Thursday, October 1, 2009

Australian Wine and the French Economist

Why are Australian wine makers at the mercy of a French economist?

The New York Times has an interesting article on the Australian wine industry. From 1999 to 2007 Australia exported greater amounts of wine, making it the fourth largest wine producer. As its output increased, wine prices fell - consistent with the law of demand. Yet with all this increase in world market share, Australian wine makers are having difficulty making a profit. From the article, let's see what economic forces have impacted the Australian wine market.

The first revolves around production and transportation costs. Australian wine producers have been facing higher production costs due to increased irrigation costs. Australia has been in a sever drought for nearly a decade, and the cost of irrigating grapes has risen. Couple this with increasing labor costs and higher transportation costs than other countries, has increased overall costs compared to American or other European wine producers.

Coupled with the decrease in the value of the US dollar, or the increase in the value of the Australian dollar, Australian wines are now relatively more expensive in the US than in the past few years.

Another is product differentiation. Many feel that Australian wines are mostly known on the low end of the market - lower portion of the demand curve, where prices are lower, and are having a difficult time convincing wine consumers to purchase better quality wines.

Another is vertical integration. Australian wines (sold in Britain) are sold primarily by a few (i.e. oligopoly) supermarkets. When an upstream firm (Australian wine bottlers) sell to a downstream firm (supermarket) and the downstream firm has greater market power (i.e. fewer firms) then the British supermarkets are able to get greater price concessions from the Australian wine sellers.

A final reason is the behavior of Australian wine producers that seems consistent with the cornerstone of industrial organization - the Cournot oligopoly proposed by a French economist. For purposes of this write-up, I will focus on the homogeneous Cournot oligopoly model, but we can come back to this idea and in class - we will look at the heterogeneous (product differentiated) Cournot oligopoly model, which is more general than the homogeneous model. Let me talk a little about the idea of the Cournot model using the most straight forward case - two firms, creatively named firm 1 and firm 2.

Cournot correctly reasoned that if firm 1 chooses its profit maximizing amount of output, then firm 1 would do so taking into account of firm 1’s demand and costs and the amount of output sold by firm 2. Likewise firm 2 in making its profit maximizing decision will take into account market conditions (demand and cost) and the amount of output produced by firm 1. The insights of Cournot are that the profit maximizing choice for each firm depends on the profit maximizing response by the other firm. Otherwise, at least one firm would want to pick another (different) amount of output to produce.

If each firm makes their output decision absent of their rivals decision how would they do so? Well from firm 1's perspective, if firm 2 produced X amount of output, how much money would firm 1 make if they produced Y amount of output? What about (Y + 1) units of output? (Y + 2), etc. Notice that in this type of decision scenario, firm 1 is assuming that firm 2 is keeping its output level at the same level (i.e. X). It is this type of management decision process that is employed in this Cournot model. Both firms are trying to gauge what their rival will do. So given their rival produces X amount of output, how much output should they produce in order to maximize profit? The same type of thought process occurs for firm 2, which is why earlier I wrote that firm 2’s best response function could be solved by symmetry. In reality, neither firm actually carries out this experiment in the marketplace, but rather this is a model describing the internal decision-making discussions by each firm.

Let me get back to why one firm doesn’t just keep producing more output. If firm 1 said they were going to produce say the uniform pricing monopolist output, but there was no additional market reason to actually believe this statement, then what is firm 2’s best response? Firm 2’s best response is to produce their profit maximizing amount of output, which has not changed. So if firm 1 did produce more than their profit maximizing level of output, market price would fall and so would both firms’ profits, but firm 1’s profits would fall more than firm 2’s.

Now from the Australian wine industry market, we see that some firms have incorrectly gauged demand, and have produced "too" much wine, which increases industry output, decreases the price, and lowers profits, which is exactly what happened in the Australian wine market. Hence my argument why Australian wine producers are at the mercy of a French economist.

The remedy? Produce less output; differentiate the product; and grow the industry - each idea is found in the article.

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