Distortionary effects of three-tier liquor regulation, Wisconsin edition

Lynne Kiesling

As Jonathan Adler notes at the Volokh Conspiracy, the Wisconsin legislature is considering a piece of legislation that would change the regulations governing the production, wholesale distribution, and retail sale of beer in Wisconsin. The controversial provision in this legislation is one that prevents brewers from owning wholesale distributors, and the controversy arises primarily because of the possible effects on small craft brewers of a piece of legislation that is intended to blunt the market power of Anheuser-Busch. As described in a recent Milwaukee Journal-Sentinel article:

The legislation, approved Tuesday night by the Legislature’s Joint Finance Committee, is designed to stop Anheuser-Busch from buying wholesale distributors, say its supporters, including a beer wholesalers lobbying group. Opponents say those fears are exaggerated, with craft brewers saying the legislation would hamper their growth prospects.

Most of the nation’s beer is sold by brewers to independent wholesalers, which earn a profit by reselling the beer to supermarkets, taverns and other retailers. That three-tier system has operated since Prohibition’s repeal, and was created to prevent brewers from forming monopolies making, distributing and selling beer – which existed before Prohibition. …

The proposal endorsed by the Joint Finance Committee is needed to avoid a similar court challenge in Wisconsin, and to prevent Anheuser-Busch from buying distributors, says Tim Roby, spokesman for the Wisconsin Beer Distributors Association. The proposal also is supported by MillerCoors LLC, Anheuser-Busch’s chief rival, and groups representing retailers, including the Tavern League of Wisconsin and the Wisconsin Grocers Association.

The legislation prohibits brewers from buying wholesale distributorships, while allowing brewers that produce up to 300,000 barrels annually to do their own wholesale distribution.

Some Wisconsin craft brewers do their own wholesale distribution. Others sell their beer primarily through wholesalers, while also doing limited self-distribution by selling beer at festivals or filling emergency orders from taverns. The state’s largest independent craft brewer, New Glarus Brewing Co., sold about 92,000 barrels in 2010.

MillerCoors, with its deep roots and strong market and employment presence in Wisconsin, supports the bill, while Anheuser Busch argues that the bill stifles competition.

The economics and politics of vertical integration are the issue here. Summarizing from a long post I wrote describing the three-tier system in 2002: before Prohibition, brewers did their own distribution to their own bars, pubs, and taverns, and profited handsomely with this strategy. With the repeal of Prohibition, federal law stipulated that wholesale liquor distribution must not cross state lines (I think of this as the Al Capone rule!), so with the growth of national-market brewers came independent wholesale distributors within each state. Over the past several decades, though, wholesale distribution has seen consolidation to the extent that even large states like Illinois have very few wholesale distributors. Moreover, those distributors are politically powerful, and use their profits and their political connections to maintain their market power, to the frustration and economic detriment of both brewers and retail outlets.

Thus one way to interpret this proposed legislation is as the Wisconsin wholesale distributors acting politically to retain their substantial market power by excluding potential competition from vertical integration of large national brewers.

But the controversial and interesting/disturbing interpretation involves small craft brewers such as New Glarus Brewing (which makes some truly outstanding beer, particularly their Stone Soup). Incidentally, New Glarus used to be distributed in Illinois, but as the political and market power of Illinois distributors grew they increased distribution fees sufficiently that New Glarus pulled out of the Illinois market, so now we have to stock up whenever we’re in Wisconsin. New Glarus currently makes 92,000 barrels/year, so they would be exempt under this bill and allowed to do their own wholesale distribution. However, for small brewers this vertical integration is costly, so, as this OpenMarket.org post suggests,

Brewers of less than 300,000 barrels annually will still be able to self-distribute, but current brewers and new wholesalers would be required to have 25 independent retail customers prior to being granted the right to distribute. According to a MillerCoors spokesperson, these new rules would also prevent small brewers from banding together to form their own distributorship. In addition to all of that, the measure would prevent brewers from owning retail licenses, meaning that they could have a brewpub, but they would only be allowed to sell their own product. Breweries that already own retailing outlets would be allowed to retain one.

I think this is the material issue — not only does this legislation insulate wholesale distributors from vertical integration by large national competitors, it also insulates them from contracting among craft brewers to form their own wholesale distributor to compete with the incumbents. The economic theory underlying this argument comes from the Klein, Crawford, Alchian (1978) article on contracting as a substitute for vertical integration, in situations of low transaction and monitoring costs. As New Glarus owner Deb Carey said in this Madison Cap Times article,

“We are losing assets and we are losing control over our products,” Carey says. “This debate boils down to the fact that the wholesalers do not want a drop of beer going to market in Wisconsin without them making their 30 percent profit from it. That’s it.”

That’s the economic argument supporting the craft brewer’s position in this debate; the proposed legislation is anti-competitive, distorts the market, and hampers the business potential of craft brewers in Wisconsin not by preventing them from self-distributing, but by preventing them from contracting to create a craft wholesale distributor to compete against the politically powerful incumbent wholesale distributors.

Goose Island: What if acquiring capital cannibalizes your market?

Lynne Kiesling

Last week, Chicago craft brewery Goose Island agreed to be acquired by Anheuser-Busch, which purchased a 58% equity stake in the brewery. Goose Island founder John Hall argues that the deal enables Goose Island to make investments to increase capacity, an investment necessary for continued profitability. He recognizes that some may be skeptical about the deal:

But Anheuser-Busch didn’t buy us to change us. It bought us because we can do things its people can’t. They’re megabig, so it’s harder to get people who sell huge brands to really push new products. As in a lot of industries, it’s the small guys who are really creative, because they have to be creative. That’s what’s made us what we are.

It’s wonderful our customers feel they have a vested interest in us. That’s something we’re all proud of, and we want to continue that tradition.

The reality, however, is that we’re in a capital-intensive business, and it takes an awful lot of money. Not counting our two brewpubs, we’ve up to 115 to 120 regular employees, having added about 20 people just last year.

To deal with that lack of creativity in the “megabig” firm, one of Anheuser-Busch’s strategies over the past decade has been to enter into distribution agreements with craft breweries, and then over time acquire majority ownership stakes in the craft brewery. Before Goose Island, A-B did this with Redhook from Seattle and Widmer Brothers from Portland (through which A-B had a distribution agreement with Goose Island).

Here’s the challenge, though, for growing craft brewers and for A-B: once the craft brewer is acquired by A-B, lots of the people who make up the craft brewer’s traditional market lose interest. Almost all consumption goods are multi-dimensional, and beer is no exception — those who form the traditional market for craft beers value two dimensions that diminish when the brewery is acquired by A-B: independence and localness. Sure, the brewery is still physically operated locally, but it’s a really tough line to follow to grow nationally while maintaining the local relationships and local touch.

Independence is an interesting aspect here. For many craft brewing consumers, once the brewery is no longer independent they lose interest in the beer. Part of what those consumers are buying is, for example, what we enjoyed at Green Man Brewing in Asheville, NC over spring break: sitting at the brewery’s bar, enjoying a beer brewed on premises, and having a really engaging conversation with people who are intimately involved in the production of the beer. BTW, the Green Man IPA really, really rocks. That connection, that intimacy, gets lost as the brewery grows, and certainly is threatened if not destroyed when the brewery is acquired by A-B.

Part of this, I admit, is snobbery regarding mass-market beers, but part of that snobbery is grounded in the fact that the form creativity takes in craft brewing is often the emphasis on unusual flavors or the amplification of intense flavors (one reason why so many craft brewing consumers consider themselves “hop-heads”). Thus a lot of craft beers intentionally appeal to a small sliver of the overall market, and there’s a large concern that A-B acquisition will lead to the “watering down” of the beers and the modification of the recipes to make the flavors less distinctive or intense. But clearly the craft brewing market is growing, so is there a chance that A-B acquisition will not lead to recipe modification at Goose Island?

Another aspect of the localness is that the growth in the craft brewing industry is also manifesting itself in an increase in small local breweries. Between the local breweries in Chicago (Half Acre is in my neighborhood, and Three Floyds in northern Indiana is outstanding, and there are others; in fact, Half Acre’s web page pulls up in my browser saying “Half Acre is a LOCAL Chicago brewing company”) and our retail access to craft beers from other locations (Victory, Dogfish Head, Lagunitas, etc.), the craft brewing market is incredibly rivalrous.

If, at the margin, the sense of localness and the independence make a difference between my choosing a Half Acre Daisycutter over a Goose Island IPA, then Goose Island will be reducing some of its market in its move to increase capacity and try to acquire a larger national market. I hope that they succeed in doing so, but I do think that they will lose some customers who value independence and localness in the process.

Weekend jaunt from Chicago: New Glarus, Wisconsin

Lynne Kiesling

The area around New Glarus, Wisconsin, is one of our favorite places when we want to get out of town. Great roads for cycling, camping, beautiful scenery, and of course the newly-expanded New Glarus Brewery. Gone are the days when we could get Spotted Cow and Uff Da Bock around here; now we have to drive to Wisconsin to get some. If you are not familiar with the area, this Gaper’s Block post provides a good weekend getaway guide, including recommendations for bicycling on the several very good trails in the area — especially good for families!

Scottish Pubs: Serving Only In Sippy Cups?

Lynne Kiesling

Caught my eye on Friday, but I got distracted: Kerry Howley’s Hit & Run post on pending regulations outlawing the use of glass in Scottish pubs. How ridiculous is that? Making everyone drink out of crappy glasses just because a few morons refuse to control the exercise of their tempers (or their livers, for that matter). Belhaven Wee Heavy (one of the best beers on the planet!) out of a plastic pint glass? My taste buds shudder at the thought. And my soul shudders at the heavy hand of the state working this one.

Of course, one of the amusing comments on the post also occurred to me: when glass pints are outlawed, only outlaws will have glass pints.

Kerry’s reference to the recent Economist article on the proliferation of regulation, red tape and bureaucracy in Scotland also falls in line with Mr. Seat’s comments on Scotland in response to a post of Jonah Goldberg’s at the Corner. Mr. Seat, fresh from an Asian sojourn, offers some heartfelt but guarded optimism about the potential for Scotland to rediscover its small-l-liberal tradition and implement it in modern policy.

Sorry, luv, I’m not holding my breath.