228 PART FOU R Production, Co st s , and Supply
A P P L I C A T I O N 6.4
Returns to Scale in Beer and Wine
Returns to scale have played an important role in the evolu-
tion of the beer and wine industries in the United States and
elsewhere. In principle, both of these industries exhibit
increasing returns to scale as a result of the geometry of
their production methods. Because both beverages are pro-
duced by volume but the capital involved in production
(brewing kettles, aging casks, and so forth) has costs that
are proportional to surface area, larger-scale producers are
able to achieve significant cost savings. Of course, there are
differences between beer and wine in the nature of the raw
material used (wine grapes are much more variable in quality
than are the ingredients of beer) and in the nature of demand.
These have produced rather significant differences in the
evolution of each industry.
Increasing Concentration in Beer Production
Prior to World War II, beer tended to be produced on a local
level because of high transportation costs. Most large cities
had three or more local breweries. Improvements in shipping
beer together with national marketing of major brands on
television caused a sharp decline in the number of breweries
after the war. Between 1945 and the mid-1980s, the number
of U.S. brewing firms fell by more than 90 percent—from 450
to 44. Major brewers such as Anheuser-Busch, Miller, and
Coors took advantage of scale economies by building very
large breweries (producing over 4 million barrels of beer per
year each) in multiple locations throughout the country. Bud-
weiser became the largest-selling beer in the world, account-
ing for more than one-third of industry output.
Product Differentiation and Microbreweries
Expansion of the major brewing companies left one signifi-
cant hole in their market penetration—premium brands.
Beginning in the 1980s, firms such as Anchor (San Francisco),
Redhook (Seattle), and Sam Adams (Boston) began produ-
cing significant amounts of niche beers. These firms found
that some beer consumers were willing to pay much higher
prices for such products, thereby mitigating the higher costs
associated with relatively small-scale production. The 1990s
saw a virtual explosion of even smaller-scale operators. Soon
even small towns had their own breweries. A similar course
of events unfolded in the United Kingdom with the ‘‘real ale’’
movement. Still, national brewers continued to hold their
own in terms of their total shares of the market, mainly
because of their low costs.
Wine: Product Differentiation to the Extreme
Although wine production might have followed beer pro-
duction and taken advantage of economies of scale and
national marketing to become increasingly concentrated,
that did not happen. In part, this can be explained by pro-
duction technology. Maintaining quality for high volumes of
production has been a recurring problem for winemakers,
even though there are cost advantages. Most production
problems arise because wine grapes can have widely differ-
ent characteristics depending on precisely when they are
harvested, how much rainfall they have had, and the nature
of the soil in which they are grown. Blending grapes from
many areas together can be technically difficult and will
often result in a wine that represents a ‘‘lowest common
denominator.’’
The impact of these difficulties in large-scale wine
production are exacerbated by the nature of the demand
for wine. Because wine has a relatively high income elasti-
city of demand, most wine is bought by people with above
average incomes. These consumers seem to place a high
value on variety in their choices of wine and are willing to
pay quite a bit for a high-quality product. Demand for a
low-quality, mass-produced wine is much less significant.
These observations then reinforce Adam Smith’s conclu-
sion in The Wealth of Nations that the ‘‘division of labor
[that is, economies of scale] is limited by the extent of the
market.’’1
TO THINK ABOUT
1. How do transportation costs affect attaining economies
of scale in brewing? How might a large beer producer
decide on the optimal number of breweries to operate?
2. Laws that limit interstate sale of wine over the Internet
were relaxed significantly as a result of a Supreme Court
decision in 2005. How would you expect this to affect the
scale of production in the wine industry?
1
For more on the technology of beer and wine production (together
with information on other alcoholic beverages), see Y. Xia and
S. Buccola, ‘‘Factor Use and Productivity Change in the Alcoholic
Beverage Industries,’’ Southern Economic Journal (July 2003): 93–109.