When prohibition ended in 1933, laws were passed that regulated the sale of alcoholic beverages, ostensibly to protect wholesalers from the depredations of suppliers and the public from the ill effects of alcohol. This book examines the monopoly protection laws, also known as franchise termination laws, and how they lock suppliers into government-mandated contracts with alcohol wholesalers that affect consumers by raising prices and reducing the quality of alcoholic products and services. This study also investigates the notion that alcohol consumption is a sin and how legal restrictions have substituted the moral judgment of legislators for that of the consumer. Strange Brew demonstrates that the monopoly protection laws reflect powerful special interests in the political process who use such measures to control markets, shield themselves from competition and consumer preferences, and set prices with relative impunity. This book will be of great value to those in the alcoholic beverage industry as well as to students of economics, regulation, and public policy.
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About the Author
Douglas Glen Whitman is research fellow at The Independent Institute and assistant professor of economics at California State University at Northridge. He received his PhD in economics from New York University and has taught at the John Jay College of Criminal Justice and the Institute for Humane Studies at George Mason University. His articles have appeared in such scholarly journals as Journal of Legal Studies, Critical Review, and Constitutional Political Economy.
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Alcohol and Government Monopoly
By Douglas Glen Whitman
The Independent InstituteCopyright © 2003 The Independent Institute
All rights reserved.
Although the Prohibition era ended almost seventy years ago, the alcoholic beverage industry remains one of the most regulated businesses in the United States. The Twenty-first Amendment to the Constitution, which repealed Prohibition, simultaneously set the stage for extensive state intervention in the production and distribution of alcohol: "The transportation or importation into any state, territory, or possession of the United States for delivery or use therein of intoxicating liquors, in violation of the laws thereof, is hereby prohibited" (Section 2). The inclusion of this section gave (or is often interpreted to have given) the states permission to continue restricting, in principle even prohibiting, the marketing of alcoholic beverages. In the years that followed passage of the amendment' in 1934, the fifty states have implemented a menagerie of alcohol regulatory regimes.
Almost every state took steps to entrench a three-tier distribution system consisting of suppliers (brewers, vintners, and importers), wholesalers (also known as distributors), and retailers (liquor stores, restaurants, and so on). The alleged, and possibly original, intent of the system was to prevent vertical integration in the industry, which some commentators blamed for abuses in the pre-Prohibition era. The practical effect, however, was to inflate the market for alcohol wholesalers: the middlemen who stand between suppliers and retailers now claim a substantial share of the profits and raise prices to consumers in the process.
The interest of wholesalers in maintaining the three-tier system is apparent even to the idle observer. Although it is unlikely that a repeal of laws supporting that system would result in the disappearance of wholesalers, it would surely cut deeply into their profits, especially now that the Internet has substantially lowered the cost of direct contact between suppliers and their customers. It comes as no surprise that wholesalers' associations regularly lobby federal and state legislatures for statutes that will enhance their economic well-being. Foremost among the laws favored by the wholesaler sector are the monopoly protection laws, also known as franchise termination laws. These laws, implemented in almost every state for beer and in twenty states for wine and distilled spirits, shield wholesalers from competition by raising barriers to the termination of their contracts by suppliers.
In most cases, the monopoly protection laws require suppliers to show "good cause" for termination or nonrenewal of a contract even when the contracts in question specifically provide otherwise. What qualifies as good cause differs from state to state, but often the term is taken to rule out economic considerations such as failure to meet contractual sales quotas. The laws also typically require advance notice of termination, give wholesalers a month or more to cure any supposed problems, and prevent any contractual waiver of the law's mandates. In addition, they often provide for exclusive wholesaler territories. Among their overall effects, these monopoly franchise laws inhibit competition among wholesalers, raise prices, and (with the possible exception of exclusive territories, as explained later) reduce consumer welfare.CHAPTER 2
The Three-Tier Structure of the Alcohol Industry
Following the repeal of Prohibition, responsibility for regulating the alcoholic beverage industry fell to the states, which adopted a variety of different approaches to the issue. Whereas the eighteen "control" states chose to monopolize the distribution and (sometimes) the sale of wine and spirits in the hands of the state government, most states — known as "license" states — chose instead to regulate the behavior of private wholesalers and retailers. In all states, the sale of beer was left entirely in the regulated private sector.
The most significant post-Prohibition regulations aimed to prevent direct interaction between the suppliers and retailers of alcohol. Many of the alleged evils of the pre-Prohibition era involved excessive promotion of alcoholic indulgence by the suppliers and retailers of alcohol, who were often one and the same. Suppliers sometimes owned retail establishments directly; other times they used inducements such as free equipment and interest-free loans to induce retailers to sell the suppliers' brands exclusively (WSWA 1999). The perception was that such "tied house" arrangements encouraged the promotion of alcohol consumption beyond acceptable limits: "Besides pressuring retailers to handle only their own brands, suppliers pushed retailers to increase sales whatever the social costs" (WSWA 1999).
Although the term social cost requires qualification, the perceived connection between tied houses and greater promotional effort is a plausible one. As the discussion here makes clear later, a vertically integrated firm can more easily encourage brand-building efforts such as advertising and provision of additional services. These activities are not necessarily undesirable, but undoubtedly some segments of the public historically perceived them as such, and that perception influenced the regulatory choices of federal and state legislatures after Prohibition. The Federal Alcohol Administration (FAA) Act was designed specifically to prevent the kind of marketing practices used by the tied houses:
The FAA Act tied-house provisions prohibited many commercial practices that were (and are) not only widely accepted but taken for granted with other consumer products. They proscribed all practice[s] that would give the appearance of inducing retailers to carry one supplier's brands in lieu of those of other suppliers. Expressly prohibited were gifts to retailers having meaningful value ($150 for many years, and now rising in tandem with the Consumers Price Index to $238 in early 1993) and the providing of bar equipment to bars and taverns. The FAA Act also prohibits suppliers from having ownership interest in retailers, although it does permit them to own retailers outright. (WSWA 1999)
The states often went further in their efforts to prevent contact between the supplier sector and the retail sector. Twenty-three states, not including the control states, "required suppliers to sell only to locally licensed wholesalers and prohibited them from having any interest in a wholesale establishment as well as prohibiting them from having any interest in a retail establishment" (Metz 1996). The overall effect of the federal and state mandates was to create a three-tier system of alcohol distribution in the United States (see figure 1). Almost all alcoholic beverages must pass through the hands of wholesalers because suppliers typically cannot deal with retailers directly.
In effect, the regulations passed since the end of Prohibition deliberately impede vertical integration in the alcohol industry. They simultaneously inflate the profits of the wholesaler sector, whose market position depends in large part on state protection. In this environment, the lobbying efforts of wholesalers aim to entrench the three-tier system — and to shield the wholesalers from market competition.
The economic advantages of franchised distribution are substantial; moreover, they are not dependent on government intervention. Given these benefits and the substantial growth of franchised distribution in other industries, it stands to reason that an unregulated alcohol industry would still have developed, at least to some extent, something like the current three-tier system. Nonetheless, the advantages of having an incompletely integrated structure depend crucially on the state of technology and other economic factors. As the cost of direct contact between manufacturers and retailers or consumers falls, the wholesaler sector should be expected to shrink. In recent years, small wineries wishing to ship their products directly to out-of-state consumers — who may have discovered the winery over the Internet or during a vacation — have challenged legal restrictions that require them to deal with wholesaler intermediaries (Lynch 2000; Martin 2000). Were it not for such laws, small wineries could employ the efficient distribution network of large-scale shipping companies while avoiding the price markup of the wholesalers. Not surprisingly, wholesaler associations oppose lifting these laws — although they couch their argument in terms of protecting the public, especially children who could allegedly order alcohol through the mail (Metz 1996). Fortunately for consumers and vintners, the legal challenges have met with initial success: in November 2002, a U.S. district judge declared New York's law against direct shipment of wine unconstitutional (McCullagh 2002).CHAPTER 3
Franchise Termination Laws and Their Effects
The issue of Internet and direct-mail sales of alcohol, though likely to become increasingly important in the years to come, is only a microcosmic example of the more pervasive tension between suppliers and wholesalers. The nonintegrated character of the alcohol industry, whether a result of economic advantage, legislative mandate, or (as seems most likely) both, leads naturally and predictably to incentive problems common to industries with franchise distribution systems. These problems typically manifest themselves as conflicts, in both litigation and legislation, over the ease with which suppliers should be able to terminate contracts or deny renewal of contracts with their wholesalers.
Alcohol wholesalers have regularly sought legislative protection to limit the power of suppliers to terminate their contracts. They are not alone in seeking such statutory privileges, of course: franchisees in numerous industries have lobbied for legislation that alters or restricts the terms of franchise contracts. Beginning in the 1970s, twenty-one states began to pass laws intended to protect the interests of franchisees against the market power of franchisors. These laws typically created nonwaivable requirements of "good faith" for termination of franchise contracts by franchisors. Because it was not always clear whether these laws applied to the alcohol industry (as the term franchise has both broad and specific meanings), and also because alcohol wholesalers pressed for additional protection, alcohol-specific franchise termination laws were passed in many states as well. In addition, such laws typically require advance notice of termination, give wholesalers a month or more to cure any supposed problems in the fulfillment of their duties, and prevent any contractual waiver of the law's mandates. Table 1 summarizes the franchise regulations of the fifty states and the District of Columbia.
The Double Markup
The principal effect of franchise termination laws is to exacerbate what is known as the double markup problem, a phenomenon that occurs in industries that are not completely integrated. When a supplier and a wholesaler make separate pricing decisions in a situation of imperfect competition, both firms have the opportunity to mark up the product price above its marginal cost of production. Not surprisingly, consumers are worse off because they pay more for the product and buy less.
A more surprising consequence is that total profit over the two firms is also lower than it would otherwise be. In other words, the price ends up higher (and quantity lower) than it would be if there were a single, integrated, profit-maximizing firm because when one firm raises its price, the gain from the increment in price is accrued entirely by the firm that raised it, but the loss from fewer consumers buying the product is distributed over both firms. The final price ends up higher than if a lone firm had been exposed to all gains and losses.
It is clearly in the suppliers' interest to prevent this problem from occurring, because the wholesalers' markups reduce the demand for the suppliers' products. Any individual supplier that fails to find an effective means of dealing with this problem may find itself losing in the interbrand market (i.e., the market where it competes with other brands) because its wholesalers are pricing the product too high relative to competing brands. The usual solution is to impose contractual obligations on wholesalers. For example, the contract may specify or allow the supplier to determine maximum resale prices on the products in question. Unable to raise prices above the contractual level, wholesalers are unable to increase revenues except by expanding quantity. Equivalently, the contract may specify a minimum sales quota. In order to meet the quota, the wholesaler must either price the product sufficiently low or, possibly, increase demand by advertising or expanding its network of retailers.
Franchise termination laws unfortunately short-circuit the contractual solution. In order to enforce provisions designed to control excessive markups, suppliers must be able to terminate their relationships with wholesalers who fail to meet their contractual obligations. The predictable result of impeding such terminations is inflated markups by wholesalers. Alcohol wholesalers' markups routinely account for 18 to 25 percent of the price of wine to retailers and for 15 to 25 percent of the price of liquor (Freedman and Emshwiller 1999, A1), percentages that exceed the typical markup in other industries (ATR 2001).
Opportunism and Shirking
The proponents of franchise termination laws argue that they are necessary to restrain opportunistic behavior on the part of suppliers — an argument that is not without some merit. To build their businesses, wholesalers have to make up-front and ongoing investments. For example, they must spend time and effort approaching new retailers and persuading them to purchase alcohol brands they carry. Over time, a wholesaler develops a relationship with a network of retailers, and this network constitutes a large part of the value of the enterprise. Premature or unjustified termination of a contract by a major supplier can thus severely damage the value of the wholesaler's business because his built-up personal capital is reduced when he cannot deliver the brands he has advertised to his network of retailers. Worse yet, to the extent that a wholesaler's investments are brand specific, a supplier may be able to appropriate their value by terminating the wholesaler's contract.
Suppose, for instance, that a wholesaler makes large investments of time in creating a network of retailers who want to buy a particular brand of beer. This network has continuing value to the manufacturer of that brand, but it has value to the wholesaler only as long as he carries that brand. After the wholesaler has made the investment, the manufacturer could terminate the contract and then appropriate the value of the network by handing it over to another wholesaler willing to accept less-desirable terms in his contract (such as paying a larger initial fee or a higher price per case of beer). Or, more likely, the supplier could use the threat of finding a new wholesaler to strong-arm price concessions from the current wholesaler.
Although opportunism is a real issue in the alcohol industry, the threat is not as great as it might seem. In other franchised industries, in particular business-concept franchises, opportunism can be a serious problem because the franchisee deals with only one franchisor. A McDonald's franchisee deals with the McDonald's corporation and no one else. A large portion of the franchisee's investment goes toward satisfying the particular requirements of running a McDonald's restaurant. Even so, Beales and Muris did not find any strong evidence of opportunism in their study of thirteen franchised industries. They surmise that "the need to recruit additional franchisees is a significant constraint on franchisor opportunism" (1995, 178) because a franchisor with a reputation for appropriating the investments of its franchisees would find it difficult to attract willing business partners.
A typical alcohol wholesaler, in contrast to franchisees in most of the industries considered by Beales and Muris, deals with numerous suppliers (Barsby 1999), which changes the complexion of things substantially. Each supplier's brand constitutes only a fraction of the wholesaler's products, thereby limiting the wholesaler's exposure to opportunistic behavior by a single supplier. This does not mean opportunism is not a problem in the alcohol industry, but its seriousness is dampened.
Though wholesalers are right to be concerned about opportunism, legislating the content of private contracts creates at least as many problems as it solves. Closing the door on opportunism by suppliers opens the door for shirking by wholesalers. A major difficulty confronting suppliers is finding a means of motivating wholesalers to maintain product quality and to provide adequate services to customers maintain product quality and to provide adequate services to customers and retailers. Franchise termination laws weaken the contractual provisions designed to assure good quality and service provision.
Excerpted from Strange Brew by Douglas Glen Whitman. Copyright © 2003 The Independent Institute. Excerpted by permission of The Independent Institute.
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Table of Contents
ContentsChapter 1 Introduction,
Chapter 2 The Three-Tier Structure of the Alcohol Industry,
Chapter 3 Franchise Termination Laws and Their Effects,
Chapter 4 Exclusive Territories,
Chapter 5 Paternalistic Justifications for Franchise Termination Laws,
Chapter 6 Conclusion,
About the Author,