Monday, May 31, 2010

Napa Wine Pricing: Up Escalator Only?

In a February 18th Freakonomics blog post, Robin Goldstein described two wine pricing models.  The supply-side model uses the cost of production, other ancillary costs, a modest profit, and distribution costs to arrive at the price of the wine to the consumer.  The demand-side model says that the wine should be priced at whatever level the market is willing to bear.  In the halcyon days of yesteryear, makers of premium Napa wines embraced the latter model wholeheartedly and consistently priced their products to market.  As prices continued to rise, new players entered the market in order to get a piece of the pie.  They saw the model as simple: buy a piece of land in Napa (never mind the price); contract with a "name" winemaker to put your juice "through its paces"; get a 95-point score from Parker; and you are off to the races.

But, things did not quite work out like that.  According to Nobel-Prize-winning economist Paul Krugman, the US lost 8 million jobs in the last recession and recent job gains have only put 500,000 people back to work.  Wine consumers and prospects are either unemployed or, if still working, have cut back drastically on things that are not perceived as core to existence in today's straitened environment.  The wine industry, as a result, has suffered significant sales declines (the $15 and under market increased it sales by 15% in the last year) and some of the players face uncertain futures.  The April 30 issue of The Wine Spectator, in an article on Napa wines, notes that "the distribution chain is clogged up with unsold wines."

If you subscribe to the demand-side model, and demand evaporates, you should be reducing your price to spur demand or to bring it into equilibrium with the existing demand levels (Of course you could also dump product to reduce glut levels and, in that fashion, bring supply and demand into equilibrium.  I do not see that happening in Napa.).  Instead, the winemakers are utilizing strategies such as giving price breaks to restaurants (hoping that they keep the increased margins for themselves rather than passing it through to the customer) or pushing "premium" juice into lesser-pereceived-value brands.  There have been a few cases of high-profile wineries (Joseph Phelps Insignia, Caymus Special Select) lowering their prices but that is more the exception than the rule.  While prices ramped up rapidly in the face of perceived high wine demand, they are very "sticky" on the down side of demand.

The industry definitely has a short-term problem to solve but, if Mr. Krugman is right, they may also have a longer-term problem.  According to Mr. Krugman, "We may be heading for a Japan-style lost decade trapped in a prolonged period of high unemployment and slow growth."  If that is the case, then winery strategies of waiting this out may not be the best way forward.  If demand does not rebound, the industry will have to cope with an excess-capacity problem.

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