This Case Study is followed by a series of Market Simulations that explain each period within the beer industry lifecycle.

The economic history of the Beer Industry starts off by following the same economic pattern that all industries “should” follow. According to conventional wisdom, industries are supposed to go through:

1. an introduction phase,
2. a growth phase,
3. a maturity phase, and
4. a consolidation or decline phase.

The Beer Industry was doing just that right up until the 1980’s when the unexpected happened. Microbrews.

This simplified economic history traces the Beer Industry in the USA from 1800 up to the present. By quantifying the differentiation of products within the industry, and by understanding how the nature of this product differentiation was changing, we can explain each period within the industry’s lifecycle.

In follow-up Case Studies we will use Market Simulation to model these changes. Market Simulation is a type of Artificial Intelligence (AI) that examines markets and predicts how customers will react to change.

Part 02 – Local Monopoly

Part 03 – End Local Monopoly

Part 04 – Pasteurization and Refrigeration

Part 05 – Mass Marketing

Part 06 – Microbrews

These detailed Case Studies and Market Simulation workflows assume you have already downloaded the open-source KNIME analytics platform and installed the free Market Simulation (Community Edition) plugin. If not, start by returning to Getting Started.

Lager – the pale, dry, clean-tasting and crisp beer – dominates the consumption of all beer in North America. Over 98% of beer sold in the USA is a lager, and 90% of all consumers cannot tell one conventional lager from another.

This homogeneous, undifferentiated, and critically-judged “bland-tasting” beer has all the character of a commodity. Hence it ought to be subject to intense price competition. And yet consumers are intensely brand-loyal, and profit margins are fat and healthy.

Even more peculiar was the sudden, and unexpected, rise of the microbrew industry. Industry experts had predicted that, because leading manufacturers so dominated their industry, the emergence and survival of new brewers ought to be impossible.

Economics and Market Simulation has no difficulty explaining both phenomenon. What was difficult to understand at the time was that the underlying structure of the industry, specifically the source of market power and product differentiation, was changing.

Why Study the Beer Industry?

Why use the economic history of the Beer Industry as a Case Study for Market Simulation? There are two reasons.

First, the Beer Industry is old. In the United States it is at least 200 years old. And because it is a regulated industry, there is a long and reliable set of industry data that can be researched.

Second, the Beer Industry suffered several changing market conditions or “shocks”. Each shock directly impacted a different type of differentiation that defined the products. Hence it becomes possible to observe how the market responded to these shocks over many decades.

Predictable Lifecycles

In the auto-industry, both the number of automakers as well as the number of suppliers, followed the conventional pattern. First enjoying rapid growth, maturing, and then declining through consolidation.

Market Science and Alcoholic Prohibition

The Beer Industry was also following this exact same, predictable pattern.

So predictable, in fact, that the industry was held up as the poster-child of Market Science. When debate arose as to whether markets are really a scientific phenomenon, microeconomists point to the Eighteenth Amendment in the United States Constitution, the Prohibition of Alcohol, as proof.

To explain, let’s first look at a chart of the number of breweries in the United States:

The chart illustrates a smooth evolution of the growth and maturity of the Beer Industry from 1810 when the industry (as well as the population of the United States itself) was small. This continued through to 1980 when the industry (but not the number of breweries) was huge. We’ll deal with post-1980 below.

Note in particular the steady decline in brewery numbers from the 1880 peak of over 3,000 down to just 101. We also explore the reasons for the decline later.

Now look carefully at the gap between 1920 and 1933 – the period during which the sale, manufacture, and transportation of alcohol for consumption was banned nationally due to Prohibition.

It is hard to image a more major shock to a market than 18^th Amendment to the United States Constitution. And yet, look at how the market recovered to precisely the point that would have been projected (dotted line). As far as the industry was concerned, it’s as if Prohibition didn’t exist at all.

This would indicate that the factors that dictate the shape of a market are far from capricious or arbitrary. Markets are scientific, and “Market Math” is needed to understand them.

“In the year 1660 New Amsterdam had 26 breweries and taverns.”

“George Washington and Thomas Jefferson both brewed their own beer.”

Source: “Brewed in America: A History of Beer and Ale in the United States” by Stanley Baron.

Early history of the brewing industry when Market Power is based upon “Geographic Differentiation”.

Geographic Differentiation provides local Market Power

The early history of the growing USA Beer Industry through to 1880 closely tracked the growth of the USA population. Every new American town needed to have its own brewery. Beer could not be transported long distances, so a single brewer in a small town had an effective market monopoly over the local production and sale of beer.

A microeconomics chart explaining the phenomenon would look like this:

On the left of this chart we see the consumer preferences for two products in the market (Product #1 from Pittsburgh and Product #2 from the next town). On the right we see exactly the same information but with the two charts overlaid on top of one another.

We can see that Customer A (top-left) receives a high benefit from Product #1 because they live near to the Pittsburgh brewery where the product is made. The same Customer A (bottom-left) receives a low benefit from Product #2 because they live far away from where that product is brewed in the next town. Hence Customer A (right-hand-side) effectively can only choose Product #1 to buy and is thus subject to a monopoly. The same is true for Customer F who can only choose Product #2 to buy.

From these “value curves” we see that only a very few people (Customers C and D) who live between Product #1 and Product #2 have a competitive choice.

Trains and refrigerated boxcars mark the end of the Local Monopolies due to Geographic Differentiation.

By 1870, the population of the United States was still growing rapidly, and yet the number of breweries starts to shrink. The amount of beer being consumed is not dropping, so what’s happening?

The answer is “technology”. At that time the railroad network was expanding nationally, with the First Transcontinental Railroad completed in 1869 (the year before the number of breweries peaked). New insulated boxcars were able to distribute beer long distances without spoilage.

In economic terms, the value curves were flattening. The value difference that Customer A to Customer F perceived between the products was shrinking. All Customers found they had more choice in where they could buy beer. This caused the market power of local monopolies to dissipate and prices to decline. Without Geographic Differentiation, the industry found that its products were undifferentiated commodities.

“Between the Civil War (1860) and National Prohibition (1920) per capita beer consumption increased six -fold.”

“From the mid 1940s to 1980, the market share of the five largest breweries increased from 19% to over 90%.”

Improvements in brewing technology such as pasteurization and refrigeration illustrates the value of “Vertical Differentiation”.

Vertical Differentiation causes Growth and Consolidation

Soon breweries were also starting to make better beer using pasteurization and refrigeration technology. In economic terms, they were adding Vertical Differentiation to their products.

Vertical Differentiation exists whenever all consumers would agree that one product or feature is better than another. For example, all modern consumers would agree that having 4 GB is better than having 2 GB. Many breweries were forced out of business because they couldn’t match the Vertical Differentiation offered by bigger manufacturers with the newer production technologies.

Consider Product #1 and Product #2 in the following chart.

At the top of the chart is a histogram of consumer preferences for Product #1. The horizontal axis plots the “value” or Willingness To Pay (WTP) that consumers perceive for the products. Some consumers (like “Z”) like the product a lot and have a high WTP, but other consumers (like “A”) don’t like it much at all.

The pasteurization and refrigeration technologies used in generating the otherwise identical Product #2 adds Vertical Differentiation. All consumers looking at Product #2 have a higher preference than they do when looking at Product #1. Even Customer A is a little happier! The histogram has been shifted to the right, and all consumers would prefer to purchase Product #2 over Product #1 – especially if the price were the same.

The Vertical Differentiation introduced by the leading breweries forced the lagging breweries out of the market. But when the smoke cleared and all the remaining breweries offered the same, high-quality beer, the products again looked like undifferentiated commodities. The industry needed to find another way to reinvent itself.

“From 1950 to 1980, marketing increased from $0.51 per barrel to over $5.00 per barrel.”

Source: “The all-American beer: a case of inferior standard (taste) prevailing?” by David Y.Choi and Martin H.Stack (2004)

Mass Marketing of Beer creates Brand Power as a form of “Horizontal Differentiation”.

Horizontal Differentiation and Mass Marketing

As the industry matured and high quality beer became pervasive in the market, the brewers started branding and mass marketing their products. Today over 20% of industry revenue is spent on marketing.

Look at the Budweiser advertisement from 1987 (above) and think about how it changes your impression of the brand? For some, this image raises the enticing possibility that drinking Budweiser will lead to an association with bathing suit models. For others, the image invokes only negative feelings towards the brand.

The fact that different consumers place a different value on an otherwise commodity product is called “Horizontal Differentiation”.

Horizontal Differentiation exists when products or features do little to change the average Willingness To Pay (WTP), but substantially impact the WTP of individual customers. In other words, Customer preferences are reordered without changing the overall average.

A good example of Horizontal Differentiation is product branding. The average value customers have for the Miller brand is about equal to the average value customers have for the Budweiser brand. But, according to Miller Brewing’s President and COO (1997):

“30% of consumers will not buy and Anheuser-Busch product, and another 30% will not buy a Miller product.”

Hence this reordering of brand preference polarizes the market, and give sellers a greater degree of pricing power over a smaller number of consumers.

Brand became such a large part of the value a consumer was purchasing from beer that by 1996, according to F. M. Scherer [Industry structure, strategy, and public policy] the industry was very profitable despite the fact that:

“90% of all consumers cannot tell one conventional lager from another.”

Branding, in economic terms, causes a redistribution of customer preferences. This phenomenon can be seen in the following chart.

In the example above, these consumer preference histograms are like the ones shown earlier for Vertical Differentiation. But now the position of the highlighted consumers in these histograms (namely “U”, “V”, “G”, and “E”) are reordered causing the overall curves to be uncorrelated.

The branding efforts of the major brewers are altering the perspective of individual consumers towards each product.

In this case, after seeing a highly pervasive advertisement on television, Customer E decides that he has a much stronger preference for Product #2 than Product #1. On the other hand, Customer U finds the same advertisement offensive. This shifts their preference for Product #2 downwards.

It is important to remember that Customer E would almost certainly not be able to distinguish the two products in a blind taste test. But dividing and polarizing the market using Horizontal Differentiation means that the price of an otherwise commoditized product can rise, and the profits of all manufacturers can increase.

“National beer brands seek to offend no one, therefore offer little to excite anyone.”

Source: “The all-American beer: a case of inferior standard (taste) prevailing?” by David Y.Choi and Martin H.Stack (2004)

“Strange Differentiation” allows Microbrews to emerge and survive in niche Markets.

Strange Differentiation and the Rise of the Microbrew Industry

The world-renowned Harvard Business School professor and market strategist, Michael Porter, in his famous 1980 book “Competitive Advantage” stated that:

“Opportunities for small players are so limited that the Beer Industry exemplifies barriers to entry.”

Michael Porter recognized that a new market entrant to the Beer Industry would need to have both the economies of scale of the Miller Brewing Company and the brand power of Budweiser to gain a foothold in the United States beer market. The emergence of such a competitor was inconceivable.

The market strategists of 1980 had no idea that the Microbrew Industry, led by the scrappy Boston Beer Company, could so unexpectedly transform the industry.

Today there are 4,000 breweries in the USA – more than any other time in history.

How did the Microbrewers do it? The following chart explains how they managed to tap into yet another type of product differentiation called “Strange Differentiation”.

Strange Differentiation exists whenever a relatively small group of customers value a product or feature disproportionally to the industry average. They provide an opportunity for niche products in the market.

Product #1 (we are using Budweiser here as our example) and Product #2 (a typical Microbrew) are competing for consumers. Budweiser has strong Vertical Differentiation, which means that most customers prefer Budweiser over the Microbrew. But the Microbrew has Strange Differentiation – that is, a very wide range of consumer perspectives such that two customers, “Y” and “Z”, prefer the Microbrew over Budweiser.

With just this tiny part of the market (less than 12% of beer drinkers choose a microbrew), the 4,000 microbrewers have managed to survive and thrive.

But if lagers are as bland and tasteless as their critics’ claim, are microbrews a “superior” kind of beer?

No. In objective terms, microbrews typically offer an inferior product – especially in the early days. Consumer Reports, in their 1996 article entitled “Can you judge a beer by its label?” stated that:

“The most consistently high-quality products came from contract brewers, major domestic brewers, and large regionals. Beers from true micro-brewers often earned low scores with stale, sulfury, medicinal and cooked-vegetable flavors.”

The Boston Brewing Company, itself, took a different approach than most microbrews by developing an extremely high-quality product. But to do so, they need to spend about 43 cents more per six-pack on ingredients than the major breweries. Furthermore, the Boston Brewing Company spent 7 times more (on a per-case basis) on its advertising than Anheuser-Busch spent on its super-premium Michelob brand. And the Boston Brewing Company’s sales force (150 people of their total 225 employees) was bigger than the sales force of Coors – a company 20 times lager.

A Scientific Approach to Markets

Markets, like most of the phenomenon we witness in life, are driven by the rules of math and science.

Value-based pricing, for example, requires a deep understanding of the differentiation offered by the products in the market. A company may be offering lots of value, but the company cannot charge a premium for that value if they are not differentiating their products.

But what exactly is differentiation? Are there different types? What type of differentiation is best? How can differentiation be quantified for different customer segments? How can an understanding of differentiation be used to shape a product portfolio? And what’s the connection between differentiation and pricing?

Quantifying Differentiation

As we’ve seen in this Microbrew Case study, there are at least four different types of differentiation:

1. Geographic Differentiation
2. Vertical Differentiation
3. Horizontal Differentiation
4. Strange Differentiation

Geographic Differentiation refers to the distribution points of sale, the product placement and the degree of inconvenience that must be suffered by the consumer in making a purchase. Geographic Differentiation can be approximated using the linear distance from the Customer to each Product.

Vertical Differentiation typically describes a product’s objective criteria whereby every customer in the market would agree that one feature-level is better than another. All customers agree that 16 megapixels is better than 8 megapixels. Vertical Differentiation can be measured using the difference between the mean of each Product. Or more precisely, the difference between the mean of the Willingness To Pay (WTP) Customer Distribution of each Product.

Horizontal Differentiation typically describes subjective criteria where there may be great differences between individual customer preferences – even though, on average, the competing products are quite similar. A product’s brand is often a good example of Horizontal Differentiation. Horizontal Differentiation can be measured using the correlation between the WTP of Products.

Strange Differentiation refers to the breadth of consumer perspectives and how preferences are averaged when features are bundled together. Strange Differentiation is measured using the standard deviation of each Product. Note the simple memory aid that both “Strange Differentiation” and “Standard Deviation” share the acronym “SD”.

Products can, and often do, exhibit all these types of differentiation simultaneously.

Market Simulation

With so many types of dynamically-shifting differentiation, it is often difficult for a market analyst to make sense of it all.

Luckily Market Simulation technology can help.

Market Simulation numerically quantifies each type of differentiation for each feature, benefit, and product. Market Simulation takes a holistic approach, so models can be tuned using any and all known facts about the market.

Once tuned, a Market Simulation model can predict how customers will react to change. This allows the user to develop optimized pricing, targeted promotion, and new product development to maximize their return from the market.

What’s Next?

Start exploring how each one of the periods described above in the economic history of beer can be explained with Market Simulation.

• Part 02 – Local Monopoly
• Part 03 – End Local Monopoly
• Part 04 – Pasteurization and Refrigeration
• Part 05 – Mass Marketing
• Part 06 – Microbrews