Read an Excerpt
American Wine Economics
An Exploration of the U.S. Wine Industry
By James Thornton UNIVERSITY OF CALIFORNIA PRESS
Copyright © 2013 The Regents of the University of California
All rights reserved.
ISBN: 978-0-520-95701-5
CHAPTER 1
The Economic Approach to the Study of Wine
To explain the economic organization of wine production and consumption and the behavior of American wine firms and consumers, it is necessary to apply a set of basic economic concepts and principles. This chapter begins by explaining the important ideas of scarcity, choice, opportunity cost, rational self-interest, and economic incentives. These concepts are then used to develop the logic of choices by wine consumers and wine firms and the principles of individual demand and supply. Lastly, supply-and-demand analysis is presented as an analytical tool that can be used to organize our thinking about how buyers and sellers interact in the wine market, and how the quantities of wine grapes and wine traded and their prices emerge from these interactions.
SCARCITY AND CHOICE
The fundamental economic problem that confronts all of humanity is scarcity, which arises from two incontrovertible facts of life: human wants and desires are unlimited, but the resources available to satisfy those wants and desires are limited. As a nation, the United States does not have enough labor, capital, and natural resources to produce all of the wine, food, automobiles, cell phones, computers, education, healthcare, and countless other goods and services that Americans want.
Because resources are scarce in relation to wants and desires, individuals, business firms, and entire nations must continuously choose among alternative uses for their scarce resources. Choosing is a direct consequence of scarcity. Someone with limited money and time must decide whether to spend $50 on a bottle of luxury wine, or two bottles of premium wine, or a new sweater, or a new garden tool; sleep an extra hour or read the morning paper; work an extra hour or take an additional hour of leisure. A farmer must decide whether to use his own time, land, and capital equipment to grow grapes, apples, peaches, nuts, or some other crop. A wine firm must choose the type of varietal or blended wine to employ its winemaker, cellar workers, fermentation tanks, maturation vessels, and bottling line to produce. The nation as a whole must determine the amount of wine and other goods and services to produce with its scarce labor, capital, and natural resources.
OPPORTUNITY COST
Whenever a choice is made, a cost is incurred. Economists call this opportunity cost. The opportunity cost of a choice is the benefit forgone from not using the resources engaged for their next best alternative. This forgone benefit is the value the decision maker places on the alternative. For example, if one chooses to use $100 to purchase a bottle of Silver Oak Cabernet Sauvignon, the opportunity cost is the benefit forgone from not using this $100 to buy something else, such as a new shirt and pair of pants. If one chooses to use two hours to attend a "free" wine-tasting event sponsored by a local wine shop, the opportunity cost is the benefit forgone from not using this time for another activity, such as watching a football game. If one owns five acres of land and chooses to grow grapes on it, the opportunity cost is the benefit forgone from the most highly valued alternative use of the land. Suppose the land has two alternative uses. One can also use it to build a house or sell it for, say, $25,000. If the perceived next best use of the land is for a house, the opportunity cost of using it as a vineyard is the satisfaction of living in a home on the land. On the other hand, if the perceived next best use of the land is to sell it for $25,000, the opportunity cost is the benefit of the other goods and services the money could have purchased or the return on investing the money. The concept of opportunity cost tells us that in a world of scarcity, there is no such thing as a free lunch: you can't get something for nothing.
The above examples illustrate that opportunity cost may or may not involve money, and if it does involve money, the real cost is the resources, goods, or services those dollars could have purchased. It is useful to make a distinction between two types of opportunity costs. An explicit cost is a money payment that an individual or business firm makes to another party; an implicit cost does not entail a money outlay. Because explicit costs arise from expenditures that are actually made, such as paying $25 for a bottle of wine or $1,000 for an acre of land, they are relatively easy to observe and measure. However, implicit costs are typically not obvious and are revealed by careful consideration of a choice situation. Economists often impute a monetary value to these costs so that they can be compared to explicit costs. In fact, whenever possible, economists measure opportunity cost in dollars, facilitating comparison of different types of costs.
Implicit costs associated with wine firms' choices often involve money payments forgone. Consider the following applications of the concept of implicit cost. The most important input used to produce wine is grapes. Many wine firms own vineyard land and grow some or all of the grapes used to produce their wine. While these firms incur no explicit cost in the form of rent, the implicit cost is the money payment forgone from not renting the land to someone else. Conceptually, there is no difference between making a money payment of, say, $1,000 to rent vineyard land from someone else or forgoing a money payment of $1,000 by not renting vineyard land you own to someone else: both of these alternatives involve giving up $1,000. The implicit cost these firms incur from choosing to use the grapes they grow to produce their own wine is the money forgone from not selling them at the going price. To increase grape quality, some of these firms choose to reduce the number of grape clusters per vine several months before harvest by sending workers into the vineyard to cut off grape bunches, allowing them to fall to the ground and rot. The explicit cost of this choice is any money outlay required for the services of the workers who perform the cluster pruning. However, there is also an implicit cost, which is the money payment forgone from not harvesting and selling these grapes or the wine they could have produced. A choice that wine producers must make is whether to mature wine in a stainless-steel tank or an oak barrel. Unlike in a stainless-steel tank, wine evaporates in an oak barrel at a rate of as much as 10 to 12 percent per year. The opportunity cost of choosing an oak barrel is the sum of the money outlay for the barrel and the revenue lost to this evaporation. Many wine firms are owned and operated by self-employed proprietors who perform many of the winemaking tasks. The implicit cost of the time provided by the proprietor to his firm is the money forgone from not providing winemaking services to other firms who hire winemakers as employees or consultants.
Implicit costs associated with wine consumers' choices typically do not entail a money payment forgone, and usually involve the value of an individual's time in its next best use. When a consumer purchases wine, she or he typically incurs both an explicit cost and an implicit cost. Making a wine purchase usually involves gathering information about the prices and qualities of available wines, traveling to a store where wine is sold, and paying for it. The explicit cost is the price of the wine, transportation, and any out-of-pocket payments for sources of information on available wines and their prices, such as wine guides. The implicit cost is the opportunity cost of the time devoted to gathering information and purchasing the wine. This may include time spent visiting different stores to obtain information on prices and wines recommended by salespeople, reading wine labels, magazines, studying wine-related websites, and talking with friends. The implicit cost of purchasing wine is the value of this time in its next best alternative use. It is sometimes estimated by a person's wage rate: a higher wage is associated with a higher implicit cost for any given amount of time devoted to a wine purchase.
The same wine often sells at different prices in different stores in the same market area. However, the opportunity cost of purchasing the higher-priced bottle may actually be less than that of the lower-priced bottle, taking into account the implicit cost of the time required to search for the cheaper wine. For example, suppose that a computer programmer who makes $30 per hour desires to purchase a bottle of Caymus Cabernet Sauvignon. He knows this wine is selling for $70 at a wine shop close to his house, so that it would require only ten minutes to make the purchase. Suppose that by spending an hour searching other stores in his town, he could find one that charges the lower price of $60 for the same wine. If we use his wage rate as an approximation of the value he places on his time, the actual cost of purchasing the cheaper wine is $90 and that of the high-priced wine is only $75.
RATIONAL SELF-INTEREST
Scarcity requires individuals to make choices, and the choices people make determine how they behave. But exactly how are these choices made? Economists assume that people make rational choices that are in their own self-interest.
People act in their own self-interest when they attempt to go as far as possible to satisfy their own wants and desires. Self-interest does not necessarily imply that people are greedy or selfish; it allows them to have a variety of wants and desires. One person's wants may be limited to material goods, while another may have wants that are aesthetic or include the welfare of others. For example, some people may want to donate time or money to charitable organizations to benefit the less fortunate. A wine proprietor may want to produce wine as an artistic expression or grow organic grapes to benefit the environment. Anything a person wants is considered a good. The more a person values a good, the more satisfaction he or she gets from the good. Economists call this satisfaction utility. Therefore, an individual acts in his own self-interest when he attempts to maximize his utility.
To maximize utility, individuals make rational choices. When making a rational choice, people behave as if they consider the benefit and cost of an alternative and choose the alternative only if the benefit exceeds the cost. Cost is always opportunity cost, which is the benefit forgone from not choosing the next best alternative. In the nomenclature of economics, benefit is another word for the value a person places on a good or the utility he or she derives from a good. To say that people maximize utility is another way of saying they maximize net benefits. Rational behavior can be thought of as subjective cost-benefit analysis.
Rational decision-making also considers marginal benefit and marginal cost. These are the additional benefit and the additional cost of choosing an alternative. For example, when deciding how many bottles of wine to buy, a rational consumer considers the marginal benefit and marginal cost of each additional bottle and buys more if marginal benefit exceeds marginal cost. When deciding how many cases of wine to make, a proprietor considers the benefit and cost of each additional case produced, and expands production as long as marginal benefit exceeds marginal cost. Marginal cost does not include any cost not affected by choosing an alternative. These unaffected costs are called sunk costs. For example, when a proprietor is deciding whether to produce an additional case of wine, overhead costs such as rent on the winemaking facility and property taxes are sunk costs. A rational proprietor will ignore these costs, because they do not vary with the number of cases of wine produced.
Finally, rational decision making does not require that people have complete information about the set of alternatives from which they are able to choose. Information itself is scarce and expensive. When making a choice, a rational individual will continue to gather additional information as long as the marginal benefit exceeds the marginal cost. Rational behavior can result in mistakes. A rational consumer may regret purchasing a bottle of wine despite having expected the benefit to exceed the cost based on the available information when making the choice.
The assumption of rational self-interest implies that wine consumers choose the combination of wine products and other goods and services that maximize their utility, given their money and time resources, which limit their available alternatives. They do this by purchasing additional units of a wine, other good, or service only if the marginal benefit exceeds the marginal cost. But what does it mean for wine firms to make rational self-interested choices? Wine firms do not make choices; individuals make choices. The individuals who typically make choices in firms are the owners or managers. Like consumers, the owners of wine firms attempt to maximize their utility. To maximize utility, economists typically assume that the owners of a firm, or managers who act on their behalf, attempt to maximize the firm's profit. Profit is the difference between total revenue and total cost. By maximizing the firm's profit, the owners maximize their personal income or money resources. And by maximizing their money resources, they maximize the amount of goods and services they are able to purchase and consume, and therefore the level of utility they can attain.
This argument suggests that profit maximization is a logical consequence of utility maximization. However, there are certain conditions under which utility maximization does not necessarily imply profit maximization, and profit maximization may not therefore be a reasonable approximation of what motivates wine firms to make the choices they do. Consider a large wine firm that is a publicly traded corporation with thousands of owners who are stockholders, such as Constellation Brands or Treasury Wine Estates. The managers who make business decisions in these big firms are not necessarily the owners. In seeking to maximize their utility, these managers may choose to trade firm profit for sources of personal satisfaction such as posh offices, private planes, country club memberships, and the prestige of managing a large and growing firm, albeit one that exceeds the most efficient size. Alternatively, consider a relatively small wine firm whose owner does make the decisions for the firm. Suppose that the owner derives utility from a good that cannot be purchased in the marketplace, but can only be obtained through ownership of a wine firm. These types of nonmarket goods may include nepotism, living the wine proprietor's lifestyle, and the aesthetic value of making a high-quality wine. To maximize personal utility, the owner may choose to trade off a certain amount of profit for these sources of satisfaction. For example, recall that some wine firms choose to use cluster pruning to decrease the number of grape bunches per vine to increase wine quality. A rational proprietor will choose to undertake cluster pruning only if the expected benefit exceeds the opportunity cost. The opportunity cost of cluster pruning is the money payment made to workers who perform this activity plus the revenue forgone from the lower grape yield and wine output. If the objective of the proprietor is to maximize profit, the benefit of cluster pruning is the increase in revenue the proprietor expects to receive from selling a wine of higher quality. Suppose that the opportunity cost of cluster pruning of $20,000 exceeds the expected revenue gain of $15,000. A profit-maximizing proprietor would choose not to cluster-prune; doing so would decrease firm profit and his personal income by $5,000. However, suppose the proprietor derives aesthetic utility from the improvement in wine quality and would be willing to pay $10,000 for this nonmarket good if it could be purchased in the marketplace. The benefit of cluster pruning for this utility-maximizing proprietor is $25,000, and he would therefore rationally choose to trade $5,000 of profit for the utility he gets from the improvement in wine quality.
(Continues...)
Excerpted from American Wine Economics by James Thornton. Copyright © 2013 The Regents of the University of California. Excerpted by permission of UNIVERSITY OF CALIFORNIA PRESS.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
