Friday, January 22, 2010

Signalling Redux

The blogger and graphic artist whose "nom de plume" is Samurai Artist popped me a note to inform me of his very interesting interview with Brett Joyce of Rogue (the above is a sample of his work). During the interview he asked Brett about a post I had done in the past about Rogue and signalling. At the time Brett appeared quite annoyed by my post, and I was completely perplexed. But then I realized the problem, people were not understanding it as an equilibrium concept. Anyway, here is the exchange:

SA: There was another blog post (on the Oregon Economics Blog) that suggested that you guys use the economic term 'signalling' by pricing yourself higher to signal to consumers that your beer is of a higher quality. I know that you said that wasn't true, but I would like to see if you have more of a response to that.

Brett: Yeah, I'm not smart enough to know what 'signalling' is, but I would just say this, there is a lot that goes into the packaging, there is a lot of hops and malt that goes into our products. We have never told John in 21 years what to put into the beer. He is an artist, and it is our job to get out of the way and let him practice his craft, and it is our job to go sell it, go market it. Our beer is not inexpensive to make. It's because of ingredients and because of packaging, not because of 'signalling'. I don't even know what that means!

This is a good illustration I what I mean. I would not say that Rogue 'uses' signalling. What I was trying to provide an explanation for was the popular beer blogger complaint that Rogue is too expensive. Given that the craft brew industry in Oregon is intensely competitive it is hard to see how Rogue's prices are sustainable in the free market of beer. Signalling provides a potential explanation (not necessarily the right one or the only one, but a possible one): if people think price contains some information about the quality of a product that they cannot themselves determine before they purchase it (as opposed to something like a new shirt that you can touch feel, try on, etc.) then they may act on that information by purchasing it. Of course, all beer companies could try this, but the companies with a lesser product would find out quickly that consumers learn and their sales would plummet. Packing plays a similar role - Rogue's packaging is more expensive and a signal of the quality of what's inside. Other breweries could do the sam but if their beer is of inferior quality than their attempt to signal becomes a costly waste of time.

If the consumer tries the expensive beer and likes it then their assumption about the price being indicative of quality is correct. Only though repeated tries would the consumer learn that price is a reliable signal. And this confirmation will happen only if it is truly just the better beers that are more expensive (in general). So you see, signalling is essentially an equilibrium where better beers are priced higher, and consumers act on this knowledge.

This is why I was perplexed about Brett's annoyance with the story: it is an equilibrium story that is not an explicit strategy by Rogue. In fact it happens simply because Rogue responds to the incentives that are already in the market. And it only works if Rogue's beer really is thought of as that good once buyers purchase it. I think he thought I was saying it is an explicit strategy you can use to fool consumers and get a higher price. Precisely the opposite: it is a market outcome whereby better beers price higher and lesser beers price lower and it works because in equilibrium consumers are then correct about how price and quality are related. [Note that good and bad craft beer aren't necessarily any more or less expensive to produce so there is more to price differentials than the cost of ingredients clearly]

Full disclosure, I love Rogue and Brutal Bitter is among my top five favorite beers, but that has nothing to do with it. The answer to "how do they get away with charging so much?" is simple: the market thinks their beer really is that good. And as good beeronomists we should know not to question market outcomes, our task is to simply try and understand them better.

Finally, this model was originally applied to education: people get college degrees because they want to gain more skills and knowledge but (perhaps unbeknownst to them) it also serves as a signal to firms that they are smart and worthy of hiring. Getting a degree is hard, however, but a lot harder if you are not smart than if you are truly smart. So firms take the degree as a signal of quality and they are right to do so - because, in equilibrium, only the smart ones will find it worthwhile to spend the time and effort getting the degree.

Friday, January 15, 2010

Economies of Scale?

In the past year or two, under the 'Bond Street Series' moniker, Deschutes has sold a marvelous beer in 22oz. bottles: Red Chair IPA. I used to find it in my local Safeway and New Seasons for about $5.50. I loved it, but would buy it infrequently as the price was pretty intimidating. Now Deschutes has rechristened it 'Red Chair Northwest Pale Ale' and has placed it into their seasonal line-up and is selling it in six packs. A few days ago I bought a 12 pack for $12 in my local Safeway.

In the 22oz bottle it was going for $0.25 an ounce, now it is selling for as low as $0.0833 an ounce. First off, this is a fantastic beer selling at a regular price and I can't be happier. Second, unfortunately this is a Jan through April release, so start hoarding now - I don't think there is anything 'seasonal' about this beer and it should sell year round. But lastly, what can possibly explain the fact that the new price is 1/3 the old? Partly this has to do with niche marketing - going from a specialty beer aimed at the top of the demand curve to a mass market beer aimed at the heart of the demand curve. But, it probably has a lot to do with scale as well. Estimates exist of scale economies in brewing overall (i.e. the size for the brewery), but I wonder if any beer geeks can enlighten me about scale economies when it comes to producing a particular beer? It seems to me that this must be a big part of the story.

Finally, some gripes: I am pretty sure that it was I that came up with the whole concept of the 'Northwest Pale Ale,' I have been advocating for a long time for smaller but hops infused beers - hoppy beers don't have to be super-big. In fact I have been trying to perfect this concept in my kitchen and decided to call the result a 'Northwest Best Bitter,' the idea being a best bitter taken to the land of hops and given a re-education but with about the same alcohol content of an English version. I have every intention of creating a new category of beer. Of course my result pales in comparison to the Deschutes offering, but I await my royalty check for the NWPA idea.

Anyway, Red Chair is one of my favorite beers ever and the Deschutes move to more mass production is wonderful - so thanks Deschutes!