Thursday, 2 February 2017

The rise and fall of craft beer?

I was interested in this long article by Michael Donaldson in the New Zealand Herald last week, entitled "End of the golden age of craft beer" (the Herald also had a follow-up editorial the next day). Donaldson writes:
But despite massive growth in the industry, [Epic brewer Luke] Nicholas fears there's a regression of sorts at work - it's almost as hard now to sell beer as it was back in the day when he was knocking on doors until his "knuckles are bleeding".
"The other day I was trying to figure when we were in the 'golden age' of having the right number of breweries and customers and I think it was 2012 - that was the time before all the me-toos started coming on board.
"Every wannabe homebrewer, every person with money who wanted to buy a brewery, every branding guy who says, 'Look at this double-digit growth, I'm jumping on that.'
"People who are doing that now are already late because things are going to get tough."
That bit struck me because it reminded me of a model that we discuss in some detail in ECON100, based on dynamic supply and demand (or what Steven Lim calls in our ECON100 class 'the cyclical patterns model'). Here's how it works.

Consider a perfectly competitive market, as shown in the diagram on the left below. The diagram on the right will track changes in firms' profits over time. Initially (at Time 0) the market is at equilibrium (where demand D0 meets supply S0) with price P0, and firms are making profits π0. Now say there is a permanent increase in demand at Time 1, to D1 (this increase in demand is the discovery of craft beer by hipsters). Prices increase to P1, and firm profits also increase (to π1). There are no barriers to entry (this is a perfectly competitive market), so the higher profits encourage new firms to enter this market (new brewers flood the market, as noted in the quote by Nicholas above). Supply increases to S2 (more producers) at Time 2. Price falls to P2, and firm profits also fall (to π2). This is where we are probably heading now.

Of course, that's not the end of this little story. Now, at Time 2 profits are low and some firms will exit the market (no barriers to exit because this is a perfectly competitive market). Supply decreases to S3 (fewer producers) at Time 3. Price increases to P3, and firm profits increase to π3. As you can see from the profits over time (in the right-hand diagram), a cycle of high profits-low profits-high profits- etc. is created.

How realistic is this model? If you have a long memory, you may recall something similar in the kiwifruit industry in the 1980s (see for example page 6 of this paper about Katikati). Initially, a few farms made big profits. More farms planted kiwifruit. A few years later, the price collapsed due to oversupply. Many kiwifruit farmers went bust, and investors lost big. There are other similar examples as well, like venison in the 1990s.

All that is required are two things: (1) a perfectly competitive market (or one that is close to it); and (2) some shock to kick things off. In the case of craft beer, is it a competitive market? Remember that the characteristics of a competitive market are: (1) there are many buyers and sellers; (2) all products are homogeneous (the same); (3) information flows quickly and accurately; (4) there is freedom of entry into and exit from the market. The most problematic of these in the case of craft beer is the last one. Is there free entry and exit from the market? Now that craft brewers can simply lease existing plant from other brewers, I'd argue that there probably is low barriers to entry, which makes this market somewhat (but not perfectly) competitive.

There are a couple of other things to take away from the model above. First, a smart player in this market would adopt a 'hit-and-run' strategy. If prices and profits (and the costs of entry) are low, this might be a good time to get into the industry, but if prices and profits are high, this might be a good time to cash out (and bank a large capital gain). Maybe think twice before investing in that new craft brewer, unless you are confident the boom will continue (how confident are you that we haven't yet reached peak hipster?).

Second, the amplitude of the cycles on the right of the diagram gets smaller over time. This is because people are learning, i.e. more people recognising the cycle and trying to take advantage of it, such as by getting out before it hits the peak. Which may go some way to explain the motivations of the previous owners of Emerson's or Tuatara on their decisions to sell out to the major brewers.

Lots of investors got burned in the kiwifruit industry in the 1980s. Will craft beer burn investors next?

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