Does the Wine Industry Sell Lemons? Adverse Selection in the Wine Industry 2 nd Int’l Wine Marketing Symposium July 9,

1. Does the Wine Industry Sell Lemons?Adverse Selection in the Wine Industry2nd Int’l Wine Marketing SymposiumJuly 9, 2005 Robert Eyler Department of Economics Sonoma State University eyler@sonoma.edu

2. Introduction • Wine Industry Economics revolve around niche • Marketing key in this industry for three major reasons: • Many beverages outside the wine industry to from which to choose; • Many wineries competing for the same shelf space and consumer; and • Global competition and markets on the rise.

3. Adverse Selection • Quality is a constant worry for winemakers • Change in quality can immediately change consumer tastes. • Many substitutes for specific wines. • Reputation seems to be a larger focus. • All wineries preach high quality in their wines • What rational winery would say their wine was “low” quality? • Given this, consumers face an adverse selection problem. • Consumer does not know ex ante wine quality. • Imperfect information exists concerning wine quality

4. Adverse Selection (cont.) • “Lemons” Problem • Akerlof used-car market, no equilibrium exists due to lack of information. • Consumer “adversely selects” car, and thus demands a lower price to compensate risk. • Applications widespread • Finance and Labor markets the most abundant • Spence (1973), Rothschild and Stiglitz (1976), Stiglitz and Weiss (1981), Shapiro and Stiglitz (1984), seminar in their fields.

5. Signaling using Wine Tasting Scores • Signaling a large part of the producer avoiding the adverse selection problem. • Without it, adverse selection should lower revenues for firms. • Signaling provides consumers with some knowledge of quality • Much like labor markets, where worker signals to firm. • Seller signals buyer in hopes of not lowering price.

6. The Model • The price of a wine, especially inside a certain price point, is determined by quality. • The average quality is what the consumer is willing to pay when quality unknown. • Under these conditions, no equilibrium exists. • In the wine industry, quality information does exist • Can it be used to increase price, if perceived as a positive signal?

7. The Conundrum • If wineries pay for third-party quality assessments, must expect some return. • Price increase, increased sales, or both must outpace cost of tastings. • If average consumer uses this information as a signal of quality, return to wine tasting results should exist • The “signal” differentiates one wine from the other.

8. Separating Equilibrium • What every winery wants • To price based on perceived quality • Consumer tries to maximize utility, based on info. • Low quality wines separated from high quality based on signal? • This is the big question • Theories from other markets help provide some insight • In labor, market may be better or worse with signal. • In finance, market generally better off with signal. • Are efficiency gains guaranteed?

9. Questions and Conclusions • Do signals in the wine industry provide wineries and consumers with efficiency gains? • Do media sources, online and print, provide appropriate market signals? • Publications, like the Wine Spectator, operate in a signaling market • Is this market efficient? • What are the threshold scores for the average consumer? • Do wineries have power to change price when this signal is provided?