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Wednesday, October 22, 2008

Not for the Layman

This here is a beer blog, see, and we don't like no fancy talk from the ivory tower. Well, we do, but in our befuddled state, we must confess that it goes over our head. Thus the beerconomist's formula looks more complex than a double-decoction mash:
In this picture the demand curve for the downstream firm, or distributor, (denoted d) is given in blue. [In this case we make the simplifying assumption that both firms are simple monopolists - but any market power is enough for the analysis to follow] This is the demand for beer from retail establishments which (since they are highly competitive) closely resembles the demand for beer in the market. Since the distributor is a monopolist they make their price and quantity decision where their marginal revenue (denoted MRd) equals their marginal cost (denoted MCd). Their marginal cost is the price they have to pay the brewer. From this quantity (qu = qd ) they would charge their margin which is the difference between MCd and Pd. Thus the distributor gets a profit equal to the dark red shaded area.

So where does MCd come from? Well, note that depending on what the brewer (the upstream firm = u) charges, the quantity demanded will be read off of the downstream firm's MR curve. Thus the downstream firm's MR curve is the same as the upstream firm's demand curve, creating an upstream firm MR curve. The brewer's MC curve comes from the cost of making the beer and so they set MRu=MCu and lo and behold, the quantity demanded from the brewer is the same as a the quantity sold by the distributor, qu = qd. The brewer's profits are given by the light red shaded area. So consumers would pay pd (assuming competitive retailers) and consume qu = qd beer.
Err, right. Did I mention that this here is a beer blog? Good lord. I believe this is a subtle analysis of the relationships in a three-tiered system of brewing/distributing/retailing, but it might also be a description of stem cell research. I believe the man who named econ the "dismal science" must have understood it about as well as I.

Whew, time for a nice porter.

9 comments:

DA Beers said...

this might be the first time i've ever seen a graph in a beer blog, math and beer should only interact when trying to figure out a tip, hehe.

Joe said...

ummm, this is unnecessarily complicated. It is true that production will occur only if marginal revenue equals marginal cost. The only entity that matters for is the brewer and that is at Qu. It only matters for the brewer because they are the only one creating a product. So the only lines that matter are the demand curve, the marginal revenue and cost curves of the brewer and a vertical line through Qu that represents the supply of beer. Based on the demand curve the market clearing price for that quantity is Pd (where Qu cross D). If there were no distributor the revenue to the brewer (not profit) would equal P*Q. Because of our current laws with distributors the price the brewer gets is something less than the market clearing price. The distributor then marks the price to something less than the market clearing price (but higher than the price paid to the brewer) to the end retailer who then marks up to the market clearing price. The consumer doesn't get hosed in any of this because a profit maximizing entity will charge the market clearing price. The entity that gets hosed in this is the brewer. This is because they have to pay 2 people to do the job of one or possibly none. It is also impossible to figure out the profit of any participant based on the information provided, only revenue. Profit is revenue minus cost. We only have marginal cost, the cost of the last unit produced which gives no insight into the overall cost of the operation. Basically what is ridiculous about this set up is that it allows the government to levy a tax on 3 occasions instead of one; from brewer to distributor, from distributor to retailer, and finally from retailer to end consumer. The tax is an extra cost that gets passed along to consumer.

Joe said...

ummm, what I just wrote was also unnecessarily complicated...

Beer Aficionado said...
This comment has been removed by the author.
Beer Aficionado said...

I just heard the spot on NPR's "All Things Considered" about the Honest Pint Project. It was good stuff. I'm honestly surprised more people don't already know not all "pint" glasses are a full 16 ounces.

The glasses I have in my house are only 14 ounces, but that works for me because I mostly pour 12 ounce bottles for myself and rarely something larger.

Beer Aficionado said...

Also, understanding the microeconomics of one's industry is essential to understanding how much one should charge for one's product.

There are different price optimization models a brewer (or any entity which sells a product either directly or indirectly) can use to maximize profits and growth. Randomly picking a price for a product is not in the best interest of a business. The concepts are really not nearly as confusing as they seem.

Colby said...

don't like hosing folks?...buy the beer from the brewery...that's what I do...doesn't work for liquor though...distilleries here in oregon have to send everything to the OLCC and buy it back from them (for an OLCC profit) even if they wish to sell a bottle from their tasting room

Patrick Emerson said...

Ummm...OK...so perhaps this wasn't as clear as I had hoped. But give me a break, without impenetrable terms and graphs people would figure out that this is just the simple logic of the middleman - everyone takes their cut – and I would be out of a job! What is useful about doing it carefully with graphs is that we understand less intuitive things like the fact that brewery profits are actually hurt by this. Anyway, the post was for undergrad econ students who for four years are forced to digest this stuff before they can forget it all. The lesson is simple: middlemen cause higher prices for the consumer and lower profits for breweries.

Joe said...

Patrick, thanks for the post, you're obviously smarter than I am at this but one question:

How does the consumer end up paying higher prices? For instance, a pint at the brewery costs the same as a pint at the bar. Both are charging the market clearing price.

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