Beeronomics & Econ 101: Economies of Scale - Redux

After my post this morning, Beervana blogger Jeff Alworth sends along this new picture and writes: "Each one of those tanks at Widmer is 1500 barrels (46,500 gallons)--the annual production of a big brewpub.  There are six in that room and one of the brewers joked, "the biggest six-pack in Portland.""


Here is another aspect of economies of scale: the cube-square law.  According to Galileo (via Wikipedia) this law states: "When an object undergoes a proportional increase in size, its new volume is proportional to the cube of the multiplier and its new surface area is proportional to the square of the multiplier."  So if you double the size of a tank in a brewery, the cost of the materials to make it (stainless steel) increases fourfold but the volume increases eightfold.  So if you have the production to support it, you get double the bang for your buck in tankage - thus the average cost per ounce of beer decreases (all else equal - like just as easy to clean and maintain as smaller tanks).  Now you know.


And for my students - after these two posts, I have now made attending my class today almost entirely redundant, but as it already happened you cannot act on this knowledge - so my ego is safe for another day.  

Beeronomics & Econ 101: Economies of Scale

Over at the Beervana Blog, Jeff Alworth notes (and photos) a new set of tanks being delivered to Coalition Brewery near his house.  To the economist in me this picture says one thing: economies of scale.

Economies of scale simply refer to any productive activity whose average costs decrease with output.  In many cases this is due to large fixed costs - those costs that do not depend on the quantity of the output.  Take this brewhouse for example: the cost of these tanks will be the same if they brew no beer or if they brew to capacity.  Alex at Upright, for example, has a beautiful brewhouse but is only brewing at about 60% capacity - if memory serves.  So if Upright brews more, the average cost of the beer they brew will go down - the fixed cost will be spread across more beer.  Since breweries require a lot of large scale equipment, it is an industry prone to economies of scale. There are other sources of economies of scale that are relevant to the beer industry as well: bottling, distributing and marketing to name three.

The implications of economies of scale have been discussed here at length, but the main one is a tendency for such an industry to be prone to concentration.  It is no accident that the big macrobrewers have become bigger and bigger through acquisitions and mergers.  [I have noted in a previous post how the fact that craft brew is an artisanal product and an experience good creates a countervailing force for small scale brewers to exploit]

The good news for Portland and Oregon craft brewers is that, like these internal economies of scale (that depend on the firm's activity alone), external economies of scale exist.  For example, with a lot of local craft brewers there is more demand for ingredients.  This high demand allows farmers and other input providers to achieve their own economies of scale, promotes competition and allows for efficiency in distribution of inputs.  So it is likely that inputs costs are low in Portland and Oregon not just because of proximity to the growers but because of all the brewing that goes on in Oregon.  [There is also a demand side effect, but that is a topic for another day]

So this external economies of scale is a pretty groovy story: the more local craft brewers brew, the lower are the costs for their fellow brewers.  Once again we see that competitors can also help each other out - even unintentionally.  For an industry that is remarkable for its sense of community and fellowship, this shows that they are not just deluded hippies - they are also savvy businesspeople.

Beeronomics: The Novelty Curve, Economies of Scale and the State of Craft Brewing

Whew, how's that for a title?

Over at Beervana, Jeff Alworth has blogged a couple of times recently about some new data purporting to show the health and growth of the craft brewing industry.  He discusses how the data reveal an interesting fact about the industry: there are a few big players (Boston Brewing, New Belgium, Sierra Nevada, Full Sail, Deschutes) and a TON of very, very small breweries.  He and I have also had conversations about the overall trend.  Craft beer cheerleaders look at the remarkable growth in market share over the last decade and the still small share in general to suggest that the future is bright and that there is no reason we should not expect craft beer to continue to grow both in overall volume and in the number of breweries. I am skeptical.

The model I have in my head of the craft beer industry in the US is one that is mainly characterized by a tension between two forces: novelty and scale.

The first comes from the natural desire of consumers to consume variety. Most of us don't eat the same meal for dinner every night and we tend to get tired of any one meal we eat too often.  But the variety desire at the market level can be also arise because of static and different tastes. Finally, tastes can evolve - consumers get used to hoppy beers, for example.  So dynamic tastes, where consumers of beer find their tastes evolving and are always looking for new and interesting experiences, can also drive the market demand for variety.  All this leads to the advantage new breweries have in brewing new styles reach customers that were previously badly served because no beer was available that matched their preferences well, or to consumers looking for new things, or to consumers looking for more adventurous drinking experiences.   Jeff has coined this the 'novelty curve,' and suggests that new breweries have an advantage over established ones because of new, fresh products. [Ninkasi comes to mind]  Established breweries, like Bridgeport for example, have a more difficult time trying to keep a standard line-up selling while at the same time satisfying the desire for new tastes.

The second is a natural aspect of many industries - the larger the volume of the firm, the lower the average cost of producing the product. In brewing the size of the brew house, the ability to have your own bottling line, efficiency in distribution, number of taps, brand recognition, and many other aspects make brewing an industry that is subject to significant economies of scale.  What this means is that larger breweries can undercut smaller ones, all else equal.  [My colleague, Vic Tremblay, has estimated economy of scale effects for the large industrial breweries up to about 23 million barrels, if memory serves]

Because of these two forces and how they interact with the craft brewing industry, I expect that the industry will always be characterized by a lot of volatility.  I think that there will be some stable mainstays (the Deschutes and Full Sails of the world) that have the scale advantages and try hard to keep up a line of unique, one-off, specialty beers to feed the novelty curve.  And a lot of churn (in economics-speak) among the smaller breweries.  I think the brew-pub model is the way to go here as a stable revenue stream from food and an in-house captive audience for the beer can help tame the vagaries of a fickle consumer base.  

All that is to say is that I don't think the number of breweries continuing to increase is a sustainable path and I expect another round of shake outs in the market, unless small brewers can establish a successful restaurant operation.  And in general, I think we can always expect breweries to come and go regularly.  But this is not necessarily a bad thing - the better breweries, those that brew good beer, are well run businesses, market well, etc. will stick around and new start-ups will keep offering new, interesting beer.

This doesn't mean that the overall market share of craft breweries won't continue to increase, but as this increases it may reinforce the economies of scale advantages of bigger craft breweries.  That said, mainstays like Boston Brewing have seen sales stagnate, while lots of little breweries have opened, so we may be in a period where the variety motive in the market is ascendant.  The good news in all of this is that the market should always be interesting from here on out for this observer - I think craft beer is here to stay.

Note: the picture is of Hangar 24 craft brewery in Redlands, CA, where my brother is a brewer.  Check it out if you are in the LA area.

Economies of Scope and Scale: Pearl Jam

In the heyday of the music business, record labels were important and successful because they could offer two advantages to musical acts: economies of scale and scope.

In the 'old' days getting potential consumers to know about you and your music was very difficult. Big record labels were able to offer a world wide distribution network that worked because the label was able to sign numerous acts and 'scale up' the operation, meaning that they were able to build a huge PR department because of the size of the artist roster and this allowed them to become very efficient at what they did. The also had economies of scope, meaning that they not only got records in stores, provided posters and promotional material, they got the music out to radio, helped artists book venues and TV appearances, and so on, and all of these different activities were mutually beneficial.

The thing is that all of these scale and scope efficiencies were a result of the difficulty of distributing and promoting music. These days the internet and digital music files have almost completely obliterated the source of these advantages and so it is no wonder that the old music industry is in trouble. New bands are using new media more often to reach out directly to fans and to establish an audience. It is still not and easy thing to do by any means, and thus the vast PR shops of the record labels still have a lot of power, but much less so than 20 years ago.

Now established acts are starting to think about whether they need labels at all. In perhaps the biggest move that highlights the shifting economics of the music business the band Pearl Jam has cut the middleman and is releasing an album by itself - in other words, not using a major label. It will be interesting to see if this path breaking approach catches on, for the other thing a multi-album deal on a major label does provide a bit of risk insurance. Consider R.E.M.s five record deal with Warner Brothers in 1996 that paid them $80 million. This was at the height of their popularity and subsequent sales have been disappointing. If Pearl Jam's sales fall short, they are the ones taking the hit, not a big record label.

By the way, the new album is fantastic, in case you were wondering. I even found my way to a Target so I could actually by the physical disk. Call me sentimental but iTunes joust doesn't produce that same level of excitement I remember from my adolescent years where going to the record store and actually holding the album was a source of rapture. Bringing home the album (yes, they were vinyl in my youth) and pouring over the art and liner notes while listening to it was sheer joy. I am also old enough to remember Mother Love Bone at the Satyricon, the Vedder-fronted Mookie Blaylock at the Melody Ballroom and then the overwhelming rocket to stardom that soon followed the release of their first album as Pearl Jam. Boy I am getting old quickly - fun then to have the band playing like a bunch of teenagers on this album, albeit exceptionally talented teenagers...makes me feel young.

Econ 101: External Economies of Scale

Most people understand internal economies of scale, the reduction in average cost of production that comes from producing in mass quantities. Utilizing machines, specializing tasks, economizing with big shipments all make sense. But economists know that economies of scale can be external as well. These come from the fact that a large industry can create economies of scale in upstream and downstream industries, can promote development of new process innovations and can lead to more efficient distribution networks.

I thought of this when I was listening to a commentator on the radio suggesting that the US automobile industry needs to be much smaller. It is quite possible that he is right, but if the automobile industry shrinks it is likely that producing cars will become more expensive, further hurting the industry that remains. Why? External economies of scale. Producers of components and inputs in general will have fewer customers and thus lower demand meaning that they might not be able to produce at an efficient scale, and the same is potentially true for the suppliers of raw materials.

A local example might be the brewing industry in Oregon. I have no idea how true this is, but one example is the fact that there are now (to my knowledge) two competing mobile bottling firms in the region, up from one a year ago, which is likely to reduce costs for the small brewer. More local breweries might also spur the planting of more hops allowing local cultivators to realize economies of scale and thus reduce input prices.

How does this all relate to the current economic catastrophe? Well at a time when demand is waning, firms might not be able to operate as efficiently as possible due to scaling back of operations and as they fail, supporting firms might also become less efficient. On the other hand, labor costs should be coming down pretty quickly as the demand for jobs skyrockets, so the effect on prices is unclear.

Have a good weekend everyone...

Beeronomics: Specialization and Product Variety

Last Friday I had the distinct pleasure of having lunch with John Harris, brewmaster at Full Sail and the man responsible for, among many other amazing beers, slipknot Imperial IPA (shown here - go get some, it is fantastic). I learned many interesting things from John about the beer business including learning about an outfit called 'Microbeer Source.' A number of very small bottling breweries use Microbeer Source to bottle their beer, including Full Sail for the 'Brewmaster Reserve' line that is brewed at the Pilsner Room in Portland. Microbeer source is, you see, a mobile bottling line which brings the line to local breweries and bottles their beer for them. Upon researching this, I discovered that this is very common in the wine industry, which makes sense, the wine industry is mostly made up of many very small producers whose product is needs to be bottled in order to send to market. Bottling lines are pretty expensive, take a lot of space, and without this kind of specialization, it would be hard for small producers to survive. Economists often talk about such industries in the context of "natural monopolies," industries where there are such high fixed costs to begin production, that the market can only support one producer (which means having large economies of scale, but in a particular way).

In this context, if all small wineries had to have their own bottling lines, many would not be able to cover the cost of the line from the sales of their wine and would, therefore, not exist. There would not be monopoly, but the number of wineries would be drastically reduced. This is the same, albeit on a smaller scale, in the microbrewing industry. It is unlikely that breweries like Roots, a small Portland outfit (whose "Woody IPA" is fantastic and available in bottles down here in the sticks thanks to Microbeer Source) would be able to sell in bottles without such a bottling service available to them. So, through specialization of tasks, we can not only improve efficiency (as in Adam Smith's archetypical pin maker story), but in these cases, we can improve product variety as well. For what this means for consumers of beer and wine is not just lower prices for the increased efficiency that specialization brings, but many more choices available to them when they wander into their local supermarket or beer and wine store. Ah the wonders of economic organization...

P.S. John raised an interesting question, to which I have a number of plausible answers, but I will ask it as an open question first: why are just about all of the major bottling breweries in Oregon today the very same ones that were here 15 years ago? In other words, why have there been no new entrants into the industry in the last 15 years (with the exception of Terminal Gravity)? Ideas?

Beeronomics: Widmer and Red Hook Merger

Its all happening too fast! I had planned, after the close of voting for your favorite Oregon brewery (one day left!!), to write about craft brewers and strategy. I was going to talk about more mainstream strategies like Widmer and less mainstream like Rogue. I was going to talk about product variety strategies, like Full Sail bringing Session to market and Ninkasi's Schwag. And I still will. But the merger between Widmer and Red Hook, as reported in today's Oregonian has forced my hand early, so be prepared for a few days of Beeronomics. (Drat, that monumental post on stabilizing Oregon's revenue collection will have to wait another week it seems)

So what does the Widmer/Red Hook merger signify? One thing is that it may perhaps signify a trend in craft brewing toward larger scale to capture efficiencies. I am fortunate to have Vic and Carol Tremblay as colleagues, for they are experts on the economics of the beer industry. One of the things they have studied is what is known as "Minimum Efficient Scale" (MES) in the beer industry. This is how economists refer to the exhaustion of economies of scale - you know, how things become cheaper per unit as you produce more. It turns out that MES in beermaking has rapidly increased in the past 50 years. In 1960, they estimate, MES was 1 million barrels but had reached 23 million barrels by 2001. (And, by the way, we generally do not think that you can get too big as you can always divide operations between different plants so 23 million barrels is a target to meet or surpass). Why?, well increased mechanization, better transportation and bigger capacity for a start. To give one specific example, in 1987 a high speed canning line in a large brewery could fill 2,000 cans per minute! So to operate just one of these lines efficiently, you would need to produce at least 2.18 million barrels of beer. Methinks Caldera is just a wee bit under that target. This has nothing to do with quality, variety, honor...whatever. These are the cold, hard facts: economies of scale exist in beer brewing, they can be quite large and thus the economic incentive is to grow bigger and become more profitable and/or more competitive.

So where does Widmer/Red Hook fit in all of this? According to the always excellent John Foyston of the Oregonian, the combined brewery will produce 650,000 barrels a year. Far form MES, but probably a significant enough improvement in scale efficiency to make this venture worthwhile. This is about what Sierra Nevada produces, but is still quite far behind Boston Brewing - the craft beer king. It is perhaps no coincidence that Widmer, perhaps the most commercially minded brewery (consumer-driven?), is at the forefront of consolidation. (Both Widmer and Red Hook also have Anheuser-Busch as a minority owner)

This is a troubling trend for the craft brewing industry in Oregon, in my opinion, because there are competing economic forces at work. Consumers love variety, but producers love scale. The question will be, do consumers love variety enough to shell out $9 for a six pack of Dead Guy versus $5 for a six of Broken Halo? (Psst...go for the Dead Guy) I fear the answer to that question, for it is one thing to have brew-pubs where you can find quality, interesting craft beer, but it is another thing to find it in supermarkets (especially when you have two young kids and pubs are not so easy to frequent). This and the shortage and expense of hops and barley make me fearful of what may happen to Oregon's wonderful craft breweries over the next few years. There may be more pressure on economizing on ingredients and reducing the variety of offerings in the years to come.

NB: Jack Joyce of Rogue will be hosting the OSU Economics Club at the Brewery in Newport where we'll get to ask him about all of this stuff. OSU students: contact me if you are interested in joining.