The International Competitiveness of the California Wine Industry
Robert C. Eyler
Sonoma State University
Department of Economics
Rohnert Park, CA USA 94928
Copyright (c) 1999 Robert C. Eyler. All rights reserved.
Wine production, sales, and consumption in the United States are growing. Competition in this growing market involves product differentiation. In the US wine industry, firms attempt to differentiate themselves in two main ways. First, in response to competition, both foreign and domestic, there are continuous changes to the product. In fact, the wine's chemistry may be little changed; the marketing and the tale surrounding the wine changes to modify consumer preferences toward the wine. Also, wineries may offer wine in different wine segments, thus changing the competitive forces on their brand. Many smaller wineries offer products that cater to those looking for a low-price wine and for those seeking a good value with excellent quality. This further differentiates the winery's product, allowing their competitive advantage to step to the foreground. Michael Porter (1985) speaks of "competitive advantage" as the way firms use their inherent advantages to compete. This is not necessarily in terms of costs, but how the firm adds value through specific functions. The way value-added activities are measured and compared to their competitors is through Porter's value chain. This study involves a look at the US wine industry through some comparative statistics, and attempts to identify the nature of its competitive advantage. We claim that the quality perception is a major part of these advantages, especially in higher-priced segments. Throughout the paper, the nature of Chilean competition is discussed to give an insight as to Chile's ability, or lack thereof, to penetrate US wine markets.
In Section 1, a description of the US wine industry provides a broad perspective of the US wine market forces and barriers to foreign entry. Section 2 focuses on the statistics describing the US wine market, especially California. In these statistics, we see how the European producers enjoy a strong competitive position and how Chilean producers gain market share. European producers have a long-standing market in the US, and a great deal of market power 1 . The Chilean wine industry has penetrated US markets, putting added pressure on California wine producers to find ways to compete. Section 3 begins our formal analysis, as a basic demand model describes the possible factors in the US wine industry by testing for the relationships between the product differentiation of Chilean and US wines. Historically, Chile has not competed well in the United States 2 . However, as wine prices increase, Chilean wine enjoys a niche as a low-cost, high-quality alternative to US wines. The model's results are related to competitive advantage, in terms of the Porter's five forces. Section 4 begins the value-chain analysis for the US wine industry, using a typical US firm as an example. Section 5 concludes our analysis.
1 How producers from Chile may infiltrate the US market is discussed in Section 3 .
2 Chilean imports, in the last ten years, enjoyed phenomenal success in the United States. According to 1998 US WineStats, the leading wine statistics publication in the US, Chile's average import growth rate was 43.7% from 1988-1997! The only major wine-producing country close to those figures in the last ten years is Australia, which averaged 24.9% growth in wine imports. Most of this is due to the low volume of overall US imports from both countries before 1988, and to some good firm policy: find certain varietals that have no market leader, differentiate the product, and procure a strong market share.
1.The United States Wine Industry
The United States is arguably the best place to grow grapes in the world. Two fundamental economic reasons lead to this possibility. First, the United States boasts world-famous growing areas that rival France and Italy in quantity produced and in quality of wine, as the technology and weather are extremely similar. Napa and Sonoma Valleys are also key tourist attractions, providing a constant source of customers. Second, wine prices in the United States are rising. US wine firms engage in fierce competition, especially in Napa and Sonoma Counties in California, forcing continuous changes in product quality. Few other countries boast such a large market base and compete against each other simultaneously for an expensive, non-durable consumer markets.
The US wine market has many domestic suppliers, Regions, styles
and varietals. A competing wine from outside the US finds it
difficult to compete on a varietal basis alone; however, many wine
Regions in the US produce wines of extremely variable quality, even
within the higher-end Regions of Northern California. Where the
French and Italian producers aim for quality over quantity, US wine
sales and production seem to concentrate on bulk sales. Table 1 below
illustrates the latest US wine consumption figures, broken down by
size of container.
|Customer Size||Market Share (%)|| Volume Sales
(9 liter case equivalents)
| % change in
|3.0 liters (Box)||1.3||733,362||-3.4|
|3.0 liters (Bottle)||11.2||6,269,400||-7.1|
|4.0 liters (Box)||0.1||62,689||-19.6|
|4.0 liters (Bottle)||6.2||3,474,718||-5.8|
|5.0 liters (Box)||18.4||10,317,510||1.6|
Source: Wine Business Monthly, May 1999
Two key aspects of the US wine market are apparent from above. The classic bottle, 750ml, is not the market leader in volume presently. As we can see, 1.5 liter bottles have the largest US market share. However, over the last year, 750ml bottles accounted for 54.2% of the dollar sales of wine, while 1.5 liter bottles accounted for only 28.7%. The larger bottle size is sold with a lower per liter price than its smaller counterpart. The discrepancy between the two seems extreme. Wines with higher perceived quality are mainly sold in 750ml bottles. This perceived quality differential is reflected in price differentials. As a result, most wineries manufacture few 1.5 liter bottles, even of high-quality wines, for market reasons. The discussion of product differentiation continues on this subject below.
The US wine market includes many bulk wines, those in containers greater than 3 liters that are not varietal or vineyard specific that enjoys a large following. These wines account for more than 30% of total US sales by volume and use a great deal of the US wine supply. The same sales account for only 14.3% of total dollar sales. The same principle applies as above: the larger the container's volume, the lower its unit price. Should US wine producers use the bulk market, which few international competitors compete in directly, to attract new wine drinkers and make wine more accessible? Or is the US wine drinker becoming more concerned with quality over time? It seems obvious that there is a market for bulk wines, and that US wineries are producing a large amount of bulk wine volume 3 . Most experts feel that the industry's future lies in quality wines.
California is the largest grape-growing and wine consuming state in the US. Other major wine-consuming states include Florida (7.1%), Illinois (5.1%), Texas (4.7%), and New Jersey (4.2%). These states gain access to California wines through distributors and winery sources. However, this depends on the state. In certain US states, wine transactions must be handled through state-approved stores, and wine cannot be shipped to certain states. This is a large issue at California wineries today, as international competitors face different laws on shipping and distribution than domestic wineries.Table 2:
|State|| Consumption as a % of
entire US market volume
| Production as a % of
entire US market volume
|Remaining 45 States||67.35||2.62|
The leading state in wine production is obviously California, where 90.57% of American wine was made in 1997. These additional states are generally much lower quality than the average California wine, but Oregon and Washington are receiving high praise. How important are these reviews to the consumer? For California wineries, it seems to be the key for demand. Small quantities can be sold out in one day based on a single review. This is true for any country's wine, but especially California. These tasting scores act as barriers to competition, and these barriers are key assets of US wineries.
3 International competition is much more prevalent in the 750ml and 1.5 liter markets, competing with varietal-specific wines from large producers. This is product differentiation, but it is larger than just a marketing scheme or customer targeting through price. The US wine market, and all the firms that sell wine in this country, must attract new wine customers to control market share. If demand sags due to lack of interest or the possibility that the present surge in wine consumption is a fad, all producers lose.
2. An Empirical Overview of the US Wine Demand.
The growth in US wine sales has been strong over the past five years. Its growth has been, according to industry leaders and experts, the result of higher demand, better marketing campaigns, and a concentration on quality. Figure 1 depicts the long-term trend in the growth rate of US wine sales as compared to US GDP growth over fifty years.Figure 1:
Percentage Change in Wine Sales and GDP, US: 1948-1997
Source: US WineStats, Steve Barsby and Associates, 1998 (Wine); DRI Economic Database, McGraw-Hill Publishers, 1999 (GDP)
Wine consumption patterns are changing in the United States, but is this trend simply passing fancy? Some firms and investors are betting on this fad and are trying to reap all they can from the industry before it is too late. Others feel a long-run change is taking place, and are positioning themselves for market share acquisition through land purchases, mergers, and buyouts. Most of the consolidation is taking place in California wine Regions, the focal point of the US wine industry 4 .
One way of explaining the change in wine consumption is how wine sales are related to overall consumption. We make the case below that the recent increase in wine sales may be a fad if not closely related to changes in complementary food consumption. If food consumption growth and wine sales growth are closely linked, wine is becoming a stronger complement to food consumption. Figure 2 shows the trends in both food consumption growth and wine sales growth over the past fifty years.Figure 2:
Comparison of Percentage Change in US Food Consumption/Capita and US Wine Sales/Capita: 1947-1997
Source: US WineStats, Steve Barsby and Associates, 1998 (Wine); DRI Economic Database, McGraw-Hill Publishers, 1999 (Cons)
As expected, the volatility is large in per capita wine sales and seems to follow changes in per capita food consumption over time 5 . The hope of wine marketers is that wine expenditures and consumption expenditures walk hand-in-hand. This complementary aspect of wine is huge in Europe and South America. Most in the industry believe, and rightfully so, that the American consumer has not made the leap of her global counterparts and taken wine as an everyday grocery item. The United States currently ranks 31st in the world in per capita wine consumption (1998 US WineStats).
The US wine industry has a three-tier system, much like other industries, with suppliers (wineries), wholesalers (wineries or distribution houses), and retailers (wineries, wine shops, grocery stores, etc.). Wine suppliers are important in this system. They may serve all three tiers: the winery acts as supplier, as the producer of the product, and as wholesaler when sales are made to retailers directly from the winery; the tasting room, if the winery employs such a facility, acts as a retail establishment on the winery grounds. Tasting rooms eliminate some additional shipping and distribution channel maintenance costs; however, most statistical representations of wineries do not include wine sales made at the tasting room as part of retail. The figure below indicates of the sales growth over the last ten years in each tier.Figure 3:
Source: US WineStats, Steve Barsby and Associates, 1998
The US wine industry contains wine demand wine segments: economy wine, sub-premium wine, premium wine, super-premium, and deluxe wine 6 . Below we discuss the need to estimate wine demand elasticities to forecast trends and form marketing campaigns from a theoretical perspective in terms of these segments and wine quality.
4 Our main discussion in this study will be the California wine industry.
5 The standard deviation of food consumption in the US from 1947 to 1998 is 2.4% while wine sales have a standard deviation of 8.6%.
6 See Gilinsky, 1999 for more. These categories are the source of raging political debates, as having groups based on price suddenly changes the qualitative demand aspects of certain wines. If the consumer believes that wines within a certain subgroup have similar qualities, demand may change purely from a reclassification.
2A. Wine Segments in the United States
New wineries attempting to niche and compete in the United States may focus on certain demand segments of the industry. These demand segments are primarily concerned with price. If price and quality are highly correlated, as the literature and personal experience suggests, then these segments separate wines by perceived quality. The importance of these segments is discussed in the model section below. For now, a qualitative examination of each segment builds foundational knowledge about the California wine market.
Economy Wines: Economy wines are dominated by large players in the US, as largesse in firm size is reflected in product volume. Gallo, through its many bulk brands, is the key US player. We define economy wine as wine sold in bottles or boxes of more than 1.5 liters, with no small quantities available. These wines are priced up to $3/liter, depending on varietal, brand, and seller. From personal experience and observation, these wines have found comfortable markets in consumers that drink wine with most meals and use wine as a complement to food and other purposes around the home.
Sub-Premium Wines: The sub-premium wine segment has its roots in the economy wine sector, but has become its own market by virtue of international competition. This has been a great market for blends of primarily premium wineries, and a way for the economy sector to move to higher price markets in this phase of growth. We also see the dominance of the larger firms in the SCWI begin to cement market position. Gallo and Kendall-Jackson are the largest players here, using different brands and varietal names to niche in this market. The wine may be varietal-specific or claim a blend dominated by a native varietal of the original vineyard's area. Economy wine is normally a blend from many different sources and areas. Sub-premium wine differentiates itself by selling in lower-volume bottles and provides wine drinkers a low-cost, varietal-specific alternative for everyday use. These wines sell from $3.01 to $7 per liter, and fulfilling the needs of moderate wine drinkers looking for low-cost, quality alternatives to our next group, premium wines.
Premium Wines: This segment answers the call for inexpensive, varietal-specific wines. This category is the market penetrator for larger, bulk wine manufacturers to differentiate their products. A chasm between sub-premium and super-premium wines emerged in the 1990's, and many firms raced to fill this void. Many premium wine houses use lower-quality varietal fruits to produce in this market. Two key players in this market are the Turning Leaf (Kendall-Jackson) and Gossamer Bay (Gallo) labels in Sonoma County. Napa County enjoys a large amount of wineries that focus completely on this market, including Sutter Home, Niebaum-Coppola, and Mondavi. These wines are more expensive than sub-premium wines, ranging between $7 and $10 per liter, but differentiate themselves more decisively by using varietal specificity as a marketing tool.
Super-Premium and Deluxe Wines: It is here that a major separation takes place in the wine market. Large firms are not as dominant in the super-premium and deluxe markets. This is due to many factors, the two largest are as follows. First, to produce higher-quality wines takes more precision, more care over the fruit source, and different production and marketing policies. It is impossible to turn thousands of tons of grapes into a super-premium wine, according to many winemakers. Second, the ability to differentiate is necessary to stay competitive in the smaller, higher-priced markets. Something lost in much of the writing on wineries is the importance of differentiation to the smaller firm's ability to compete. Certain firms have their production sold out years in advance, with no land owned by the firm. These wineries are built on marketing ideas and a commitment to concentrating on quality. This segment contains wines from large firms, but no one firm dominates the industry. It is in the super-premium and deluxe markets that the economic paradigm governing wine production shifts from market control to market competition.
The super-premium sector contains the largest amount of firms and the most variety. These wines have become the focal point of marketing campaigns seen in magazines, on televisions, billboards, and radio commercials. The separation of premium wine from super-premium wine is subtle. We claim that premium wine is always varietal-specific, and is mainly sold on the premises of the winery itself 7 . Firms compete for fruit, as the supply of high-quality fruit for certain varietals is dwindling in Napa and Sonoma County. This has an escalating effect on prices, driving a larger wedge between the premium and super-premium wine markets. Super-premium wines sell anywhere from $10.01 to $14 per liter. These wines are believed to be consumed with complementary goods and not on a regular basis.
The deluxe sector is reserved for those wines that command more than $14/liter. These wines differentiate themselves in two key ways. First, the production process mocks that of the classic French competitors, such that the product marketing reflects their attempt to seem more European. This allows higher prices, an alternative to fine European wines at home. Second, using marketing and tastings allow these firms to enter the super-premium market worldwide. We make the contention below that it would be impossible for these firms to compete against their French and Italian counterparts without international exposure. Their infiltration into fine restaurants worldwide leads to even higher pricing, making these deluxe vintages reap major rewards. Many firms exist like this in the US, and it is an extremely prohibitive market to penetrate. The market structure changes to more monopolistic as the quality and the image acts as an entry barrier. In California, each major growing area has firms in each of the segments above, where Napa and Sonoma Counties specialize in super-premium and deluxe wines. Below are the major California wine Regions and their characteristics.
7 The premises of the winery are now changing with the advent of the internet. We define the "premises" of the winery as its tasting room, website, or bought through distributors. If the majority of the wine is sold directly to retailers, it is considered economy, sub-premium, or premium wine. This is another differentiable aspect of these wines: the marketing campaign is based on the production process and location sold by building an image.
2B. California Wine Regions
Concentrating on California, we look at that state's five main Regions below. These are listed in terms of importance to the US wine market more than by perceived quality, though anyone may contend this listing is inaccurate 8 .
Napa Valley. The most famous of US wine Regions, its location not only grows great wine, but is also proximate to San Francisco, a large national and international trade and tourist center. Napa Valley is immersed in the wine industry, and very few businesses go untouched by its presence. Key varietals include cabernet sauvignon, merlot, and pinot noir. Wine prices are rapidly increasing here; however, demand conditions drive the inflation, as well as diseased rootstock producing supply contractions. Sparkling wine, from the Carneros subiii.sonoma.edu/search~S1/, is considered to be some of the world's best.
Sonoma County. Not far behind its Napa neighbor in quality and prestige is Sonoma County, specializing in zinfandel, chardonnay, pinot noir, and sauvignon blanc. Some Sonoma County subRegions boasts world-class sparkling wines, especially those proximate to the town of Sonoma itself. This iii.sonoma.edu/search~S1/ has many microclimates, allowing for a large breadth of wines produced. Russian River, Sonoma, and Dry Creek Valleys are key subRegions. One of the key characteristics of Sonoma County is that it serves as the second home of Gallo Wineries, the largest wine-producing firm in the United States. Gallo's main facility is in the Central Valley.
Central Valley. California's Central Valley is home to Gallo's main operation facilities, and also produces about 60% of California's wine supply. Most of this wine, however, fills three, four, and five-liter containers, and acts as blending material for varietal-specific wines from other Regions. Lodi, Modesto, and Madera Valleys serve as important subRegions.
Mendocino County. Deriving a great deal of its strength from its close neighbors, Mendocino County produces red and white wines similar to those in Sonoma County, and sparkling wines similar to those in Napa County. A cooler climate and diverse varietals allow this county's production to be very important. Mendocino County is home to large wineries (Fetzer, Associated Vintage Group), and acts as a good combination of the Napa and Sonoma Counties.
Monterey County. The Paso Robles iii.sonoma.edu/search~S1/ of Monterey County is home to Almaden, a large bulk-wine producer, and many chardonnays, pinot noirs, and rieslings. The climate is mild; premium wines were all but an impossibility before the 1970s. Monterey County wineries have the longest growing season of all California Regions, providing the largest risk to winery owners.
With California, the United States leads many countries in the wine market. Many characteristics of growing wine in California provide producers with competitive advantages that other countries cannot approach, even if government-subsidized. The model and hypotheses below attempt to make sense of competitive advantage theory in the US wine industry's context. It also explores the strides the Chilean wine industry has made toward penetrating our markets.
8 The perceived quality of wine is, from an economic standpoint, the market fulcrum. A wine's tasting scores in key US publications determine, in many cases, the viability of the vintage and (in extreme cases) the brand. For our purposes, the winery's marketing and public relations functions concentrate on presenting the wine in the best quality-specific light; a lack of quality is directly related to a lack of sales.
3. The Economics of Competitive Advantage
Porter's idea that a firm finds advantages in niching through many different ways allows a great deal of flexibility for managers and policy makers in budgeting, forecasting, and planning for future developments. The firm's ability to compete depends on how it can compete. A firm's prosperity is created, not inherited. In the true capitalist sense, firms must constantly seek the parts of their enterprises that function at a more efficient level than in competing firms. All firms that survive must have some attribute that leads to cost advantages. This is the basis of comparative advantage, the theory of international trade predicated on a country being the low-cost provider of a good to export the good in net. In a similar way, competitive advantage claims that firms inherently strive to focus their output using a mix of their low-cost segments such that the sum of these segments, the value chain, delivers the maximum profit possible for the firm.
The economic ideas of competitive advantage derive from industrial organization theory (IO). IO suggests that firms will act and react depending on how their competitors act and react to them. This "interdependence" is the cornerstone of IO, as its implications reach all decisions of the core business leaders in the firms and the industry. Pricing, new products, segmentation, niching all depend on how competitors react in the industry. If competitors react in such a way that buyers see a better value in the competing good, the firm loses market share. The firm gains competitive advantage through two sources. First, the firm uses overall cost leadership to obtain some basic advantages over rival firms. The second way is through differentiation. The firm uses new techniques, new products, and new ideas in an attempt to become more competitive or profitable. Let us not forget the economic foundations of this analysis. The firm, if rational, is still striving for the maximization of profit. It is my belief that the California wine industry is dominated by its drive to differentiate, and seeking low-cost alternatives is not as important. Many nations have penetrated these markets by differentiating themselves. As competition rises, each firm and country mocks each other's movement in an attempt to gain market share. This is where competitive and comparative advantage intersect. The 1997 import situation in the US is given by Figure 4 below.Figure 4:
Source: Wine Business Monthly, April 1999.
This study attempts to show that aspect of wine industries in two ways. First, by looking at the industry's firms, we see that many are mature firms, set in their individual structure due to constraints and managerial choice. More importantly, these firms are worried about trying to product differentiate, using techniques that are not cost effective but rather revenue-producing. This strategy allows a low-cost, high-quality product to infiltrate the market for Sonoma County's wine, hence the growing competitive position of Chilean wines. Differentiation, not cost control, is the focus of California wineries.
3A. Mature Industries and Supply Constraints.
The California wine industry is full of mature firms that use fixed amounts of production capital and raw material (grapes) to produce a product with perceived high quality. (McCline, et al., 1999) A small supply and high quality force managerial choice about production to be geared toward raising prices through perceived quality and not looking to take advantage of scale economies. The loss of this idea that size matters is at the heart of competitive advantage: if the firm is not looking for cost reduction, they must be differentiating to compete.
The short-run solution to this problem is to procure large plots of dairy land, rich in nitrogen, and convert them into vineyard. Of course, these purchases come with political battles over land use and increasing market power through controlling supply; as Gallo seems to be vertically integrating before our eyes in California. This is, however, consistent with competitive advantage. By purchasing more lands, and controlling the types of varietals produced in Sonoma County, Gallo takes advantage of both economies of scale and product differentiation, combating Porter's five forces well.
Porter's five forces are easily applied to this industry. The relative bargaining power of buyers is of larger interest to the firm's marketing strategies. Firms are recognizing consumer wine patterns to consume wine as a complementary good, rather than push its substitutability with other beverages and foods. Suppliers, such as Gallo and Heublein, have large relative supplier bargaining power, becoming larger through acquisition and vertical integration. There is a large threat of new entrants, especially in the pop-premium market, to all wineries in California. We concentrate on this when making our conclusions about the Chilean ability to compete. The threat of substitute products leads all firms to product differentiate, regardless of size, costs, or market share. This is the greatest challenge to this industry, and forces more decisions based upon demand conditions rather than supply. Gallo and Kendall-Jackson showed, through lawsuits over labels, that the intensity of rivalry among the current competitors is extremely high. Managerial choice is at the center of the industry trends, and today management seems to be concentrating on differentiation. How these choices take place depends on the firm's strategy; differentiation defines the ideas below.
3B. The Economics of Differentiation in the California Wine Industry
Differentiation in economics comes from an ability to change price and stay competitive. This ability becomes a strong, managerial tool if it delivers new products and constantly separates itself from close substitutes by new ideas and entrepreneurship. The ability to control price comes from a customer inability to find a close substitute. In the wine industry, non-price differentiation comes from two sources, and allows some basic price discrimination on the part of the winery.
Matching Food and Wine. Differentiating products at the firm level is making wine a more attractive complement to food. Wine is seen in Europe as a basic complement to meals, fine dining, and life. This strategy is extremely solid for long-term market share. By changing the consumer's philosophy about the good, the winery induces purchases based on the purchases of other goods. Some firms have taken this idea to different levels. Some firms match wine with everyday foods, like potatoes, hamburgers, chicken, etc. Other firms look for more specific matching, where there is a strategy behind the pairings that attempt to sell more items out of the tasting room.
Attempts to market non-wine foods in California tasting rooms center on wine and food pairing. Food and wine pairing can have many end uses. The tasting room is the differentiation process takes place. Tasting rooms serve many purposes. First, they provide the ambiance of the wine-growing area with the product. Tourists mix with local consumers for an experience of wine, location, and camaraderie among individuals with similar wine tastes. These tasting rooms also showcase the winery's product. Of Porter's five forces, matching food and wine in the tasting room comes under the threat of substitutes. If the largest threat to the winery is substitutes, these marketing facilities allow California's wineries to react quickly to competition. This ability to differentiate signifies that the market is monopolistically competitive, and not contestable 9 .
9 There has been a large literature following the contestable markets hypothesis of Baumol, 1982. The idea is that a monopolized market structure may become perfectly competitive if differentiation leads to market entry at no cost. We know that wineries can change their product from year to year, but does this change their market, or allow them free entry into another market. This question is asked in the model below.
Market Structure and Wine. Because of the number of firms in California, any claim of oligopoly is somewhat ludicrous. There certainly are market leaders, but these leaders only control price in certain market segments, namely economy and sub-premium wine. The remaining segments are extremely competitive, and have become more and more competitive every year.Figure 5:
Source: Wine Business Monthly, April, 1999.
Three key aspects of this market structure stand out for this industry. Obviously, product differentiation is a huge aspect. The firm's ability set price is also a major consideration, as it allows the use of promotions, events, and special discounts to entice demand. Finally, the nature of the competition is global, but California firms have not realized the threat of new entrants in the international arena. The Chilean industry is not the only threat felt by these firms. Australian wines have also infiltrated the sub-premium and premium markets. These markets seem to be the entry point for most new producers, and the super-premium and deluxe markets are saturated with Californian, French, and Italian wines. For the wine firm, the ability to compete is tied to recognizing threats and reacting optimally.
The Wine-Making Process and Marketing Quality. We now turn to the idea that the successful winery must try to enter new markets over time. The tasting room alone cannot be the center of the winery's marketing campaign. The ability of many wine drinkers to travel to a tasting room is limited, and is a large endeavor that includes many tasting rooms on one trip. Successful wineries and tasting rooms realize that to be a threat themselves in a global market, their marketing scheme must also be global. Many US wineries employ a Regional and national sales force, and make strategic alliances with distributors and international concerns.
3C. Comparing US and Chilean Wines: The Essence of Quality Pricing
One of the most unfortunate, and most intriguing, aspects of the US wine industry is its dependence on tasting scores for demand. Like no other industry, quality seems to drive demand. This is not to say that quality drives price, but we see below that perceived quality and price are highly correlated, and this fact is true for US and Chilean wines. The following tables present some comparisons between the two country's wines in terms of price and tasting score. These tasting scores come from the Beverage Testing Institute, USA (BTI), and are free from bias and selection problems 10 . Figure 6 shows the average tasting scores and prices from a random sample of US and Chilean wines from vintage years 1991 through 1997.Figure 6
Source: Beverage Testing Institute
By looking at certain varietals, we can see how prices and tasting scores range. Notice that price and quality seem highly correlated. In the last six years, however, the Chilean industry has made major strides to penetrating the US markets and the face the constraints of competing not only on price, but also on perception of quality. Figure 7 breaks the data above down by year.Figure 7
Source: Beverage Testing Institute
This chart is more revealing as to the yearly changes in perceived quality. Notice that in 1997, the average tasting score is virtually the same in each country 11 . Also, notice that the average price is falling over time in both countries. More competitors, and a reliance on quality to sell the product leads managers and strategy makers to formalize the aspects of their wineries that promote competitive advantage. The model below provides a framework to study wine demand and this competitive advantage.
10 Many publications and private concerns that make their living from tasting wines, rating them, and distributing these scores to the public are often biased by lack of variability in tasters, lack of scientific control over their "experiments", and by endorsements from certain wine producers. BTI claims to be free of all these scientific vices, and is the choice for that reason.
11 For 1997, the average Chilean tasting score was 82.9 while the average US score was 83.0.
3D. A Model of Competitive Advantage in the US Wine Industry
The literature on wine pricing follows two tracks. First is the "hedonic" pricing literature that exploits a more qualitative view on pricing, via quality characteristics of the product. This literature derives its strength from the works of Grichiles (1961), including Landon and Constance (1998), Combris, et al. (1997), and Buccola and VanderZanden (1997). The other camp concerns the pricing of wine in more conventional ways, taking a textbook, market approach. These studies concentrate on how firms price in a monopolistic competition framework, worrying about how product differentiation and price discrimination work themselves into the firm's price. The model below is a combination of the two, following the hedonic literature more closely than the latter.
Pricing at the Typical US winery. Pricing is a function of many characteristics of the typical US winery. We assume the winery's price (Pj) is a function of the quantity demanded for the wine (); the price of international competing wine, in particular the price of Chilean wines (Pk), and the tasting scores of both US (TSj) and competing wines (TSk). Finally, we feel it also depends on aggregate personal consumption in the US (CUS). Thus, the demand function for winery j is:
The hedonic pricing literature uses the quality measure of the tasting score as part of the demand function. First, the competitiveness of Chilean wines in the US is assessed by the cross elasticity of demand between Chilean wines and US wine demand. Second, we look at the price elasticity of US wines, and also how tasting scores affect US prices explains the hedonic aspects of wine pricing. Third, we use the tasting scores of Chilean wines to attempt an analysis of cross-hedonicity, as changes in the tasting score of Chilean wines may affect the demand for US wines. If this is true, Chilean wines may find a competitive advantage. If the cross elasticity shows that Chilean wines are true substitutes for US wines, then by the nature of their tasting scores elasticity with US wine demand, we may see some ways in which Chilean wines can infiltrate the US markets. And we may not, as the US wines may be insulated by their own price elasticities and the lack of perceived substitutability between Chilean wine products and those from the US.
The following hypotheses mathematically represent the thoughts above. Essentially, the qualitative implications above can be quantified into testable hypotheses as shown below.
Hypotheses Concerning Competitive Advantage
1. The price elasticity of demand for wine is greater than one in absolute value, implying relative substitutability in wines and producer homogenity in the eyes of the consumer.
2. The cross-elasticity of demand between Chilean wines and US wines is greater than 0, defining them as substitutable goods.
3. The tasting-score elasticity of demand is greater than zero, implying that as the tasting score of the wine increases, the demand for wine increases.
4. The foreign tasting-score elasticity of demand is less than zero, implying that as the tasting score of the Chilean wine increases, the demand for the wine increases.
5. The consumption elasticity of demand is greater than zero, implying that as consumption increases, the demand for wine increases. This further implies that as income increases, wine consumption increases.
These elasticities are easily estimated through an econometric model, a linear regression where the US demand for wine is based on the inverse demand function above.
In a forthcoming study, historical data will be used to test these hypotheses. Tasting scores are difficult to find for older vintages, but a cross-section analysis somewhat defeats these problems. More research in this area is needed.
4. The Basics of Sonoma County's Value Chain
The methods to look at industries via a value-chain use the basic devices of microeconomics to analyze the firm. Firms are rated in terms of their advantages, as weighted in many different categories. The weightings take place through separating firms into Strategic Business Units (SBUs) such that all the firm's activities are assigned a category and specific function. Competitive advantage takes place when a firm has differentiation in activities such that they do that activity better than any other competing firm. This leads to cost advantages, and overall better competitiveness, much like comparative advantage in international trade.
Competitive advantage promises profits if the firm differentiates itself adequately. Through competitive advantage, a firm finds ways to compete through niching in activities rather than final products. Standard microeconomic theory places product differentiation at the core of how firms differ themselves from very close substitute goods and firms. Porter (1985) implies that through profitable activities, comparative advantage in the industry (competitive advantage) can be struck and held. Porter also defines these categories as shown below.
Primary Activities. In the examination of competitive advantage, we focus on primary activities. These activities are the cornerstone of the production and distribution processes in the firm. In the context of a US winery, these activities are centered on the acquisition of the fruit and the fruit's use in the winemaking process. The tasting room is the central way in which the production and distribution of the wine is connected. A connection to the quantitative analysis brings the tasting room to the foreground of our analysis. We now explain each of these subactivities specifically for Californian wineries.
1. Inbound Logistics. These activities begin with the fruit itself. The importance of receiving the fruit as a function of a winery depends on being an estate winery (a winery that produces some wine from fruit that are grown on the premises) or a winery that must procure all its fruit from outside sources. If the latter, the fruit must be delivered to the production facility, if that facility is on the grounds where the bottling and storage takes place, and must be immediately prepared for the wine-making process. If the fruit comes to the winery, and no estate fruit is used or available, then the labor and vineyard management positions are not part of the winery's primary activities. We claim below that those wineries that produce no indigenous fruit and wine use these activities as support activities rather than primary endeavors.
2. Operations. Once wine has arrived at the production facility, the operations end of wine begins. In most US wineries, a cellar crew, an enologist, ancillary laborers, an assistant winemaker, and the chief winemaker perform the wine-making process. The California winemaker is part labor and part winery administration. Because of the importance of tasting scores to the marketing and public relations activities, the winemaker's role is very dynamic in the United States. The process by which the winemaker forms the final product becomes part of the marketing campaign and image of the winery. These campaigns are the basis of the tasting room and the conduit to expanding the brand and selling the products.
3. Outbound logistics. The size of the winery dictates the sales force breadth of the firm. Larger wineries, such as Kendall-Jackson, have multi-level sales forces, with certain sales representatives specializing on certain customers: restaurants, grocery stores, wine shops, exports, etc. These personnel and duties may also be broken down by Regional, national, and international sales. Smaller wineries may consolidate these functions to cut down on costs, using only location-specific personnel rather than function-specific underneath a Regional coordinator. Other, small wineries have no sales force or a limited budget and rely completely or partially on a distribution company to act as a middleman for transactions. Two important aspects of the winery's distribution choices include choice of markets and lot size. Regardless of the number of cases produced by the winery, the wine's distribution is a major part of the firm's overall image. If the winery's market is high-end dining establishments, and not grocery stores, the wine competes with different wines, foods, and beverages. In this sense, if the tasting scores and marketing are important to the firm, the segment choice and the amount to be sold per customer in that market may have an influence on the firm's overall image. This image is the key to the marketing scheme of the firm.
4. Marketing and Sales: The most significant change in the wine industry concerning marketing is the new focus on the complimentarity between food and wine. Tasting rooms symbolize the push toward making wine an everyday product of homes in the US. Thus, many wineries employ both a marketing and public relations team, where one side (marketing) tries to find ways to reach more and more customers, while keeping their steady customer base involved with wine clubs, special events, and lifestyle complements in advertising. The other side (public relations) is concerned with the image of the winery, involvement in local organizations, and connects with marketing in the tasting room. The tasting room becomes the source of the winery's image, and the place where people gather most likely for the sole purpose of drinking the winery's product.
The latest challenge to the marketing of US wine is the changing demographics of wine drinkers. Many producers, marketers, retailers, and others worry about the changing demand conditions for wine. First, many industry experts feel that customers perceive wine as a luxury item, only to be consumed with restaurant experiences. In fact, wineries have brought this problem upon themselves somewhat, as the price of wine has escalated over time. However, more and more wineries are delivering alternative, popular-premium wines that are moderately-priced and varietal specific. This is where Chilean and Australian wines have influenced pricing and marketing campaigns. Second, many wineries and wine organizations were attracted to the high prices and the upper-class clientele that came with it. This left many soon-to-be wine drinkers associating wine with their parents, the upper-class, and not with a good time. Beer has dominated the younger drinkers' consumption habits. Certain US consumer groups (Wine-X, Wine Brats, etc.) formed specifically to help the wine industry make this transition in marketing campaigns to focus on those under 30 years of age. How the wineries attack this problem in the future remains to be seen, but its presence has forced every winery, regardless of size to be cognizant of how certain competitors may try and differentiate such that the younger market is established. It is to be a great challenge.
5. Service. Few wineries engage in long-term, service relationships with their customers. In many cases, the wineries establish strategic alliance with certain restaurants and distributors such that post-sale services are part of the transaction. Because of the perishability of wine, and the fact that the storage of wine is very important to its quality, certain wineries set up delivery, storage, and spoilage instructions and warranties.
Support Activities. Any activities called support act as a complement to the primary activities above. While the image of the winery is built and maintained above, the support activities help the winery guide day-to-day functions as a firm, and encompass many of the roles that are not wine-specific. In many cases, California's firms combine support and primary functions. These are not the main ways the firm differentiates its product, nor gains access to comparative advantage. These are, however, the activities that protect the firm from losing its comparative advantage once established.
1. Procurement. For most California wineries, the procurement processes are divided into three distinct groups. For buying the grapes, barrels, labor, and direct production inputs (labor, land, capital, entrepreneurs), the owner and CEO play a direct role. The winemaker also participates in fruit procurement, as it is the key input for the winemaking process. In certain wineries, the winemaker and the vineyard manager control the purchasing of the grapes, labor, and storage units. The second group deals with the office supplies and the basic technology for running the winery as a firm. This includes goods such as paper, copiers, computers, pencils, telephones, utility services, etc. In the average winery, the office manager, or the person who runs the business functions of the winery purchases these goods. The third group includes the tasting room, if one exists. If a tasting room is in place, then a tasting room manager is normally employed by the winery to not only procure the non-wine goods sold in the tasting room, but also the labor used for tasting room purposes and special events. In some cases, the public relations director or the marketing manager serves both functions.
2. Technology Development. Technology enters the winery in two key ways. First, the winemaking process may become more mechanized, involving the winemaker in new capital and new techniques. In other cases, the changes in technology do not affect the winemaking process at all; if the winemaking takes place in a archaic fashion, technological changes do not affect the firm. In some cases, the winemaking style, especially if it is a labor-intensive, hands-on process, may become part of the winery's marketing scheme.
The other key area for technology at wineries is in microcomputing. The accounting, inventory, and marketing functions are now computerized at most California wineries. Productivity in these positions: office workers, bookkeepers, etc., should be augmented the faster and more proficient the computer software. With the increase in the use of the internet, many wineries have websites, links, and internet sales. If the winery has technology support, it normally is a consulting position. In certain cases, California wineries employ an individual that has computer skills.
3. Human Resource Management. The tasting room manager normally oversees all hires inside the tasting room. The president/CEO oversees other administrative hires. All field hires, if an estate vineyard is owned, are through the vineyard manager, while all cellar hires are made by the winemaker. Thus the chain of command at a winery can be somewhat disaggregated. If their is a sole owner, the owner may want input on administrative hiring, but certainly allows the field and cellar labor to be hired ultimately by those not directly involved in that position.
4. Firm Infrastructure. The firm infrastructure ranges from incredibly nuclear to peripheral. In some cases, especially larger wineries, the accounting, legal, public relations function may take place internally. In smaller wineries, they may choose to subcontract this labor out, allowing for some administrative cost increases, but not provide the on-site infrastructure of more office space. Many firms fulfill these needs for smaller wineries, specializing in wine accounting, legal matters for wineries, and public relations. The type of infrastructure is normally a function of size, as larger wineries can absorb more fixed costs to keep a lawyer and accountant; however, regardless of size, most wineries have at least a public relations director, any may use some outside help for larger jobs.
The California wine industry mixes the best and worst characteristics of the US wine industry. There are spectacular producers, winning global accolades for their wine, and selling their entire production years in advance. There are other producers that are in the industry for bulk purposes, and provide large volumes of lower-quality wine. We saw above that Chile is a possible competitor for these firms, especially in the way they are niching in the pop-premium and premium wine segments. California's firms must recognize the threat, and adjust their marketing, public relations, pricing, and varietal choices as to protect their competitive advantage. The key, according to Michael Porter's writings, to controlling one's market share is through competitive advantage. Product differentiation and maintaining low costs lead to this advantage. With changing consumer demographics and international competition, California's wineries are great examples of dynamic firms in a dynamic market searching for a strategic plan.
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Copyright (c) 1999 Robert C. Eyler. All rights reserved.