investments in Brand Equity D. The First Tier: Wine and Spirits Suppliers
III. Economic Analysis A. Economic Efficiency and the Three-Tier Industry Structure 1. Three-Tier Systems are Widely Used, Implying Efficiency 2. Three-Tier Systems Economize on the Volume of Transactions Required 3. Investments in Electronic Transactions 4. The FTC Staff Report and the Efficiency of the Three-Tier System B. The Effects of Allowing Direct Purchases by Retailers 1. Current Alcohol Distribution Structure: The Use of Exclusive Territories 2. Direct Sales to Large Retailers: Free Riders and Inefficiency 3. Bypass of the Three-Tier System: Loss of Economies of Scale,
4 6
9
10 12 14 14 16 18 18 22 25 25 26 26 27 28 28 31 34
Scope and Density 4. Effects of Allowing Bypass: Lower Prices for Limited Products, Higher
36
Prices for Others, Loss of Innovation and Decrease in Business Entities 5. Channel Conflict and the Stability of the Three-Tier System
38 40
IV. Conclusions
42
Executive Summary
Executive Summary
4
Wholesale distribution serves an important and integral function in every major segment of the U.S.
economy. Wholesaler-distributors are key contributors to the efficiency and effectiveness of productsupply chains. In the wine and spirits trade, wholesalers play an important role in marketing established and new products in addition to providing an efficient infrastructure for distributing the products.
In the U.S., most states regulate alcohol distribution to consumers through a three-tier
system requiring producers to sell to wholesaler-distributors who then sell to retailers. These states
use this system to collect state-imposed taxes and for the accountability necessary to ensure that
alcoholic beverages are legally sold to consumers in their states. More generally, states use the three-tier system for the efficient oversight of the distribution of a socially-sensitive product.
Some smaller domestic wineries, wine retailers and large chain stores (also known as big-
box stores) have asked state regulators and courts to create yet another distribution channel, one that bypasses wholesale distribution, arguing that wholesalers are no more than an unneeded layer
in the sale of wine and spirits. That position, however, (i) belies a lack of understanding of the
distribution system for wine and spirits—which encourages product development and competition—
and (ii) ignores the likely negative consequences that would result from its removal.
The analysis here demonstrates that the wholesale tier is an integral part of an economically efficient distribution system that provides:
I Incentives to suppliers, wholesalers and retailers to serve the vast majority of consumer demands for wine and spirits at low cost; I Wide product variety at reasonable prices; and I New products that are designed to satisfy changing consumer preferences.
The analysis also demonstrates that the creation of the new direct channel that bypasses the three-tier system is likely to have negative effects. We find that:
I Wholesalers market the brands they represent, helping suppliers develop “brand equity.” If big-box stores are permitted to purchase directly from suppliers, incentives to invest in marketing—the development and maintenance of brand equity— will be reduced, and incentives to “free ride” on the marketing investments of others will increase. I If laws limiting direct purchases of wine and spirits by big-box stores from suppliers are overturned, the traditional three-tier distribution channel will compete with a new direct supplier-retail channel. Fundamental differences between the business models and incentives of the traditional wholesale channel and a direct supplier-retail channel (i.e., “channel conflict”) will likely result in market failure and economically inefficient outcomes.
* John Michael Stuart Centennial Professor of Economics, University of Texas at Austin. Professor Sibley holds a Ph.D. in economics from Yale University and a B.A. in economics from Stanford University. He recently completed an 18-month term as Deputy Assistant Attorney General for Economic Analysis in the Antitrust Division of the U.S. Department of Justice. Previous public service includes serving as adviser to the Chairman of the Civil Aeronautics Board, and as senior staff economist in the Council of Economic Advisers. Professor Sibley
I A correct interpretation of the FTC Staff Report referred to above is that online direct sales are more expensive than conventional outlets for all but a tiny percentage of wines. I Customers who continue to rely on traditional retailers for products not available at big-box stores will likely pay higher prices for many products. Consumers purchasing wines and spirits from big-box stores will pay lower prices for a limited number of products. Losers may easily outnumber winners. I Some suppliers, wholesalers and retailers will go out of business as big-box stores undercut and free-ride on wholesalers’ marketing efforts. I Ultimately, innovation and product variety will be reduced. I Investments once made by wholesalers in the local economy will decrease as free riding increases.
has taught at Princeton University and at the University of Pennsylvania. He held the position of research manager at Bellcore and Member of Technical Staff at Bell Laboratories. The authors gratefully acknowledge financial assistance from the Wine & Spirits Wholesalers of America, Inc. ** Principal, ERS Group. Dr. Srinagesh holds a Ph.D. in economics from the University of Rochester, and a B.A. in economics from St. Stephen’s College, Delhi, India. He previously taught at the University of Illinois at Chicago and
at Williams College, and was later a Member of Technical Staff at Bellcore. 1
Costco Wholesale Corp. v. Maleng, No. 06-35542, 2008 WL 852396 (9th Cir. Jan. 29, 2008).
2
See Report from the Staff of the Fed. Trade Comm’n, Possible Anticompetitive Barriers to E- Commerce: Wine (2003), available at http://www.ftc.gov/os/2003/07/winereport2.pdf (hereinafter “FTC Staff Report”).
Executive Summary
I Assertions that the three-tier distribution system is inefficient betray a poor understanding of the economic function of wholesalers in the wine and spirits trade. In part, these assertions draw unwarranted conclusions from a widely-cited staff report by the Federal Trade Commission (FTC) that studied online direct sales in 2003 (FTC Staff Report).
5
I. Introduction
6
I.
Introduction
A recent economic study states that there are approximately 503,000 jobs in the wine and spirits industry as a whole in 2008, and the industry contributes $137 billion to the U.S. Gross Domestic Product (GDP).3 The wine and spirits industry consists of three general parts: (1) product suppliers,
(2) wholesale-distributors and (3) product retailers. In most parts of the U.S., wine and spirits are
distributed through these three segments, and this method of distribution is collectively referred to as the three-tier system. Most states created a three-tier distribution system after the enactment of
the Twenty-First Amendment to the U.S. Constitution, which granted broad authority to each state to regulate the importation and transportation of intoxicating liquors within its borders.
The first tier consists of suppliers: wineries and distilleries that produce wine and spirits.
The second tier consists of wholesalers or distributors: intermediaries that purchase wine and spirits from suppliers in the first tier for distribution to retailers in the third tier. The third tier, retailers, includes package stores, grocery stores and other outlets that sell wine and spirits to consumers for
off-premises consumption, as well as restaurants, bars and hotels that sell wine and spirits for on-
premises consumption.
All three tiers of the wine and spirits industry are subject to state regulations in each state
where they operate. States have adopted a variety of regulatory structures, and their rules governing business practices vary. Although specific regulations affecting wine and spirits differ from state to
state, states generally create legal separation between the tiers to limit the ability of firms in one tier
to control firms in another tier, as has occurred in the past, to the public’s detriment.4 Furthermore,
state regulations typically share several policy goals in common, including but not limited to (1)
efficiently collecting taxes, (2) preventing the sale of alcohol to minors, (3) fostering and overseeing
responsible competition in a regulated environment, (4) ensuring product safety and (5) preventing the sale of counterfeit products.
Certain interest groups seeking to change the traditional three-tier structure have alleged
inefficiencies of the wholesale tier. For example, the Wine Institute has alleged that the distribution
(or wholesaling) layer of the three-tier system would be effectively and profitably eliminated but for
its legally-protected status.5 The Free the Grapes Foundation also suggests that the elimination of
the distribution layer would result in consumer benefits including greater variety for consumers.6
Neither the Wine Institute nor the Free the Grapes Foundation supports its position with a
coherent economic analysis of the wine and spirits trade.7 Indeed, a balanced economic analysis of
the three-tier system shows that those criticisms are one-sided and inaccurate. These views neglect the need for any distribution system, including a system using the three-tier hierarchy, to solve key
externality problems such as free-riding, which can result in reduced product innovation, diminished product choice, and less investment in local economies.
In this paper, we describe the three-tier system and the benefits that the wholesaler tier
provides. We explain why using wholesalers is economically efficient and examine criticisms to the Specifically, we examine whether allowing retailers to purchase products directly from suppliers—
by allowing either the retailer or supplier to also act as a wholesaler—will undermine business
arrangements where suppliers grant an independent wholesaler an exclusive territory within which the wholesaler markets specific brands to all retailers on a non-discriminatory basis. In other words,
we analyze the effects of opening a new supplier-retailer channel that can bypass the existing
supplier-wholesaler channel.
As this analysis demonstrates, opening a direct supplier-retail channel (that will effectively
be used only by large-chain (or big-box stores) encourages free-riding, which will likely result in cheaper prices on the limited items that the big-box stores will sell, but will also (1) likely cause
rising prices for wine and spirits sold elsewhere, (2) result in less local investment, (3) reduce brand
development, (4) reduce product innovation and consumer choice for wine and spirits overall and (5) force some local suppliers, wholesalers and retailers out of business. 3
See The Economic Impact of the Wine and Spirits Industry in the United States, prepared by John Dunham and Associates for the Wine & Spirits Wholesalers of America, Inc., 2008, available at http://wswa.org/userfiles/Economic%20Impact. pdf (last visited Sept. 8, 2008).
4
See Carole L. Jurkiewicz & Murphy J. Painter, Why We Control Alcohol the Way We Do, in SOCIAL AND ECONOMIC CONTROL OF ALCOHOL: THE 21ST AMENDMENT IN THE 21ST CENTURY 6-7 (Carole L. Jurkiewicz & Murphy J. Painter eds., 2008).
5
See Background on Anti-Direct Shipment Laws — What Constitutional Law & Prohibition May Have in Common, http://www.wineinstitute.org/ initiatives/stateshippinglaws/backgrounder (last visited Sept. 8, 2008). (“In any other business, if you’ve found a way to effectively and profitably eliminate the middle distribution level, you’d be considered a business wizard. In the alcoholic beverage industry, you’d be considered a criminal.”)
6
See Free the Grapes Research! — Issue Summary, http://www.freethegrapes.com/ research.html (last visited Sept. 8, 2008) (“The U.S. Supreme Court, Federal Trade Commission, state alcohol regulators, and state legislators have joined consumers to help update archaic laws many of which are merely designed to entrench state-sanctioned monopolies in wine distribution.”); see also Free the Grapes! — Our Mission: To Ensure Consumer Choice in Fine Wine., http://www.freethegrapes.org/ mission.html (last visited Sept. 8, 2008) (“[W]holesaler middlemen are aggressively supporting state-sanctioned monopolies in wine distribution.”)
7
This is not altogether surprising. Recently, three Nobel laureates in economics (and their coauthors) noted that “[t]he U.S. wine market has been subject to relatively little systematic empirical or econometric analysis.” Brief of George A. Akerlof, Daniel L. McFadden, Vernon
L. Smith, Donald J. Boudreaux, Robert W. Hahn, John M. Letiche, and Robert E. Litan as Amici Curiae in Support of Respondents Eleanor Heald et al., Granholm v. Heald, 544 U.S. 460 (filed Sept. 23, 2004), available at 2004 WL 2190368, at *4, reprinted as George A. Akerlof et al., Brief 0402, Regulation of Interstate Wine Shipments, AEI-Brookings Joint Center for Regulatory Studies Paper (Sept. 2004) (hereinafter “Akerlof et al.”). Akerlof et al. analyze removal of the prohibition of direct interstate sales of wine by suppliers to consumers. In this paper, we analyze a somewhat different problem: the effect of vertical integration by big-box stores into the wholesale layer for wine and spirits. The economics of wine and spirits wholesaling, the central topic of this paper, is perhaps the least understood aspect of the three-tier system.
I. Introduction
contrary. We then analyze the effects of weakening the traditional prohibition on vertical integration.
7
8
Distribution Overview:
The Three-Tier System - Benefits, Value and Choice To comprehend the economic effects of altering the current distribution
system of wine and spirits, one must understand how the current marketplace
functions, as well as each tier’s role in the marketing and sale of products,
especially the lesser-known role of the wholesaler. This section provides an overview of each tier’s activities and explains how wholesalers interact with the two other tiers providing value-added benefits that are passed on to
consumers. We begin with a discussion of the wine and spirits purchasing
environment and consumer preferences, which shape how each tier conducts
business and the business arrangements among the tiers.
II. Distribution Overview
II.
9
A. The Purchasing
Environment of Wine and Spirits: Variations in Product Characteristics and Individual Taste Create Marketing Challenges
II. Distribution Overview
10
Wine and spirits are constantly evolving as
well. Green’s, a retail chain with six outlets in
Georgia and South Carolina, introduces two new
brands or line extensions (i.e., a new flavor of an existing brand) to its customers each week.11
Central Distributors, Inc. (Central Distributors), an Arkansas wholesaler, carries about 1,800
brands of wine and liquor, of which more than
half are less than ten years old. Central
Distributors introduces about 500 new brands per year to retailers, of which about half fail within one year of product launch and 95
Consumers can select from wine and spirits that
differ widely across many dimensions, including
taste, alcohol content, quality, image, geographic origin and price. For example, Wine Spectator
percent fail within ten years.12 These figures
demonstrate a rapid rate of innovation, which reflects a supply-side response to consumers’
lack of brand loyalty, especially among younger consumers who are more likely to experiment
allows members to research more than 199,000
with new products.13 This innovation is also in
the Wine Business Monthly, 65 percent of sales
extremely heterogeneous. A product that is
wine ratings on-line.8 According to an article in
response to consumer tastes, which are
of case wines to grocery, liquor and mass
popular with one consumer group may be flatly
per bottle, and just two percent are priced above
create new products for consumer groups that
merchandise stores are priced below six dollars
$15 per
bottle.9
Consumers looking for
relatively inexpensive wines can choose from among several tens of thousands of products.
Even consumers looking for relatively expensive wines (i.e., those that cost more than $15 per
bottle) face a daunting prospect; while there are
far fewer wines in this category, the price can range from $15 to $2,000 or more per bottle. Spirits, like wine, are also available in an
increasingly wide range of varieties and prices.
One source on popular brands of tequila, for
example, lists 55 different tequila products to choose from.10
rejected by another, giving firms the incentive to are not well-served by the current array of products.
Consumer choice is far more difficult in
Adding to this complexity, most wine and
this environment than is the case with more
spirits are classic experience goods, meaning a
of information regarding available products
or spirit, or compare it to another wine or spirit,
Therefore, merely offering a high-quality new
spirits are experience goods, consumers respond
in commercial success. When faced with large
them to test products they have not experienced
marketplace, consumers are likely to use
tasting at a retail outlet. At these events, a
homogeneous products. The sheer amount
is too voluminous for consumers to process.
wine or spirit at a low price is unlikely to result amounts of information in a rapidly changing
quality”) to narrow their search. The filters
employed by consumers may help to expedite their decision-making, but these techniques
also prevent them from assessing each product choice
individually.14
In this environment,
without first tasting it.15 Because wine and
especially well to marketing activities that allow
previously. One such activity is a wine or spirits consumer has the opportunity to taste new
beverages and engage in discussions with a
knowledgeable professional. Free or discounted samples at sporting events, concerts or other events can help expose a consumer to wines
or spirits that he might not otherwise try. Sales
marketing and brand management are
by the glass or drink, and half-size or smaller
that can help a product break through the clutter
in some settings.
particularly important and influential activities
of information and competing products flooding
bottles also reduce the cost of experimentation All three tiers of the wine and spirits
the marketplace. In fact, marketing strategies
industry attempt to help the consumer make
consumers who prefer those products over
wholesalers are integral to assisting consumers
play a key role in matching products to
others, a task that is complicated by the constant flow of new products to the market.
choices in the marketplace. While less visible, navigate this complex purchasing environment
as wholesalers play an important role in creating, organizing and executing these marketing opportunities in the locations they serve.
8
See Wine Spectator online — Wine Ratings, http://www.winespectator.com/Wine/Free/WS_ Wine_Ratings/ (last visited Sept. 8, 2008).
9
See Mary-Colleen Tinney, Wine Sales: All Price Points $6 and Above Experiencing Robust Growth Overall Wine Sales Up 11.3 Percent in March, WINE BUSINESS MONTHLY, May 15, 2006, available at http://www.winebusiness.com/html/MonthlyArticle .cfm?dataId=43171 (last visited Sept. 8, 2008).
10
See Colleen Graham¸ A Guide to Popular Brands of Tequila, http://cocktails.about.com/od/spirits/p/ tequila_brands.htm (last visited Sept. 8, 2008) (emphasis added).
11
Interview with Suzie Riga, Owner, Green’s, in Columbia, SC. (Sept. 20, 2007).
12
Interview with Stan Hastings, President, Central Distributors, in Little Rock, Ark. (Sept. 20, 2007).
13
See All Business – Millennial Consumers Seek New Tastes, Willing to Pay a Premium for Alcoholic Beverages, November 26, 2007, http://www.allbusiness.com/consumerproducts/food-beverage-products-alcoholics/ 5316539-1.html (last visited Sept. 8, 2008).
14
See, e.g., Maria L. Cronley et al., A Selective Hypothesis Testing Perspective on Price-Quality Inference and Inference-Based Choice, 15 JOURNAL OF CONSUMER PSYCHOLOGY 159-169 (2005).
15
Experience goods are those that “users learn about through experience.” Carl Shapiro, Optimal Pricing of Experience Goods, 14 BELL JOURNAL OF ECONOMICS 497-507 (1983).
II. Distribution Overview
heuristics (such as “low price equals low
consumer cannot appreciate or evaluate a wine
11
B. The Third Tier:
one time, and approximately half of the labels
change every year.22 Costco and other big-box
Wine and Spirits
stores provide significantly less choice than do traditional off-premise retailers even though
Retailing
there is considerable variation in size among
traditional retailers. For many customers, retail outlets are not just a
also advertise and act as a primary location for
also a principal source of information about, and
tastings.23 At these outlets, consumers purchase
convenient source for wine and spirits, they are II. Distribution Overview
12
Retail outlets not only sell products; many
a place to sample, new products. In 2004, there were approximately 206,000 full service
promotional activities such as free or paid wine familiar products, learn about unfamiliar
products from knowledgeable employees (often
restaurants and approximately 48,000 bars in the
educated by wholesalers) and promotional
approximately 29,400 beer, wine and liquor
with the growth of wine and spirits tastings
United
States.16
stores.17
In the same year, there were
In 2005, there were about 369,000 jobs
in the retail tier of the wine and spirits industry, which contributed about $18 billion toward the U.S.
GDP.18
Table One (at right) displays the percentage
of total sales in each category of retail outlets for the period 1990 to 2005. As the table shows, the percentage of sales flowing through each
category of retail outlet appears to have been
displays (often supplied by wholesalers) and, (often organized, staffed and paid for by
wholesalers), experience a larger number of new wines at low or zero cost. In turn, retailers and wholesalers gain a deeper understanding and intimate knowledge of the role of product attributes and promotional strategies that
attract customers from different locations and demographic groups.
Because wholesalers serve a wide cross-
relatively stable over this period.
section of retailers, they are uniquely positioned
and spirits they carry. A typical bar- or full-
differences among the retailers they serve and
Retail outlets vary in the number of wine
service restaurant offers consumers a few dozen wines and spirits. Larger traditional retailers
such as Knightsbridge Wines in Illinois and the
Wine Club in California stock about 8,000 SKUs
(Stock Keeping Units, or distinct
items).19
In
the state of Washington, state-operated retail stores stock about 1720 SKUs.20 In South
Carolina, Green’s stocks upwards of 5,000
SKUs in its stores.21 By contrast, a typical
Costco Wholesale Corp. (Costco) outlet sells
120 wine labels and 30 to 35 spirits labels at any
to observe closely any common trends or
to convey their understanding of the marketplace to the suppliers they represent. This valuable
information efficiently flows in both directions helping retailers and suppliers respond more
effectively to varied and changing consumer tastes.
TA B L E 1 : Proportion of Alcoholic Beverages Sold Through Different Channels, 1990 – 2005 (Percent) 1990 1995 1999 2000 2001 2002 2003 2004 2005 Packaged Alcoholic Beverages
52
52
50
50
49
48
48
48
Liquor Stores
26
24
23
23
23
22
22
22
23
Food Stores
15
15
15
15
15
15
15
15
15
All Other
12
13
14
12
11
12
11
11
11
48
48
48
50
50
51
52
52
52
37
38
38
40
40
41
42
42
42
5
5
5
5
5
5
5
4
4
6
6
6
6
6
5
5
5
5
100
100
100
100
100
100
100
100
100
Alcoholic Drinks Eating & Drinking Places Hotels and Motels All Other
II. Distribution Overview
52
13
Total
16
See U.S. Census Bureau, U.S. Department of Commerce, STATISTICAL ABSTRACT OF THE UNITED STATES: 2008, Table 1247. In a full service restaurant, customers are seated at a table, order their food to be brought to the table, and pay at the end of the meal. Not all full service restaurants serve alcohol.
19
17
See U.S. Census Bureau, U.S. Department of Commerce, STATISTICAL ABSTRACT OF THE UNITED STATES: 2008, Table 1014.
20
18
Economic Contribution of Wine and Spirits Industry, 2005: Retailer Tier, prepared by John Dunham and Associates, Guerilla Economics, LLC (New York, New York), available by request.
See H. Lee Murphy, Costco’s Challenge, MARKETWATCH, 25, 33 (July/Aug. 2006); Microsoft Business Solutions Customer Solution Case Study — Wine Chain Uncorks New Sales and Smashes Business Bottlenecks (June 2004), available at http://www.adctech.com/documents%5CCaseStudy _WineClub.pdf (last visited Sept. 8, 2008). Washington State Retail Liquor Sales Task Force Final Report, at 3-24 (Roundtable Assocs. Dec. 2000), available at http://www.roundtable associates.com/PDF/WA%20Liquor%20Sales%20R eport.pdf (last visited Sept. 8, 2008).
21
Interview with Suzie Riga, Owner, Green’s, in Columbia, SC. (Sept. 20, 2007).
22
See H. Lee Murphy, Costco’s Challenge, MARKETWATCH, 25, 30 (July/Aug. 2006).
23
See Microsoft Dynamics — Top Trade Secrets of a Wine Store Retailer, http://www.microsoft.com/ dynamics/rms/product/liquorretailerstradesecrets. mspx (last visited Sept. 8, 2008).
C. The Second Tier: Wine and Spirits
Wholesaler Logistics Promote Efficient Delivery
Wholesalers
Economies of scale28 are the primary source of
wholesaler efficiencies. It is estimated that
Wine and spirits wholesalers purchase goods from suppliers for resale to
retailers.24
Distributors come in all sizes, and as of August II. Distribution Overview
14
1.
2008, there were approximately 16,000
wholesaler licenses in the U.S.25 In 2002, the
four largest firms accounted for 24.6 percent of sales, the top eight for 35.9 percent, the top 20
wholesaler activities reduce retailers’ costs by almost $52.00 for every $1,000.00 in retailer sales, for a national savings in retailer
operating costs of $7.2 billion per year,
contributing to lower prices for consumers.29
The sources of these efficiencies are discussed in greater detail below.
The efficient delivery of wine and spirits
for 53.6 percent, and the top 50 for 72.4
“entails much more than driving fast and finding
employed by wine and spirits wholesalers. Total
supplier produces relatively large volumes of a
dollar spent on wholesaling is estimated to
typically demands several bottles each of a large
percent.26
In 2008, 88,500 people were directly
wages paid amounted to $3.7 billion. Every
generate $1.41 of economic activity, $0.20 in
federal tax revenue, and about $0.22 in state and local tax revenues. Total economic activity generated by this sector amounted to $6
billion.27
the shortest distance between two points.”30 Each
limited number of brands, while each retail outlet selection of brands. Wholesalers match these
very different needs of suppliers and retailers by maintaining inventories in their warehouses and
operating transportation fleets to deliver wine and spirits to retail outlets in a timely manner.31 For
example, wholesalers routinely deliver individual bottles or split cases (cases customized with
“In the overwhelming majority of cases,
wholesalers provide the cheapest method
of transporting these specialized goods to market versus transport through common carriers or individual suppliers.”
various individual bottles) to stores, bars and
restaurants, frequently within a less-than-24-hour turnaround period.32 This is a custom service provided by wholesalers for the benefit of
suppliers, retailers and ultimately, consumers. Using wholesalers, suppliers can sell large
volumes of products in a relatively small number
of transactions, and retailers can customize orders
to their specific needs. Retailers can then maintain smaller inventories and save on storage space and working capital.33
Improved technology augments wholesaler
efficiencies. Nowadays, wholesalers increasingly rely on sophisticated computer-based
information systems to extend their logistic
ship each order for timely delivery in accordance
to the heavily-regulated beverage alcohol
obligations to collect and pay applicable taxes.
capabilities, solve logistical challenges specific industry and better service their retailers and
with applicable regulations and in compliance with The efficiency of wine and spirits
suppliers clients. Central Distributors, for
wholesalers in performing the “Shipping and
sales representatives have wireless laptops that
of circumstances has been acknowledged in
example, has a paperless warehouse, and all its can be used for remote order
entry.34
These
information systems help ensure that complex shipments, payments and taxes are accurately are met. Computer- and communications-
technologies not only increase the efficiency of product ordering, handling, delivery and
reporting, but also provide a streamlined and
timely method of collecting information, which is used to better respond to consumers. The information gathered can further be used to create effective brand sales plans, which is valuable to all segments of the industry.
Most suppliers and retailers do not have
the logistical and technological capabilities, and specialized storage and transport infrastructure that wholesalers have developed and installed.
Suppliers would find it prohibitively expensive
to assemble orders for individual retailers and to
24
See Alcohol and Tobacco Tax and Trade Bureau, Importers/Wholesalers, Information By Topic Frequently Requested Listings: Alcohol Wholesalers (Excel Spreadsheets), http://www.ttb.gov/ importers/index.shtml (last visited Sept. 8, 2008) (menu of permit data as of Aug. 2008).
26
See U.S. Census Bureau, U.S. Department of Commerce, Alcoholic Beverages and Tobacco Products: 2002, www.census.gov/prod/ec02 /ec0242i01t.pdf (July 2004), at Tables 1 and 4. The FTC Staff Report relies on a Wall Street Journal article and Pacific Research Institute study to assert that the number of wholesalers fell from “several thousand in the 1950s to a few hundred today.” FTC Staff Report, supra note 2, at 6. Other researchers assert that there were 600
Staff Report establishes that timely delivery using UPS can be considerably more expensive than
delivery through traditional wholesalers for the
vast majority of wines. Even Nobel economists have conceded that, “since transportation costs
constitute a larger proportion of total cost for lowvolume shipments, on-line purchases are not a winning proposition for the connoisseur’s
sampling purposes.”35 In Section III of this
paper (Economic Analysis), we review evidence
showing that, in most cases, the logistical
operations of wholesalers are more efficient than other readily-available alternatives available to
consumers and suppliers. In the overwhelming majority of cases, wholesalers provide the
cheapest method of transporting these specialized
goods to market versus transport through common carriers or individual suppliers.
wholesalers in 2002. See Gina M. Riekhoff & Michael E. Sykuta, Regulating Wine by Mail, REGULATION 30, 31 (Fall 2004), available at http://www.cato.org/pubs/ regulation/regv27n3/v27n3-3.pdf (last visited Sept. 8, 2008). These statistics do not appear to be based on official data. The Barsby Report explains why the number of wholesalers is hard to estimate with precision. See also Steve L. Barsby & Associates, Inc., The Regulatory and Economic Basis of Wine and Spirits Wholesaling in the Alcohol Beverage Industry 27-28 (2nd ed. Undated) (A study prepared for the Wine and Spirits Wholesalers of America, Inc.) (Hereinafter, “Barsby Report”).
Unlike brokers or agents who work on a commission basis, wine and spirits wholesalers are merchant wholesalers who purchase goods on their own account for resale. Merchant wholesalers earn profits on commercially successful products and incur losses on failed products.
25
independent analyses. For example, the FTC
27
See John Dunham, The Economic Value of Wine and Spirits Wholesalers (2008), http://wswa.org/userfiles/ Economic%20Value.pdf (last visited Sept. 8, 2008).
28
With economies of scale, unit costs fall as output increases. When fixed costs are a significant portion of a firm’s expenses, economies of scale are likely to be important.
29
See John Dunham, The Economic Value of Wine and
Spirits Wholesalers (2008), http://wswa.org/userfiles/ Economic%20Value.pdf (last visited Sept. 8, 2008). 30
Barsby Report, supra note 26, at 18.
31
For example, National Wine & Spirits, Inc. (“NWS”) operates three master warehouses, three hyperterminals and seven cross-docking facilities in Indiana and Michigan, and owns approximately 319 delivery vehicles. See National Wine & Spirits, Inc., Form 10-K, Annual Report for the Fiscal Year ended March 31, 2006, at 10, available at http://www.secinfo.com/d14D5a.v44g2.htm#2zc5 (last visited on Sept. 8, 2008) (hereinafter “NWS 2006 Form 10-K”).
32
For many products, refrigerated storage and transport are necessary.
33
Interview with Suzie Riga, Owner, Green’s, in Columbia, SC. (Sept. 20, 2007).
34
Interview with Stan Hastings, President, Central Distributors, Inc., in Little Rock, Ark. (Sept. 20, 2007).
35
Akerlof et al., supra note 7, at 7.
II. Distribution Overview
tracked and that state and federal regulations
Handling” or logistical function in a wide range
15
2.
Beyond Logistics: Marketing Savvy
The U.S. Census Bureau notes that wholesalers perform several marketing functions:
orders are either vendor-initiated or client-
initiated, generally based on previous sales, and typically exhibit strong ties between sellers and
II. Distribution Overview
16
The broad description of wholesaling employed by the U.S. Census Bureau masks significant
differences across industries. In the wine and spirits industry, wholesalers are integral
contributors of the “marketing services” that
are generically described by the Census Bureau.
The long-term relationships that wholesalers
develop with suppliers and retailers are critical as these relationships uniquely position
wholesalers to effectively conduct the marketing
buyers. In fact, transactions are often conducted
functions they perform. In this section, we
longstanding business relationships . . . . Goods
undertaken by wholesalers.
between wholesalers and clients that have
are generally sold without transformation, but
may include integral functions, such as sorting, packaging, labeling and other marketing services.36
review the range of marketing activities
In general, the supplier creates the consumer
image, while the distributor communicates that
image to a number of retailers, who then help
communicate that image to consumers. Together, these efforts create the value in a product. For example, Bacardi U.S.A., Inc. (Bacardi)
communicates their strategy to their wholesalers, and the wholesalers are responsible for the
execution of that strategy. In fact, wholesalers
perform up to 90 percent of marketing and promotional activities targeting retailers.
These include some or all of the following: 37
I Spending a certain percentage of gross profit on building brand equity; I Funding expenditures by the supplier that build brand equity in the
distributor’s territory; I Creating internal divisions that exclusively represent certain suppliers;
I Placing competing brands in different divisions to ensure that these
brands are managed and marketed independently of one another; I Creating and executing new promotions and events in local areas; and I Sponsoring certain brands at specified local events.
36
See U.S. Census Bureau, U.S. Department of Commerce, Annual Benchmark Report for Wholesale Trade: 1992-2005 (Mar. 2005), at Appendix B B-1.
37
Interview with John Esposito, President and CEO, Bacardi U.S.A., Inc., in Miami, Fla. (Sept. 21, 2007).
II. Distribution Overview
I Hiring employees solely dedicated to the marketing of certain brands;
17
i. Value Added: Specialized Knowledge and Understanding of Local Markets
Wholesalers are especially well-situated to
and primarily relies on distributors to educate and convince retailers (such as bartenders) to
recommend Sazerac’s products to consumers.41
perform marketing functions because they
Even Ernest and Julio Gallo noted the
intimate knowledge about the buying habits and
industry, describing wholesalers as “vital to
possess important marketing tools and have
demographic characteristics of the customers in
each of the retail outlets and every neighborhood
they service.38 They interact with all their local II. Distribution Overview
18
retailers with special, customized promotions
importance of the distributor’s role in the wine [their] business” because of the work they do with the local retailers.42
Diageo PLC (Diageo), one of the largest
retailer clients, some a few times per week, and
supplier of spirits, explains that the “successful
are selling well on an individual retailer basis at
distributors have helped increase [their] share of
they have detailed knowledge of what products
business relationships [they have] with [their]
any given time. Because wine and spirits are
U.S. spirits for 30 months now.”43 An example
marketing activities, distributors’ knowledge of
Sunbelt Group (CSG) helped Diageo test-market
experience goods and highly influenced by
consumers’ purchasing habits can be critical to the whole industry. Armed with such
of this collaboration is when the Charmer
Chocolate Mint and Crème Caramel variants of Bailey’s Irish Cream in the Arizona market.
knowledge, wholesalers can convey consumer
Relying on CSG’s detailed knowledge of retail
promotional activity to the retail outlets where
Diageo selected the accounts (i.e., retailers) at
purchasing habits to suppliers, as well as target
outlets in Arizona and their respective clientele,
the desired audiences are most likely to be
which the new products were introduced, and it
some of these functions, they are not as efficient
consumers to the brand. Following this
found. While certain third parties can perform as
wholesalers.39
Third parties marketers do not
have the depth or breadth of relationships with
facilitated promotional activities that exposed
introduction, the products tested well and were rolled out nationally. Diageo, in turn, selected
local retailers that wholesalers do.
CSG distributors to be exclusive distributors of
specialized knowledge of the local market that
recoup its investments in the Bailey’s brand.44
Suppliers recognize the value in the
wholesalers have and their important role in
marketing products. As previously noted,
these products in several states, helping CSG
Bacardi relies on wholesalers to perform
ii. Wholesaler Investments in Brand Equity
retailers. Bacardi develops the marketing
investments undertaken by wholesalers may
marketing and promotional activities targeting strategy, and wholesalers help implement it.40 Another supplier, Sazerac Company, Inc.
(Sazerac), hires only a few salespeople to help
Depending on state rules, specific marketing include:
I Performing category management by ensuring that a product designed for a particular consumer segment reaches that segment. I Organizing tastings for retailers (and sometimes consumers) to familiarize them with products and create demand for the products.
I Creating, organizing and/or sponsoring special local events, contests or festivals that feature particular brands or products. For example, Southern Wine & Spirits of America, Inc. (SWS), a wholesaler, created and hosts the Food Network South Beach Wine & Food Festival, a four-day event showcasing wines, spirits, chefs, and culinary personalities.45 I For new wines available in limited quantities, promoting through wordof-mouth, which may be the most effective marketing tool for that product.46
38
Interview with Arlyn Miller, Vice President and Assistant General Counsel; Joe Davolio, Executive Vice President, Sales & Marketing; and Ashley Wilkinson, Corporate Marketing & Communications Manager, The Charmer Sunbelt Group, in New York, N.Y. (May 14, 2007) (hereinafter “Interview with CSG Executives”).
39
Interview with John Esposito, President and CEO, Bacardi U.S.A., Inc., in Miami, Fla. (Sept. 21, 2007).
40
Id.
41
I Teaching the retailer to place the product in a preferred location in the store – i.e., a gin should be placed in the gin section, or near other gins, not with whiskies. Wholesaler intervention is often necessary to ensure appropriate placement. I Producing and/or distributing the displays at retail outlets, otherwise known as point-of-sale materials, including table tents, shelf-talkers, or brand-related merchandise. I Printing indoor and outdoor signs for retailers (e.g., a sign with the retailer’s name and the picture of a sponsor’s product for display above the main entrance). Central Distributors and many other wholesalers have invested hundreds of thousands of dollars in sign-making equipment to help them perform this function. The cost of providing signs that feature a specific brand is often shared by the supplier of that brand. I Providing laptops with marketing presentations to sales representatives for use on their visits to retail outlets.
Interview with Mark Brown, President and CEO, Buffalo Trace Distillery, in Franklin County, Kentucky (July 10, 2007).
42
See Ernest and Julio Gallo with Bruce B. Henderson, ERNEST AND JULIO OUR STORY, 203, 270 (Times Books 1994).
43
Diageo, 2007 Investor Conference – Thursday 26 April 2007, available at http://www.diageo.com/ NR/rdonlyres/ABFE8A43-A30F-4A1C-81DC92EBDC2E2CD2/0/IntroductionTranscript.pdf. (Last visited Sept. 8, 2008).
44
Interview with CSG Executives, supra note 38.
45
2007 Food Network South Beach Wine & Food Festival, About: What We Do, http://www.sobewine andfoodfest.com/2007/about.php (last visited Sept. 8, 2008).
46
Interview with Stan Hastings, President, Central Distributors, Inc., in Little Rock, Ark. (Sept. 20, 2007).
II. Distribution Overview
I Determining the appropriate means by which to introduce a new product or new campaign, increasing the likelihood of commercial success.
I Creating sample wine lists, winefood pairings, and specialty cocktails.
19
These marketing activities are also
examples of how wholesalers contribute to
SWS, the nation’s largest wholesaler, employs
market—an increasingly important activity in
Educators and seven award-winning mixologists
efforts to introduce new products to the
the wine and spirits industry. In five years, 20
nine Master Sommeliers, seven Certified Wine to help educate its employees and customers
percent of Bacardi’s profits will come from
(on- and off-premise retailers) about the brands
products generate little profit early in their life
Alvarado “offers a series of courses that cover
products that are not on the market today. New cycles and require greater effort and cost to
distribute. Shelf management is harder: a sales II. Distribution Overview
20
Investments also extend to education.
clerk who sees an empty spot on the shelf may fill the spot with a traditional product simply
because he is unfamiliar with the new brand that belongs in that spot. Exclusivity in representing
it sells.48 SWS Master Sommelier Serafin
an extensive range of subjects that vary from
wine and service fundamentals to regional or
varietal focus.”49 Such courses can be used to showcase brands represented by SWS and
expand the market for wine and spirits generally. With this expertise, SWS earns the professional
brands is especially important to ensure that the
regard of suppliers and retailers, and increases
and assure that newer products are in front of the
to retailers. The more knowledge a retailer has,
wholesaler can effectively manage marketing
targeted consumer segments. The value of this service can be significant since the inventory
holding costs associated with new brand introduction can exceed $1
million.47
the effectiveness of selling brands it represents
the more knowledge that the consumer will gain, which benefits the purchasing experience.
Wholesalers are incentivized to perform
these varied marketing functions to the
satisfaction of the supplier in order to earn
higher profits and to avoid being replaced by
another wholesaler. Even in “franchise states” where a supplier may only terminate a
wholesaler for cause, wholesalers have financial incentives to promote the brands they distribute.
Central Distributors, for example, does not fully
the NWS Annual Report for the 2005-2006
retail price is constrained by the prices retailers
million for the year ended March 31, 2006 as
are determined in negotiations with suppliers.
to the product sales segment which increased
control the margin it earns on its products – the
pay for competing brands, and wholesale prices When a wholesaler fails to sell a product at a
profitable price, the unsold inventory is deeply discounted and may be sold at a loss by the
wholesaler. As such, wholesalers often find that their most profitable strategy is to undertake efforts that increase their
sales.50
These
investments help build brand equity, while
interbrand competition keeps prices in check, ensuring that comparable brands sell at competitive prices.
National Wine and Spirits, Inc. (“NWS”),
another large wholesaler with operations in Indiana and Michigan, exemplifies the
compared to the prior fiscal year, primarily due personnel and related wages and commissions
by approximately $9.3 million, brand promotion costs of approximately $4.8 million, and greater auto expenses of $0.8 million. The increased
costs were the result of supporting the additional brands that are represented in the product sales segment that were not distributed by the
Company in the prior fiscal year.”52 CGS, SWS and NWS provide concrete examples of the marketing functions performed by many
wholesalers. Together, these three distributors
illustrate the crucial role played by wholesalers in developing and maintaining brand equity.
magnitude of the investments made by
wholesalers in promoting the brands they
21
represent. For the year ending March 31, 2006, NWS incurred approximately $66 million in
selling expenses, amounting to 9.2 percent of total revenues or 11.9 percent of its cost of
goods sold.51 Disaggregated information on
these selling expenses is not available, but their
purpose is clear from the following statement in
47
Id.
48
See Southern Wine & Spirits, Southern Wine & Spirits of America, Inc. Strengthens its Historic Commitment to Professional Excellence in Wine Education and Wine Service, http://www.southern wine.com/News/tabid/109/mid/ 521/newsid521/ 343/Default.aspx (last visited Sept. 8, 2008).
49
II. Distribution Overview
investments in marketing and promotional
fiscal year: “Selling expenses increased $15.6
“...the inventory holding costs associated with new brand introduction can exceed $1 million.”
Southern Wine & Spirits of Illinois, SWS School of Wine & Beverage Service, http://www.southern wine.com/OfficesNationwide/Illinois/ILHome/tabid/ 147/Default.aspx (last visited Sept. 8, 2008).
50
Interview with Stan Hastings, President, Central Distributors, Inc., in Little Rock, Ark. (Sept. 20, 2007).
51
NWS 2006 Form 10-K, supra note 31, at 39.
52
Id. at 23 (emphasis added).
D. The First Tier:
The four largest wineries collectively
account for two-thirds of all wine production but
Wine and Spirits
only about half of wine revenues in the United States.58 These figures imply that smaller
Suppliers
wineries tend to focus on the production of more expensive wines. Table Two displays data on
According to the U.S. Census Bureau, there were 1,551 firms in the winery sector in
2005.53
In 2002, more than half of these firms were in II. Distribution Overview
22
California (i.e., 666 out of
1126). 54
In 2005,
nationally, 795 winery firms had no more than
four employees, although seven had more than 2,500 employees, indicating a highly-skewed
size distribution.55 In 2005, there were about 32,100 jobs in the winemaking industry, and
wineries contributed $11.6 billion to the U.S. economy.56
According to the Wine Business Monthly
there were only 4,740 wineries in the United States in 2004. In 2005, there were 5,364
the size distribution of wineries.
As is shown in Table Two, the 1,398 wineries
selling fewer than 10,000 gallons of wine per year (or approximately 56 percent of the total of 2,481
wineries) together produce only about four million gallons of wine, or about 0.7 percent of the
industry output. For some of these wineries,
marketing will be prohibitively expensive, and
organic growth will be difficult. Wholesalers can provide valuable marketing support to smaller wineries in need of such support.
In addition to the output of domestic
wineries, consumers purchase imports from
Europe, Australia, Central and South America,
and, now, Africa and Asia.59 As of August 2008,
wineries operating in the United States, of which
there were approximately 9,097 permits issued
“virtual” wineries.57 The number of wineries
more than one permit, there are fewer importing
2004 to 2005. The increase in the total number
clear that a significant number of importers
3,606 were bonded wineries and 1,758 were
thus grew at an annual rate of 13.2 percent from of wineries, moreover, occurred during a period of consolidation within the industry that saw
to authorized importers.60 Since a firm can own
firms than there are permits. Nevertheless, it is compete with domestic producers.
Although spirits suppliers have not grown
acquisitions such as Beringer Blass Wine Estates
at the same rate as wineries, the number of
Beam Wine Estates by Constellation Brands; and
increased as producers have become more
by Foster’s Wine Estates; Robert Mondavi and
conglomerate United States Tobacco acquiring
Stag’s Leap wine. The growth in the number of
wineries is one indication of the rapid pace of
innovation, product development and brand
development in the wine and spirits industry.
different types of spirits has significantly
innovative. Sazerac, a diversified producer of
spirits, introduces five to ten new products per year.61 As noted previously, in five years, 20 percent of Bacardi’s profits will come from
products that are not on the market today. The
increasingly wide range of products available to U.S. consumers is evidence of rapid innovation in this industry.
TA B L E 2 : Size Distribution of Wineries, Fiscal Year 2004
Gallons Produced
Wineries (%)
Gallons
Production (%)
1,121
45.00%
1,975,555
0.40%
5,000 - 10,000 gal.
277
11.30%
2,005,951
0.30%
10,000 - 25,000 gal.
403
16.20%
6,382,083
1.20%
25,000 - 50,000 gal.
200
8.10%
7,023,206
1.30%
50,000 - 100,000 gal.
155
6.20%
10,946,218
2.00%
100,000 - 150,000 gal.
166
6.70%
19,108,508
3.50%
150,000 - 250,000 gal.
55
2.20%
10,167,182
1.80%
250,000 - 1,200,000 gal.
55
2.20%
29,016,675
5.20%
Over 1,200,000 gal.
49
1.98%
466,966,975
84.35%
2,481
100.00%
553,592,353
100.00%
Up to 5,000 gal.
Total
Source: WineAmerica, Wine Industry Data, http://www.wineamerica.org/newsroom/data.htm
53
See U.S. Census Bureau, Statistics of U.S. Business: 2005, http://www.census.gov/epcd/susb/ 2005/us/US31213.HTM (last visited Sept. 8, 2008).
54
See U.S. Census Bureau, U.S. Department of Commerce, Wineries: 2002, at Tables 1, 2 and 4 (Dec. 2004), available at www.census.gov/prod/ ec02/ec0231i312130.pdf (last visited Sept. 8, 2008).
55
56
See U.S. Census Bureau, Statistics of U.S. Business: 2005, http://www.census.gov/epcd/susb/ 2005/us/US31213.HTM (last visited Sept. 8, 2008). Economic Contribution of Wine and Spirits Industry, 2005: Winery Sector, prepared by John Dunham and Associates, Guerilla Economics, LLC (New York, New York), available by request.
57
58
Number of U.S. Wineries Tops 5,300, WINE BUSINESS MONTHLY (Feb. 15, 2006), available at http://winebusiness.com/html/MonthlyArticle.cfm? dataid=42349 (last visited Sept. 8, 2008). A virtual winery has its own management and winemaker but uses an outside bonded facility to make and bottle its wine. We note that the proprietary data reports a significantly larger number of wineries than does the U.S. Census Bureau. The Top 30 U.S. Wine Companies of 2005, Wine Business Monthly (Feb. 15, 2006), http://wine business.com/html/MonthlyArticle.cfm?dataid=423 48 (last visited Sept. 8, 2008).
59
See, e.g., Volubilis Imports, Inc., Products, http://www.volubilis2000.com/products.html (last visited Sept. 8, 2008) (identifying wines from China, Morocco, Lebanon, France, and Canada).
60
See Alcohol and Tobacco Tax and Trade Bureau, Importers/Wholesalers, Information By Topic Frequently Requested Listings: Alcohol Importers (Excel Spreadsheets), http://www.ttb.gov/ importers/index.shtml (last visited Sept. 8, 2008) (menu of permit data as of Aug. 2008).
61
Interview with Mark Brown, President and CEO, Buffalo Trace Distillery, in Franklin County, Kentucky (July 10, 2007).
II. Distribution Overview
Number of Wineries
23
24
Economic Analysis
III. Economic Analysis
III.
25
A. Economic Efficiency Through
the Three-Tier Industry Structure
It has been noted that the wine and spirits industry has an “hourglass shape” – i.e., hundreds of
thousands of wines and spirits travel through approximately 3,600 wholesalers to reach approximately 206,000 full service restaurants, 48,000 bars and 29,400 wine and spirits retailers in
the United States. As quoted above, interest groups seeking to change regulations governing the
direct shipment of wine allege that this hourglass shape creates “an increasingly narrow gauntlet”
that inefficiently restricts the flow of goods from small wineries to the retail tier.62 For example, the
Wine Institute has implied that the “middle layer” can be profitably eliminated, and the Free the
Grapes Foundation has claimed that the rules shaping the three-tier hierarchy are “merely designed
to entrench state-sanctioned monopolies in wine distribution.” Some economists even characterize the distributor network as a “bottleneck.”63 As we show below, a careful economic analysis of the
three-tier system uncovers no basis for these views. 62
Brief for WineAmerica, Coalition for Free Trade, Family Winemakers of California, State Vintners Associations and Grape Growing Associations as
Amici Curiae in Support Of Respondents, Granholm v. Heald, 544 U.S. 460 (filed September 23, 2004), available at 2004 WL 2190369, at *16.
63
Akerlof et al., supra note 7, at 6.
1. Three-Tier Systems
2. Three-Tier Systems
Are Widely Used, Implying Efficiency
Economize on the Volume of Transactions Required
Three-tier systems are not unique to wine and
The key to the efficiency of the hourglass shape
industries in which their use has not been
necessary to convey products from the producer
spirits; rather, they have arisen in many
mandated by regulators. For example, a three-
tier system consisting of publishers, wholesalers III. Economic Analysis
26
and retailers is utilized to distribute books. Soft drinks such as Coca-Cola are also distributed
is its ability to reduce the number of transactions to the consumer. An example serves to illustrate this argument. Suppose the market consisted of eight suppliers and 16 retailers, and that each
supplier sold its product to each retailer. Suppose
through a three-tier system consisting of syrup
further that each supplier makes one sales call to
use of three-tier systems in these varied
The total number of transactions in any period
manufacturers, bottlers and retail outlets. The industries suggests that such systems often
provide broad economic benefits to market
participants. Even proponents of direct shipping of wine acknowledge the efficiency of three-tier systems. For example, economists writing for
wineries state as follows: “A three-tier market structure is efficient in many settings. That is
why it exists in many unregulated commodity markets, and why it continues to exist with respect to wine sales in states that do not mandate a three-tier structure (such as
California) and in states that permit direct sales subject to some restrictions (such as
Illinois).”64
each retailer and follows up with one delivery. would thus be 8x16 sales calls and 8x16
deliveries, for a total of 256 transactions. Now
suppose that two wholesalers entered the market,
with each wholesaler representing four suppliers, and that each wholesaler sold to every retailer,
replicating the retailer-supplier transactions that
occurred when no wholesalers were present. The number of wholesaler-supplier transactions will
consist of 2x4 sales calls and 2x4 deliveries, for a total of 16 transactions.65 The number of
wholesale-retail transactions would consist of
2x16 sales calls and 2x16 deliveries, for a total
of 64 transactions. The total transactions in the
three-tier system, end-to-end, would thus be 16+ 64 = 80, or about 31 percent of the 256 transactions required in the absence of
wholesalers. The reduction in the number of
transactions is accomplished without altering the number of supplier-retailer links that existed in
the absence of wholesalers.66 That is, retailers
stock the same number of products but with fewer transactions. The resulting savings can be high
when transactions costs are fixed and do not vary appreciably with the size of the transaction.
information systems used in the wine and spirits
3. Investments in
industry and further reducing the costs of distribution while increasing the range of
Electronic Transactions The hourglass business structure also promotes innovation in the area of information
services provided.
When the distribution system is shaped like
an hourglass with a relatively narrow waist, the
transmission by allowing for a more rapid
three-tier structure can increase the number
and delivery systems. As part of managing the
transactions with greater ease, thus resulting
transition to interoperable electronic inventory flow of products from suppliers to retailers,
wholesalers manage information exchanges with regulators and tax authorities. Alcohol
distribution requires the individual tracking of
thousands of types of products, including their
various sizes and weights, their prices, and their origins. The methods of identifying products and tracking them have been disparate as different companies have used their own
systems to code and track inventory. This has resulted in inefficient flows of information.
One way to improve data synchronization is
to create industry-wide standards that business
entities can adopt. An important consideration in the development of standards is backward
compatibility, i.e., the ability to accommodate the diverse installed base of hardware and software already in use. By reducing the
in gains in transactional efficiency. Because
wholesalers link the supplier to the retailer, they are uniquely positioned to maximize the
effectiveness of data synchronization. Not
surprisingly, wholesalers are active participants in developing standards-based approaches to
computerizing transactions among suppliers,
wholesalers and retailers in three-tier systems.
For example, they collaborate with suppliers and state regulators in developing open e-commerce
standards through the Alcohol Beverage Industry E-Commerce Council, an industry group
consisting of alcohol beverage industry members who work together to promote the adoption of
efficient standards and practices. Wholesalers are collaborating with their supplier partners and
retailer clients on pilot programs to assess which
information systems will best serve the industry.67 In our discussion of the FTC Staff Report
number of parties that need to transact directly
below, we show that the advantages of the
above), the hourglass business structure reduces
not only in economic theory, but also in practice,
with one another (as was shown in the example the number of different computer systems that
need to communicate directly with one another, permitting greater interoperability of 64
Id. at 12-13.
65
We note that the size of the average transaction when one wholesaler representing four suppliers visits a retailer is larger than the transaction size when one supplier visits a retailer.
66
The efficiency of hourglass architectures for wine and spirits was recognized in the Barsby Report; supra note 26, pages 17-21. The efficiency of
hourglass-shaped three-tier system are realized rebutting the allegations by certain interested
groups that the three-tier system is inefficient.
hourglass architectures for telecommunications infrastructure was recognized by the National Research Council in its analysis of the emerging information age. See Renaissance Committee, National Research Council, and National Academy of Sciences, REALIZING THE INFORMATION FUTURE: THE INTERNET AND BEYOND 53 (National Academy Press) (1994).
67
See generally Alcoholic Beverage Industry Electronic Commerce Council, Welcome to the ABI EC Council™ Website!, http://www.abiec.org (last visited Sept. 8, 2008).
III. Economic Analysis
suppliers and retailers, and maintain records for
and types of computer- and network-based
27
4. The FTC Staff Report
wineries, placed great importance on “the
and the Efficiency of the Three-Tier System
allowing the direct shipment of wine would
In 2003, the FTC issued a staff report that
compared the prices of Wine and Spirits “Top
50” wines at retail stores in McLean, Virginia, to
enhance consumer welfare.”72 However, a more
careful reading of the FTC Staff Report shows that such a conclusion is unwarranted.
First, the authors of the FTC Staff Report
recognized that savings from on-line shopping
the cost of having wine shipped directly from an
are not uniform. For bottles with a price lower
of the report summarized their findings as
percent to 83 percent more per bottle than the
on-line retailer to the
III. Economic Analysis
28
Federal Trade Commission’s opinion that
consumer.68
The authors
follows: “McLean consumers may face higher prices and have access to less product variety
than they would in the absence of the direct sales ban.”69
The authors also stated that, “[o]n
than $20.00, the average on-line costs were eight corresponding off-line costs. Since 98 percent of all wines sold by the case cost less than
$15.00 per bottle, consumer savings from on-
line sales will apply to a very small proportion
average, consumers could save money on the
of wines. But, according to the authors, even
from out-of-state vendors, purchase six or 12
49 percent more when purchased on-line than
wines in [the] sample if they could acquire them bottles, and have them delivered via standard UPS ground
service.”70
The Wine Institute and the Free the Grapes
wines with prices above $20.00 can cost up to when purchased off-line, even when using the least expensive shipping method.73
Second, the study noted that, since wine is
Foundation have used this report to support the
perishable, most consumers would prefer using a
system could be profitably removed and that
cost, thus reducing the relative attractiveness of
claim that the middle layer of the three-tier
direct sales from suppliers to consumers would improve customer choice and allow consumers to save
money.71
Indeed, statements from the
faster shipping service, which comes at a higher on-line sales. The authors considered three
alternatives for shipping – UPS Ground Service, UPS 3rd Day Air, and UPS 2nd Day Air. They
FTC Staff Report, taken in isolation or out of
did not consider UPS’s Same Day or Next
on-line transactions that eliminate the wholesale
alternatives that are more closely comparable to
context, can appear to support the inference that
layer lead to greater choice and lower prices.
Even the Supreme Court in Granholm v. Heald,
Business Day services – more timely
a visit to a nearby retail outlet. These more
comparable shipping alternatives cost more than
a case ruling that state regulation on the direct
the shipping alternatives considered by the
discriminate between in-state and out-of state
comparison in favor of on-line shopping.
shipping of wine to consumers can not
authors, and their exclusion can bias the
Third, in calculating the total cost of on-line
purchases, the authors did not include the cost of
Finally, the report did not consider certain
required to ship wine, nor the cost of insurance.
purchasing. These include, for example:
the box and EPS foam or other packing material
other factors that work to favor off-line
They also did not factor in the costs of
compliance incurred by the shipper, such as
authenticating the age of the recipient to prevent
sales to underage persons, costs that are peculiar to selling alcoholic beverages over the Internet.
I
purchases; I
In fact, UPS requires that “[a]ll wine shipments
UPS alcoholic beverages shipping label . . .
The additional charge for the UPS Delivery
.”74
Confirmation Adult Signature Required service is $5.25, a significant increase when compared to the $6.23 cost of ground shipment for one bottle of
wine.75
sometimes available at retail outlets; and I
The inconvenience of having an adult wait at home to sign for the package.76
Also, we note that the FTC Staff Report does not consider whether or to what extent any negative
effects of direct shipment to consumers that rely primarily on the three-tier system for wine
purchases outweigh any positive benefits to
consumers that choose to purchase wine directly from suppliers.
68
See Alan E. Weisman & Jerry Ellig (Federal Trade Commission Bureau of Economics), “How Many Bottles Make a Case Against Prohibition? On-line Wine and Virginia’s Direct Shipping Ban,” Working Paper 258, available at www.ftc.gov/be/work papers/wp258.pdf (March 2003) (last visited Sept. 8, 2008) (hereinafter “Weisman and Ellig”). This source is attached also as Appendix A to FTC Staff Report, supra note 2.
69
See id.
70
See id.
71
See The Wine Institute, Wine Institute Applauds FTC Report On Direct Shipping (July 3, 2003), http://web.archive.org/web/20040620043157/winei
nstitute.org/communications/statistics/ftc_online.h tm (last visited on Sept. 8, 2008); Free the Grapes Research!, supra note 6. 72
Granholm v. Heald, 544 U.S. 460, 527 (2005) (dissenting opinion of Justice Thomas).
73
See Weisman and Ellig, supra note 68, at 40; see also FTC Staff Report, supra note 2, at Appendix A, Table 4b.
74
UPS, Shipping Wine: UPS Wine Program (under UPS Requirements), http://www.ups.com/wine (last visited Sept. 8, 2008); see also FTC Staff Report, supra note 2, at 37.
75
See UPS Rate and Service Guide: 2008 Retail Rates 112, available at http://www.ups.com/content/ us/en/shipping/cost/zones/retail_rates.html (last visited Sept. 8, 2008); see also Weisman and Ellig, supra note 68, at 36; FTC Staff Report, supra note 2, at Appendix A.
76
In their amici curiae brief, three Nobel laureates and their co-authors correctly observed that the consumers most likely to benefit from direct sales (i.e., the ones who buy very expensive wines by the case) “confront very high costs in the form of lost income or foregone leisure.” Akerlof et al., supra note 7, at 10.
III. Economic Analysis
and “must be labeled by the shipper with a special
The inability to taste a wine prior to an on-line purchase, an option that is
[ ] be shipped using the UPS Delivery
Confirmation Adult Signature Required service”
The delayed gratification from on-line
29
In the three-tier system, costs of
coordination and delivery are incurred by
support the position shared by the Free the
costs are built into the prices. Indeed, a major
abolition of the wholesale layer would make
suppliers, distributors and retailers, and these virtue of the three-tier system is that it
Grapes Foundation and the Wine Institute that most consumers better off. In contrast, it
economizes on these costs. The comparison
provides evidence that the wholesale layer is an
include all pertinent costs of delivery, and is
that any benefits from bypassing that system will
undertaken in the FTC Staff Report does not therefore not an apples-to-apples comparison.
Once all relevant economic costs are taken into account for online sales, it is clear that direct III. Economic Analysis
30
The FTC Staff Report does not actually
on-line purchases of wines are more costly than
off-line purchases for nearly all wines purchased by nearly all
consumers.77
This conclusion that
on-line sales of wine are not more efficient than
off-line sales is consistent with similar results
observed in the retail book industry. A study for the U.S. Small Business Administration with
essential part of an efficient market structure and be obtained by only a very few consumers
buying multiple bottles of very expensive wine. While the entry of big-box stores into
wholesaling is characterized by issues somewhat different from those arising in the case of direct shipments, sufficient similarities exist to cast
doubt that big-box entry into the wholesale tier of the wine and spirits industry will increase overall efficiency.
regard to books found, for example, that “Internet retailers enjoy a 15% to 20%
advantage in reduced operating costs from not
having a traditional storefront. Shipping costs largely negate these savings, averaging about 15%.”78
“Internet retailers enjoy a 15% to 20% advantage in reduced operating costs from not having a traditional storefront. Shipping costs largely negate these savings, averaging about 15%.”
B. The Effects of
1. Current Alcohol
Allowing Direct Purchases by Retailers This section presents an analysis of the economic effects of proposed changes in regulations that would permit big-box retailers to buy directly from suppliers, bypassing the wholesale tier
Distribution Structure: The Use of Exclusive Territories Consider a wholesaler who invests in building a brand, expecting that the initial marketing investment will be recouped through higher prices and increased sales volumes over the product’s life cycle. If the brand becomes
commercially successful, rival wholesalers who
are likely to result if big-box stores are permitted
an incentive to sell the now-successful product
current industry structure with the outcomes that to purchase directly from suppliers. Specifically, our analysis focuses on the two key drivers of efficient wholesaling: (1) marketing
arrangements and (2) efficiency in distribution.
made no investments in the brand would have at the now-higher prices, earning profits and reducing the return earned by the original investor. The investor’s lower return is a
negative externality. In other words, brand development poses a looming “free-rider”
problem. Initial investors need some assurance
that rivals who do not initially invest in the brand
will not later obtain a “free ride” at their expense. With no such assurances, the incentives for the original investment are reduced, causing additional economic side effects.
The economics literature on free-riding in
distribution emphasizes vertical arrangements79 that solve this type of free-rider problem.
Among such arrangements are resale price maintenance agreements80 and exclusive
territories, a practice in which one wholesaler
has exclusive rights to distribute a brand or
product within a given service area. The use of exclusive territories is widespread in the three-
77
78
The FTC Staff Report, supra note 2, does not compare online and offline costs of purchasing spirits, but there does not appear to be any reason for believing that a comparison of online and offline purchases of spirits would yield a result meaningfully different from that reached in the case of wine. Jack Faucett, Radesh Ganeshkumar & Laurence O’Rourke, Small Business Survival in Competition with Large Retail Multi-Unit Retail Firms, Part I:
Market Analysis of the Retail Book Industry, SMALL BUSINESS RESEARCH SUMMARY 27 (submitted to the Office of Advocacy, U.S. Small Business Administration) (Jan. 18, 2000). 79
Vertical arrangements are agreements between different firms operating in different tiers in a supply chain as opposed to horizontal agreements between firms operating in the same tier.
80
Resale price maintenance agreements obligate a retailer to sell the product at no less than a prespecified minimum price. Exclusive territories limit a firm to supplying the product within a prespecified territory. In both cases, the wholesaler or retailer agrees, for a consideration, to forego profitable transactions – at prices above cost but below the minimum price in the former case, or with purchases located outside the defined territory in the latter case.
III. Economic Analysis
entirely. We compare economic outcomes in the
31
tier system and may be considered part of it even when it is not required by state law. Exclusive
recognized the procompetitive effects of vertical
to limit free-riding and encourage marketing
minimum retail prices.83 Both vertical
territories typically are contractually created
arrangements such as exclusive territories and
activities aimed at developing new brands and
arrangements reduce intrabrand competition
Accordingly, an economic analysis of proposed
marketing efforts. With exclusive territories,
increasing the value of existing brands.
changes to the use of exclusive territories in the
long-established three-tier system must take into account the effects of the proposed changes on incentives to free-ride. III. Economic Analysis
32
The U.S. Supreme Court recently
Economists have studied the efficiency
properties of such “exclusive territory”
arrangements in a range of circumstances and
have identified the conditions which favor the
based on price and can stimulate retailer’s
a distributor of a particular brand does not
compete with any other provider of that brand
in its territory, but it does have an incentive to invest in its brand in order to compete
vigorously against distributors of competing brands. In situations of resale price
maintenance, the minimum price helps control the free-riding incentive and each distributor
use of exclusive territories to solve fundamental
competes with other distributors by adding value
marketing requires a distributor to undertake
seeks to restrict intrabrand competition while
business problems. For example, when
certain activities that are difficult to specify,
monitor and measure, contractual penalties for
to its product. In both cases, the manufacturer
stimulating interbrand competition by providing to its distributors incentives to make its brand
failing to perform the services may not be
more attractive relative to others. The Supreme
performed.81
as follows:
enforceable and the services may not be
By giving the distributor an
exclusive territory and some protection from
intrabrand competition, however, the supplier
creates a financial incentive for the distributor to undertake the required marketing investments
necessary to compete against brands represented by other wholesalers (interbrand competition).82
Court has recognized this logic, commenting
When a wholesaler of wine organizes
The justifications for vertical price
tasting events at multiple outlets within its
maintenance can stimulate interbrand
wholesaler attempts to identify demographic
different brands of the same type of product
for its wine and to create demand among
retailers selling the same brand. . . . A
product(s). The tastings then create a pool of
restraints tends to eliminate intrabrand
more of that product in the future and who are
retailers to invest in services or
they would have absent the tasting. Since it is a
manufacturer’s position as against rival
distributor pays a fixed price per case of wine
restraints, retail services that enhance
territory will keep any additional profits from
underprovided because discounting
event such as the wine tastings. By the same
furnish services and then capture some of
wholesaler if its marketing efforts prove
vertical restraints. Minimum resale price
territory for brand(s) it represents, the
competition among manufacturers selling
groups and neighborhoods with a preference
by reducing intrabrand competition among
consumers otherwise unfamiliar with the
single manufacturer’s use of vertical price
interested customers who are likely to purchase
price competition; this in turn encourages
willing to pay higher prices for the product than
promotional efforts that aid the
common arrangement in the industry that a
manufacturers. . . . Absent vertical price
to the supplier, a distributor serving an exclusive
interbrand competition might be
the increased demand stimulated by a marketing
retailers can free ride on retailers who
token, however, the losses are borne by the
the demand those services generate.84
unsuccessful. Granted an exclusive territory,
An example of the U.S. Supreme Court’s
incentive to draw on its superior knowledge of
determination is illustrated in the sale of wine
and spirits. As previously explained, wholesalers often perform the local marketing for suppliers. Specifically, they build brand awareness and
consumer demand by creating promotions in
their local areas. Because they possess detailed
knowledge of the consumption habits and trends of their service areas, they are best suited to
the wholesaler is presented with a financial
the local market and risk investing in activities intended to bring to consumers the wines and
spirits that best match their tastes. In practice, this alignment of incentives is effective, as is evidenced by wholesalers’ significant
investments in marketing activities and the wide
variety of products available to consumers.85
fulfill this marketing role. These efforts are
crucial, especially given the number of new
products flooding the market and consumers’ increasing willingness to try new brands.
81
See Dennis W. Carlton & Jeffrey M. Perloff, MODERN INDUSTRIAL ORGANIZATION 418-424 (Pearson Addison Wesley, 4th ed. 2005) (hereinafter “Carlton & Perloff”).
82
See id. at 421.
83
Leegin Creative Leather Products, Inc. v. PSKS, Inc., 127 S. Ct. 2705 (U.S. June 28, 2007).
84
Id. at 2708.
85
See the examples of National Wine & Spirits, Inc., the Charmer Sunbelt Group, and Southern Wine & Spirits of America, Inc. above, supra notes 31, 38, 44, 45, 48 & 49.
III. Economic Analysis
restraints are similar to those for other
33
2. Direct Sales to Large Suppliers obtain additional benefit
from exclusive territories including: I
Greater accountability – If two distributors of the same products supply the same retailer, then each can blame the other for any problems that arise (such as stock-outs, or a failure to replace defective shelf-talkers). Greater efficiency is obtained when only
III. Economic Analysis
one party is responsible for inventory management, delivery, credit, and other wholesaling functions. I
Ease in implementing marketing strategy – It is easier to teach one distributor (rather than many) about marketing strategy, and the coordinated execution of the strategy in a market is easier when only one distributor is involved.
34 I
Avoiding “free riding” problems – Distributors will not invest as much in marketing and sales if they are not offered a sufficiently high probability of recouping their investment.
Retailers: Free Riders and Inefficiency When regulations permit large retailers to
bypass the three-tier system, wholesalers will no longer have exclusive territories because
suppliers will also be able to sell direct to big-
box retailers, whose business models do not
emphasize marketing investments in the specific brands they carry. Unwilling to shoulder the marketing alone, wholesale competitors are
likely to refrain from brand-specific marketing
activities, waiting instead for another wholesaler to invest in marketing and to undertake the
efforts necessary to create or maintain customer demand for the product. Once another
wholesaler performs these activities, the
competitors who did not make comparable
investments (including any big-box retailers)
will benefit from the increased brand awareness and demand stimulated by others’ marketing efforts, despite not having performed the
activities themselves. Competitors who did not engage in marketing activities for the product
can undersell the investors, essentially “freeriding” on the investment of their rivals.
Wholesalers who helped market a product—say, by setting up tastings at retail outlets or sporting events, educating retailers, conducting
promotional events or selling the product at a
low promotional price—may find that they are
undersold in their territories by free-riding bigbox retailers that did not make comparable
investments. The ability of big-box stores to free-ride on wholesalers’ marketing and
innovation will, of course, reduce the traditional
wholesaler’s returns from such activities and
therefore also reduce its incentives to invest in brand building and
maintenance.86
This
disincentive, in turn, will have repercussions for
the industry and consumers, as will be discussed
As they have observed, “[s]uch arrangements
are not necessarily anti-competitive. In some situations, they may well lower price and improve quality.”89
LaFontaine and Slade (2005) review a
in the next section.
number of empirical studies focusing on vertical
incentives to free ride are greatly reduced, and
studies of exclusive territories, in addition to a
With the use of exclusive territories,
interbrand competition keeps prices at
arrangements. Their review includes five
number of studies of other arrangements that are
reasonable levels. In other words, exclusive
economically similar to exclusive territories. Of
investments in a brand, but they will not
by the authors, LaFontaine and Slade found
territories allow distributors to recover their
of return given the interbrand competition they face.87
The distinction between interbrand and
intrabrand competition is important here. When
consumer welfare to be higher with exclusive territories in three instances. Perhaps more relevant to an inquiry into wine and spirits, however, is the fact that three of the five
regulations do not permit large retailers of wine
exclusive territory studies involved the
will be intense competition among wholesalers
were found to have benefited from the use of
and spirits to buy directly from suppliers, there
who have invested in competing brands. When regulations permit direct purchases by large
retailers from suppliers, however, competition
is likely to be between investors in a particular brand (wholesalers) and the free riders (the big-box retailers) selling the same brand.
Economists have analyzed the relative
merits of both kinds of competition and have concluded that exclusive territories can have procompetitive
effects.88
Even economists who
favor direct shipping acknowledge that the
three-tier system can be socially beneficial.
86
The possibility of free-riding is not merely theoretical. As William Terlato, president of the Terlato Wine Group, has recognized, the “big-box stores aren’t brand builders. They don’t have the sales floor expertise for that.” Mr. Terlato’s 2005 Santa Margherita Pinot Grigio sells well at Costco, but he points out that that is the result of 25 years of brand building that occurred before Costco started stocking the wine. See H. Lee Murphy, Costco’s Challenge, MARKETWATCH, 25, 33 (July/Aug. 2006).
87
88
distribution of beer; of these three, consumers exclusive territories in two cases.90 These
findings are consistent with those of Sass & Saurmann (1996), who found that a ban on
exclusive territories for beer sales resulted in
a six percent decrease in beer purchases.91
To summarize, we note that surveys of
empirical research in the economics literature find that exclusive arrangements are often
efficient in practice. In such cases, allowing
direct purchases by large retailers, which undermine exclusive arrangements, will reduce overall economic efficiency.
Interbrand competition refers to competition between two firms selling different brands to consumers who consider the products to be reasonably close substitutes for one another. “There is a need for more empirical studies to identify both desirable and undesirable vertical arrangements. Although many theoretical papers show how vertical restrictions can be either harmful or helpful, the evidence from U.S. antitrust case law provides at best weak support that the effects are harmful.” Carlton & Perloff, supra note 81, at 437.
89
Akerlof et al., supra note 7, at 5.
90
See Francine LaFontaine & Margaret Slade, Exclusive Contracts and Vertical Restraints: Empirical Evidence and Public Policy, forthcoming in HANDBOOK OF ANTITRUST ECONOMICS 2, at Table 2 (Paola Buccirossi ed., 2005), available at http://www2.warwick.ac.uk/fac/soc/economics/staf f/faculty/slade/wp/ecsept2005.pdf (last visited Sept. 8, 2008).
91
See Tim R. Sass & David S. Saurman, Efficiency Effects of Exclusive Territories: Evidence from the Indiana Beer Market, in 34 ECON. INQUIRY 597, at 614 (1996).
III. Economic Analysis
consistently earn more than the competitive rate
the five studies of exclusive territories reviewed
35
3. Bypass of the Three-Tier System: Loss of Economies of Scale, Scope and Density Wholesalers achieve their efficiencies in large
served, economies of scope and scale will be
lost, and unit costs will increase. In either case, wholesalers will increase the prices charged to
their customers (retailers), who are likely to pass on their cost increases to consumers by charging
part because their warehouses and transportation
higher retail prices. As other economists have
facilities, giving rise to economies of scale,
charges retailers) are dependent on its ability to
fleets are shared by all the brands that use those scope and density.92 By efficiently filling
warehouses and trucks to capacity, wholesalers
III. Economic Analysis
36
If the wholesaler does not increase the area
achieve the benefits of a large-scale operation. And since the same warehouses and fleets can
noted, the wholesaler’s margin (and the prices it keep unit costs low by maximizing its
economies of scale and other sources of cost reduction.93
The costs incurred by wholesalers in
be shared by many brands of wine and spirits,
acquiring local information and building long-
across the brands they distribute. Furthermore,
are “fixed costs” in the sense that they do not
wholesalers can obtain economies of scope
term relationships with retailers and suppliers
because the unit costs of serving four retailers on
vary with the number of units sold in the near
the unit costs of serving four similar retailers on
such as the next year). Consequently, the
a five-mile stretch of a highway are lower than a 50-mile stretch, for example, wholesalers
achieve economies of density by serving all retail outlets within a given area.
If a big-box store displaces retail outlets on
a wholesaler’s delivery route, the wholesaler will have to expand its delivery footprint to
maintain its economies of scale and scope. To
fill its trucks and take advantage of economies
of scale, the wholesaler may choose to increase
the area served by a truck. Customer density in the new delivery footprint will decrease.
term (i.e., over a relatively short period of time recovery of these costs requires that wholesalers
earn revenues in excess of their variable costs of production. By increasing the volume of sales, wholesalers can reduce the fixed cost of
operation per unit of output and thus increase the likelihood of cost recovery. Conversely, when a
wholesaler loses sales to a big-box store or other
intrabrand competitor, economies of scale, scope and density are lost, and the wholesaler’s unit
costs increase. The primary effect on the market
from regulations permitting big-box retailers to purchase directly from suppliers would thus be to divert some products from the three-tier
hierarchy, reducing the scale of that system, and
increasing unit costs to retailers that continued to rely on the three-tier system, as well as their consumers.
If changes in regulations were to permit a
large retailer to purchase directly from a supplier, the retailer would, in essence, self-supply
wholesale services to itself, performing many functions (such as pick-up and delivery) that
were previously performed for it by a wholesaler. Thus, regulations permitting direct purchases by big-box firms are economically similar to entry by these firms into the wholesaling tier.
However, such entry through regulation is
significantly different from actual entry by a new services only to other firms. The most important
prices or better service. Such suspicions are neither uncommon nor unjustified. Several
suppliers, including Joseph E. Seagram & Sons,
Inc., National Distilling, Schenley Distilling Co., Publiker, and Hiram Walker & Sons Distillery
established wholesale operations only to close them after a short period. The manufacturers
found that they could not operate profitably by
carrying only their own brands. To be efficient, they needed to take advantage of economies of scope. Not surprisingly, competing
manufacturers were unwilling to use their rivals’
difference is that a traditional wholesaler does
wholesale services. In all cases, the
wholesaler’s territory, while a big-box store that
operations.94 Just as suppliers were unwilling to
not compete with retailers located in that
integrates into wholesaling will compete with other retailers in its service area. For this
reason, a traditional stand-alone wholesaler’s incentives are different from those of a large
manufacturers abandoned their wholesale use wholesale services provided by rival suppliers, retail outlets will similarly be
unwilling to use wholesale services offered by a big-box retailer. Any benefits of big-box entry
retailer with a wholesale division or affiliate.
into wholesaling will flow to the big-box’s retail
wary of purchasing from a big-box retailer’s
retailers, or more generally, to their consumers
Competing retailers will understandably be
wholesale division. A stand-alone wholesaler has no economic incentive to discriminate
operations and not to the operations of other or the economy.
The primary effect on the market from
against any retail outlet it serves, but a big-box
regulations permitting such retailers to purchase
conditions, have the incentive to discriminate in
some products from the three-tier hierarchy,
wholesaling division would, under some
favor of its own outlets. Therefore, it would be
reasonable for traditional retailers to expect that a big-box wholesaler will give its affiliated
92
With economies of scale, a firm’s unit cost of production falls as its output increases. Economies of scale are common when fixed costs are high. Economies of scope arise when the costs of jointly producing more than one product (e.g., delivering wine and spirits to a retailer in one trip) is less costly than separately producing that product mix
directly from suppliers would thus be to divert
reducing the scale of that system, and increasing unit costs to firms and consumers that continued to rely on the three-tier system.
(e.g., delivering wine and spirits in two separate trips). Economies of density arise when the unit costs of production are lower in areas populated by a greater number of customers per square mile or (for delivery systems) where there is a greater density of customers per route mile.
93
Akerlof et al., supra note 7, at 13.
94
See Barsby Report, supra note 26, at 74-75.
III. Economic Analysis
stand-alone wholesaling firm that supplies its
retailer preferred treatment in the form of lower
37
4. Effects of Allowing Bypass: Lower Prices for Limited Products, Higher Prices for Others, Loss of Innovation and Decrease in Business Entities. Regulations that allow suppliers to sell directly III. Economic Analysis
38
The loss of popular brands to large retailers,
however, will have a negative multiplier effect on suppliers, wholesalers, retailers and
consumers. To see why, consider the following. All brands carried by a wholesaler are not
equally profitable. Some well-known and expensive brands generate relatively large
profits per case, while other brands generate
relatively small profits. Wholesalers use profits
made on brands that it helped develop in the past
to big-box retailers will likely provide
to finance investments in brands it develops for
stores. On the other hand, small to mid-sized
undertaken by wholesalers initially at a loss with
consumers with cheaper products in big-box
suppliers, wholesalers and retailers will likely
the future. Risky investments in a new brand are the expectation of future profits. However,
incur increased costs, eventually resulting in lost
when currently profitable brands are diverted to
local economy and less product choice for
in brand development is diminished. In
profits, failing businesses, less investment in the consumers. Retailers competing with big-box stores are likely to face two kinds of direct economic pressure. First, they will face
increased competition in the retail market from a
big-box stores, the wholesaler’s ability to invest addition, the expectation that successful new
brands will be “poached” by the big-box stores will reduce the incentives of the wholesaler to invest in marketing activities. A profit-
new, large store possessing the capacity to
maximizing wholesaler will therefore reduce its
suppliers – concessions that neither smaller
less innovation and investment in the local
negotiate significant concessions from its
retail stores nor their wholesalers are likely to
obtain. The big-box store is likely to focus on
selling wine and spirits to customers (members) that come to the store primarily to purchase
other items. By focusing almost entirely on
well-known brands, (i) the big-box store can free ride on the past and present marketing activities undertaken by others, (ii) use its superior
negotiating position to obtain favorable prices from suppliers and (iii) given its lower costs, charge lower prices than are offered by
traditional retail outlets. As a result, big-box
stores can offer consumers decreased prices for the items it carries.
investments in brand development, which means economy.
Diminished marketing efforts by
wholesalers will, in turn, affect suppliers who,
The diversion of the most high-volume and
high-profit brands from the three-tier system
for the most part, cannot afford to perform local
will result in a reduction in the number of
reduce the resources devoted to marketing,
wholesalers. Some suppliers that could
marketing initiatives. These suppliers will
which will likely reduce the supplier’s portfolio of brands, or they will market their brands less intensively, which can be expected to lead to increased brand failure, especially for new
brands. Retailers will suffer similar effects.
As retailers lose the sales of popular, profitable be able to sustain new, unknown products on their shelves with the hope the new products
will later flourish. Additionally, they will likely
previously find wholesalers to distribute their brands will no longer be able to find willing
distributors. The ability of smaller wine and
spirits suppliers to grow and compete with larger competitors will be reduced. Consequently,
innovation from smaller wineries and distilleries will also be reduced, which is where most
innovation occurs. Retailers will also reduce the number of new brands they carry as they, too,
lose their profitable items to big-box retailers.
increase their prices of the remaining brands
Consumers will likely have less choice overall,
lose the wide product variety that exists today
increase.
they carry. Ultimately, consumers will likely as innovation and product choice decrease.
and prices outside of the big-box stores may
III. Economic Analysis
brands to big-box retailers, they may no longer
profitable and unprofitable brands carried by
39
“Consumers will likely have less choice overall, and prices outside of the big-box stores may increase.”
5. Channel Conflict and the Stability of the Three-Tier System Our analysis thus far raises certain legitimate questions: If the three-tier system with
exclusive territories is economically efficient,
why does it need to be protected by regulations
that forbid suppliers from selling their products directly to retailers? Why would there not be a III. Economic Analysis
40
These questions implicitly ignore the
externality issues that we have raised. In the
parlance of marketing, the term “channel” refers to the chain of intermediaries linking a supplier
to the final consumer. The recent growth of
multichannel distribution systems, in which a
product can be delivered to a final consumer by
means of multiple channels (e.g., online sales of books and book sales in bookstores), has
increased the potential for “channel conflict:” conflicting incentives of the traditional
competitive equilibrium in which some suppliers
wholesale channel and a direct supplier-retail
others rely on distributors? Would not this
describes a supplier’s efforts to bypass channel
sell some products directly to retailers while
arrangement be superior to the regulated threetier structure in which distributors cannot be bypassed?
channel.95 A study of multichannel systems
participants, e.g., by engaging in direct on-line sales to consumers, as a “destructive act.”
According to the authors of the study, such
channel conflicts can rob a channel participant
of its investments in the product, which in turn plunges the relationships among the channel
participants “into a spiral of hostility and distrust that ultimately could lead to dissolution” of the
channel itself.96
Other destructive acts, as viewed by a
Any conflict between a wholesaler channel
wholesaler, include “[s]elling through a mass
and a direct supplier-retailer channel will, in the
the dealer’s territory.” These destructive acts
existing and new brands and the loss of share to
merchandiser” and “[a]dding another dealer in lead to an increase in the likelihood of
disengagement between the wholesaler and the supplier, possibly resulting in the termination
of the relationship with the supplier over some
long run, result in decreased investment in
competitive brands that continue to invest in
marketing. However, in the short run, suppliers that exercise the option to bypass the
wholesaling tier may benefit from the free ride –
period of time. Ultimately, the supplier may
i.e., their private gains over the short run may
wholesaler, and efficient channels might be
of their brands. Over the long term, channel
not be able to enter into arrangements with any
conflicts are likely to lead to economically
inefficient results that would not occur in the traditional three-tier hierarchy.
“A study of multichannel systems describes a
III. Economic Analysis
replaced with inefficient alternatives.
exceed the social losses from the long run failure
supplier’s efforts to bypass channel participants, e.g., by engaging in direct on-line sales to consumers, as a “destructive act.”
95
Jonathan D. Hibbard, Nirmalya Kumar & Louis W. Stern, Examining the Impact of Destructive Acts in Marketing Channel Relationships, 38 JOURNAL OF MARKETING RESEARCH 45, 45 (2001).
96
Id. at 46.
41
IV. I V. C o n c l u s i o n s
42
Conclusions Proponents of the direct purchase of wine and spirits by retailers assert that wholesalers are no more than an unneeded layer of bureaucracy in the sale of wines and spirits. A balanced analysis, however,
must take into account all the economic effects, including externalities, associated with the wholesalers’ role in brand development and brand maintenance. The three-tier system relies on exclusive-territory arrangements that correct these externalities. Doing away with wholesalers, or
even reducing their role in the three-tier system by allowing direct sales to big-box stores, could have substantial negative economic effects on all three tiers and many consumers.
In particular, wineries and suppliers of spirits that currently rely on wholesalers to perform
marketing activities will encounter a “free rider” problem that will reduce wholesalers’ investments in the building and maintenance of brands, investments unlikely to be absorbed by suppliers or
retailers. All suppliers, including new entrants and small suppliers, will find it more difficult to
introduce and grow their brands, with the effect that innovation will be diminished and the variety of products available to consumers will be reduced. Wholesalers will operate at a lower volume of
transactions, their unit costs will increase and marginally profitable wholesalers will likely go out of
business. All retailers in the three-tier system will experience an increase in costs, and marginal
retailers will be forced out of business. Consumers who preferred traditional outlets with large selections to big-box stores with a limited number of popular brands will have access to fewer and
more distant retail outlets in the areas in which they shop, and they will pay higher prices at these remaining and less convenient outlets. In addition, conflicts between the traditional wholesale channel
and a direct supplier-retail channel can lead to market failure and economically inefficient outcomes.
Against these negative effects, customers of big-box stores are likely to find lower prices
for the relatively small selection of wines and spirits typically sold at these stores. These benefits will last as long as the big-box stores maintain low prices.
If direct sales are allowed and exclusive territories vanish, it is possible that suppliers may
try to employ some other type of vertical restriction to correct the brand-building externalities that
we have identified here. However, such restrictions have economic costs analogous to those
characteristic of exclusive dealing. Resale price maintenance, for example, places a floor on retail prices that is intended to be sufficiently in excess of the distributor’s marginal cost that the distributor
retains the incentive to develop and market the brands it represents. Big-box stores, with their
growing purchasing power, however, will likely not accept such pricing limitations for the same
reasons they do not accept exclusive territories. Furthermore, exclusive territories allow for greater Thus, there is probably not an alternative vertical arrangement to the use of exclusive territories that
will correct the free-riding incentive at a lower cost to society.
The current reliance on exclusive territories for wholesalers is an economically efficient
arrangement for almost all wines and spirits purchased by the vast majority of consumers. The substantial economic arguments in favor of the current three-tier system are not considered or addressed by special interest groups who are proponents of large regulatory change.
Our analysis has focused on the wholesale segment of the wine and spirits industry, which
performs a range of functions beyond the efficient physical delivery of wines and spirits to retailers.
As intermediaries, wholesalers have a unique view of both sides of the market – suppliers and the
products they manufacture as well as retail outlets and the products consumers demand. With their
specialized knowledge of both sides of the market, wholesalers have a comparative advantage in matching specific products to specific consumer groups. Suppliers use this informational asset to
help market their products efficiently, and the economic arrangements linking suppliers to wholesalers transfers some of the risks and rewards of marketing to the wholesalers. Retailers and
ultimately consumers benefit from the better match between the products they stock and their
consumers’ demands; superior matching that relies on the wholesaler’s knowledge of both sides of the market.
Exclusive territories are an important part of the rewards that justify the risky investments
wholesalers make in the brands they represent. Direct purchasing by big-box stores reduces the
rewards to traditional wholesalers and reduces their incentives to invest in brand equity. A movement of products to the supplier-retailer channel will reduce the economies of scope, scale and density in
the traditional distribution system, increasing the costs of all the participants of the three-tier system,
and ultimately reducing the benefits of low prices and superior variety at nearby locations to customers who rely on the three-tier system.
I V. C o n c l u s i o n s
pricing flexibility than resale price maintenance, which can benefit all three tiers and the consumer.
43
Product Suppliers Wholesale-Distributors Product Retailers Wine & Spirits Wholesalers of America 805 15th Street, NW, Suite 430 . Washington, DC 20005 www.wswa.org
