Victory for liberty and oenophiles!

According to this Declan McCullagh article from CNET.com, a New York state judge has ruled that the state’s ban on interstate shipment of alcoholic beverages is indeed a violation of the interstate commerce clause of the Constitution. Much of the success on this front in various states is due to liberty-loving oenophile and attorney Clint Bolick, whose Institute for Justice is responsible for several of these legal challenges.

Here’s an article on the subject that I wrote two years ago and never published anywhere; it’s a little dated (note the reference to disintermediation, how 20th century dot-com bubble), but still relevant:

Days of Wine and Rent-Seeking

A lot of high-tech “buzz” highlights market disintermediation as one consequence of the internet and increasingly reliable communications technologies. In the context of these changes in the transaction costs of trade and exchange, an entrenched liquor distributor system, a relic of Prohibition, has successfully fought to maintain and increase its profits in the past few years. Two dramatic manifestations of this fight exist: the prohibition of interstate mail-order purchase of alcoholic beverages, and efforts by large distributors to limit retail customers’ ability to shift their business to other distributors.

This distribution network, known as the three-tier system, arose during Prohibition as a combined federal and state response to smuggling and black-market profits (never mind that the power and profits would not have existed without Prohibition). By law, wineries, distilleries and breweries cannot sell directly to retail customers (stores, bars, restaurants) or consumers, but must contract with a wholesale distributor that will market and sell their products, along with products of their competitors, to these retail outlets. These relationships are exclusive, with each producer having only one distributor in a region. Through some unfortunate (for everyone except the distributors!) path dependence, probably aided by some lobbying at the time, the three-tier system survived Prohibition. Furthermore, the 21st Amendment, which repealed Prohibition, granted individual state governments the right to regulate the sale and shipment of alcoholic beverages. Thus if an ultimate consumer is visiting a brewery, distillery or winery, he or she can purchase beverages for personal consumption (unless, like Jack Daniels, the distillery is in a dry county; how paradoxical is that?). Whether they have to lug them home themselves or can have the business ship to them, though, is a hugely complicated issue, thanks to the tangled web of state laws surrounding the 21st Amendment. As a result of these laws, regional wholesale distributors have become large, powerful and profitable companies, and their numbers have decreased over the past decade.

This legal structure generates market power, and therefore economic rents, for the small number of wholesale distributors. For example, the three-tier system encourages distributors to engage in product tying or bundling, which is a typical indicator of a firm having market power. Behavior similar to this got Microsoft in trouble with the Justice Department, but wholesale liquor distributors do so under legal protection.

On the other hand, the distributor structure does save on transaction costs for both producers and retail customers. Producers can focus their marketing resources on advertising to ultimate consumers (within stringent government guidelines, of course, and without discussing health benefits of moderate drinking), not on hunting out and developing relationships with stores, bars and restaurants around the country. Distributors work in conjunction with the marketing personnel at producers to generate regional and in-store promotions. Distributors also provide information benefits to their retail customers, enabling them to avoid spending a lot of time and effort gathering information on all of the wines, beers and spirits in the market. Because of these intermediation benefits that a distributor could provide upstream and downstream in the transaction, such a system has had benefits and could have arisen in the absence of the three-tier law.

However (and this is a big however, heard in many guises and venues today), information technology and the internet have decreased those transaction costs, making direct communication and trade between producers and retail outlets cheaper and easier. A direct market would also enable producers and retail outlets to avoid paying for some of the economic rents associated with the substantial market power of the distributors. Therefore, although the wholesale distributors would obviously suffer in the change, the evolution of the liquor market away from the three-tier setup would probably increase overall social welfare. This disintermediation, mirroring others in the past five years, could increase the variety and availability of, for example, small-producer wines that might otherwise only be available at the winery. Increasing customer choice and happiness, potentially at lower prices, increasing producer market reach and profit — sounds like a win-win, except for those pesky distributors.

The three-tier system also prevents the development of alternate distribution structures like liquor brokers. A bar owner could, in this alternate universe, hire a broker to negotiate with distributors, or directly with producers. Current law prohibits this market, to the benefit of existing wholesale distributors and the detriment of retail customers.

Wholesale distributors have had over 65 years to develop market power and a vigorous interest in maintaining their own importance and role in liquor sales. This situation has many of the traits of a typical rent-seeking context. The distributors enjoy concentrated benefits from this legislation. The legislation’s costs, though are diffuse at both the upstream (producer) and downstream (retail consumer) level. Not surprisingly, then, we find distributors engaging in lobbying and other rent-seeking activities to create legislative legitimacy for their continued existence.

The product in question further complicates the situation. As the Wine Institute puts it, “People have an ATTITUDE about alcohol. Over time, these attitudes develop legal and political properties.” (www.wineinstitute.com/shipwine) Distributors have been able to exploit the increasingly moralistic and paternalistic treatment of drinking, particularly among teenagers and college students. This paternalism has also shown up in federal government zero-tolerance attitudes to drinking:
-Withholding highway funds from states in the 1980s if they did not increase their drinking ages to 21 (all states now have a 21 drinking age, what a surprise);
-The current public service announcements of the FDA; and
-The ongoing controversy over acknowledging the health benefits of moderate alcohol consumption, and whether that would constitute government “approval” of drinking.
Thus we see the same slippery-slope lack of logic that leads people to argue that marijuana use leads to crack cocaine use, abuse and addiction.

Mail-order wine purchase is a beautiful, painful example of distributors manipulating this attitude to their own rent-seeking benefit. Some states, like Maryland and Florida, have made mail-order alcohol purchase a felony. The Wine Institute’s web page has a map showing the legal treatment of mail order in each state in the US. See also the Wine Spectator for further discussion and links; their reader comments also indicate that consumers recognize the concentrated benefits to the wholesalers at the diffuse expense of consumers and small producers. Wholesale distributors, working with state legislators, support the political rhetoric that the interstate prohibition is directed specifically at minimizing underage drinking (see, for example the Wine and Spirits Wholesalers Association web page). This red herring is patently absurd — how many underage drinkers would pay the high shipping costs for something as heavy as liquor in glass bottles? Shipping costs would greatly increase the cost per buzz.

Mail-order prohibition also stifles the growth of small wineries and breweries. Many are not large enough to land on the radar screen of the distributors or to market their products far beyond their local communities; they would be able to reach larger markets of consumers interested in distinctive, high-quality beverages if they could ship products directly to consumers. Organizations like Free the Grapes are working on behalf of these small wineries and their potential consumers to raise awareness of the consequences of mail-order prohibition.

Another manifestation of wholesale distributor rent seeking has occurred in Illinois and Wisconsin. Untainted by the moral overtones of the mail order controversy, and hopefully more isolated and short-lived, this legislative change is largely being driven by Bill Wirtz, the owner of Judge & Dolph, an Illinois distributor (and also of the Chicago Blackhawks hockey team). Judge & Dolph covers about one-third of the Illinois liquor market with the brands it distributes. Wirtz also owns a wholesale distributor of similar market power in Wisconsin. The Illinois Wine and Spirits Fair Dealing Act and the Wisconsin Fair Dealership Law both stipulated that a retail customer of a wholesale liquor distributor could not “fire” them and hire in another distributor, even if they could demonstrate what might normally be called breach of contract. In Illinois, this legislation passed in conjunction with a state liquor tax that, at least around Chicago, retailers passed on to customers with pleas to them to complain to their state representatives. Distributors also used this opportunity to raise their prices to retail outlets, resulting in a double whammy to consumers.

Thus we see another attempt to exploit concentrated benefits to distributors and diffuse costs to producers and retail customers and consumers. This exercise is more blatant and devoid of the underage drinking red herring found in the mail order controversy, but driven by the same economic incentives.

Private individuals and organizations are working to counter these instances of rent-seeking. In late 1999 a Texas judge said that their state law violates the Interstate Commerce Act. Groups like the Wine Institute and Free the Grapes are working to spread that precedent to other states. Clint Bolick, President of the Institute for Justice and an avid oenophile, is participating in a lawsuit in New York to challenge their mail order interdiction.

The distributor laws in Illinois and Wisconsin also face challenge. Amid customer furor and questions about the constitutionality of the legislation shackling the retail customer to the distributor, the Illinois legislature repealed the legislation last spring. Unfortunately, the rhetoric on the number of distributor jobs that this legislation would save in Wisconsin seems to have kept it from the legislative rubbish bin, to the (widespread) disadvantage of producers, retail customers and consumers in Wisconsin. [Lynne’s comment: this law has been repealed since I wrote this, yay]

The alcoholic beverage industry encapsulates the shifting transaction costs that result from technological change, and these changes have laid bare the incentives of wholesale distributors. Hopefully the overreaching greed demonstrated recently in Illinois and Wisconsin and the nationwide efforts to change state mail order legislation will coalesce diffuse consumer interests and create the opportunity for disintermediation in the spirits distribution industry. Consumers can only benefit. Santé.

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