An Analytical Review of the Three-Tier Distribution System in the Beer Industry

Introduction

In 2015 the National Beer Wholesale Association (NBWA), the beer industry group, published an article entitled Who Are America’s Beer Distributors? on their website (NBWA, 2015). In the article they argued that one of the benefits of the three-tier alcohol regulatory system is that it provides the infrastructure, capital and personnel small brewers need in order to efficiently reach a wide network of retailers and, of course, the customers. While some of the key players in the alcohol production and marketing industry see the three-tier system as a necessary evil, there are many stakeholders who embrace it as a boon. One thing is certain though: good or bad, the three-tier system almost definitely played a role in getting alcoholic beverages into America’s households. It does not only determine how Americans get their booze, it also facilitates the process of selling and taxing alcoholic drinks in the United States.

I will dedicate this essay to thinking realistically and open-mindedly about the pros and cons of the three-tier system. I will start with two basic questions: is the three-tier system really effective in terms of fostering competition, enhancing consumer access to safe alcoholic beverages and providing protection against revenue loss? Or, would we be better off without it? Answering these questions requires an understanding of how the three-tier system works.

Three-Tier Distribution System in Perspective

It should be called to mind that the tradition of beer and other alcoholic beverages dates back to more than 10,000 years (Patrick, 1970). With the discovery of a Mesopotamian clay tablet, archeologists naturally became curious to decipher its cryptic markings. Incidentally those cryptic markings became history’s first known recipe for beer. The cryptic markings, according to the archeologists who analyzed it, also revealed that it was the Mesopotamian god Enki himself who handed the recipe to his people. Given that the subject of beer often pops up regularly in their work, these discovery did not surprise the archeologists. Large number of ruined cities and tombs scattered around the world often have images of people brewing, storing and drinking beer and other alcoholic beverages (Hornsey, 2003; Keller et al, 1999; Associated Beer Distributors of Illinois, n.d.).

The Babylonians used everything from black barley to wheat and honey to make different kinds of beer. The Incas were known to make beer from corn, while the Egyptians made it from honey. The Pilgrims loved beer so much that they sometimes cut their voyages short if they ran out of beer. The American brewing industry was actually well-established by 1970. It is probably this basic fact that emboldened the country’s patriots, including George Washington and Patrick Henry to argue for a boycott of English beer imports (Mittelman, 2008; Associated Beer Distributors of Illinois, n.d.). In the bigger picture, it must be conceded that the Boston Tea Party almost became the Boston Beer Party. So it was no surprise that the alcoholic beverage industry in United States, particularly the beer industry, was booming at the turn of the 20th century. History shows that in that era, local brewers usually had ownership ties to the taverns – a model known as ‘tied-houses.’ Basically, the tied-house model worked this way: the local brewers sells beer and other alcoholic beverages to the taverns on extended credit terms. They also provided equipment and supplies to participating taverns, charged them low or no interest and paid them some forms of rebates for pushing their brands or carrying it exclusively (Swinnen, 2011). Given this kind of scenario, it is only natural that competition for the control of the retail outlets (mainly the taverns) would be fierce. The quest for profit in those days was also a huge incentive for the brewers who exerted tremendous pressure on the retailers to maximize sales at all costs. Maximizing sales at all cost means that both the brewers and the retailers showed no regard to the well-being of the customers or the general public. These abusive practices were seen by the customers and the general public as unfair. Not only that, they led to the campaigns for laws prohibiting all drinking (Mittelman, 2008; Associated Beer Distributors of Illinois, n.d.). Thus in 1919, the U.S. Congress passed the 18th Amendment to the U.S. Constitution. With the passing of this 18th Amendment, the United States went through a period of 14-years dry spell known as Prohibition (Associated Beer Distributors of Illinois, n.d.).

In 1933, Congress enacted the 21st Amendment to the U.S. Constitution, which repealed Prohibition. The amendment also gave each state of the country the authority to regulate the importation, production, distribution, sale and consumption of alcoholic beverages. In addition, this amendment in many ways led to the creation of a new regulatory system known as the three-tier, whose goal was to eliminate the tied-house abuses. Under this new arrangement, tied-houses would no longer exist. To put this in perspective, the new arrangement means that beer and other alcoholic beverages would be sold through independent distributors (Hornsey, 2003; Keller et al, 1999; Associated Beer Distributors of Illinois, n.d.).

It is worth remembering that each individual state of the country has its own set of laws governing the three-tier system. However, they have one thing in common: the separation of the three-tiers via the insertion of an independent distributor between the brewers and the retailers. One more thing separates the three-tiers (that is, brewers, distributors and retailers): the laws and regulations which prohibits suppliers and distributors from having any financial interest or a controlling influence on the retailers. In other words, consignment sales are banned and the sale of beer and other alcoholic beverages on credit is not allowed.

Simply put, the major goals of the three-tier system are four-fold. First, its application to the production and marketing of alcoholic beverages can prevent the overly aggressive marketing and sales practices of the pre-Prohibition era. Second, by adopting the model, the government can effectively and efficiently generate and collect tax revenues from the alcohol and beer distribution industry. Third, the model will help the state and local government to control alcoholic beverages efficiently. Fourth, it is a model that would encourage moderate consumption of alcoholic beverages as well as ensure consumers’ safety.

Having presented a brief history and the goals of the three-tier system, I will now turn my attention to a broader description of how the system works.

Playing to Win: How the Three-Tier System Works

Without putting it in so many words, the three-tier system requires the key players in the alcoholic beverage industry to operate in three market tiers. These three market tiers, according to the model, must be separately licensed and owned, which means that they will be independent of each other. With this kind of structure, the proponents of the model argued that marketplace domination by large companies that would seek to greatly increase alcohol sales through aggressive practices will be prevented. From the proponents’ viewpoint, the system can prevent large companies from controlling the entire alcohol distribution chain, from the manufacturers to the consumers. Given that alcohol is required under this close distribution system to go from a licensed manufacturer to a licensed distributor to a licensed retailer, they argued that it will help prevent adulterated and contaminated products from reaching the consumers (Smith & Yandle, 2014; Erickson, 2013).

Policy-makers wedded to the above viewpoints also acclaim that the three-tier system argued that it is a welcomed blessing to the government. This is because, under the system, the government functionaries no longer have to collect excise taxes and track products at extra taxpayer expense. Instead, the operators in the middle tier, that is, the licensed distributors and wholesalers, does this important function for them under the model. Using product tracking procedures, these middle-tier operators can quickly identify spoiled and recalled alcoholic beverages and pull them from the shelves of the licensed retailers. The way they will facilitate this monitoring process is simple: licensed distributors generally visit licensed retailers regularly. During such visits, they can easily notice a product that they did not supply or a product that may have some issues. As licensed distributors, they have the obligation to report such products to the appropriate regulatory agency. Thus, under the three-tier system, a licensed retailer will find it very hard to systematically sell counterfeit or untaxed products. Not only that, the system, according the its supporters, will help to ensures that the licensed distributors has no incentive to offer fake products to retailers since this can jeopardize their license (Smith & Yandle, 2014; Erickson, 2013).

An open question now is whether we have seen some of these benefits. Or, do we still need the three-tier system now that a more diverse alcoholic beverage industry have been established in United States? I will start answering these questions by first of all discussing the model’s effect on competition.

Three-Tier System versus Competition

According to the proponents, the three-tier system has prevented tied houses and empowered independent distributorships. By achieving these important feats, the model encourages competition (National Alcohol Beverage Control Association, 2015). This argument showed that the main credo of the proponents of the three-tier system is that it gives the manufacturers of alcoholic beverages equal access to the marketplace – a kind of access they may not receive under other systems. Under this procedure, both large corporations and craft distillers and brewers can reach the consumers. This is because rather than being dwarfed by larger corporations, the smaller craft distillers and brewers receive equal opportunities to increase sales through distributors with nationwide network of retailers. The proponents’ consensus is that, by preventing tied houses and empowering independent distributorships, the system ensures that the consumers have more choices to a variety of alcoholic products in their bars, restaurants and liquor stores. Not only has that, the consumers enjoyed these varieties of booze options at affordable prices due to another important factor: competition (Mendelson, 2009; National Alcohol Beverage Control Association, 2015).

Going by their argument, it becomes easy to understand what could happen in the absence of the three-tied system. So, let us imagine a scenario in which a few large corporations were able to buy up bars and liquor stores and sell only their alcoholic beverages; or simply buy up all distributorships in the country and refuse to sell their competitors’ products. Imagine what would happen if these large corporations were also allowed to give away keg refrigerators to bars located in strategic neighborhoods in exchange for business. This kind of scenario would be very disastrous both to the smaller craft distillers and brewers as well as to the consumers. This ugly scenario is what the three-tier system helps to prevent by fostering an environment that allows the growth of smaller brands, according to the supporters of the system.

In as much as the above scenario looks scary enough, there are still some stakeholders and businesses (including some smaller craft distillers and brewers) who challenge the efficacy of the three-tier system with respect to competition. It is important to recall at this point that the system requires that no single company can do all three things. Simply put, brewers cannot sell their products on their premises. In addition, they are not allowed to ship their own products to other retailers. The system requires them to partner with distributors who have contracts with retailers to stock their shelves and bring in new alcoholic beverages (Mendelson, 2009; National Alcohol Beverage Control Association, 2015). The critics of this system (including my humble self) argues that, while is sounds like a good idea on the surface, that is not how it really work since no single entity is able to do it all.

The major issue here is that many distributors are owned and operated by large corporations. Even though they may generally not own them outright, they do control them through a variety of ways. The fact remains that the smaller craft distillers and brewers cannot buy their own distributors. So it is not surprising that they are often locked into very narrow markets with few options for getting their products out to the buying public. They also face other problems that are specific to small, struggling startups.

Another key problem is that every state in America has the right to tweak the three-tier system to suit itself. This means that while some states like California allow brewers to own their distribution network, other states do not. They only allow brewers to own retail sites, but not distributors (Canestorp, 2015; Weaver, 2012).

It is quite understandable why some larger corporations were against the three-tier system. Just consider this scenario: a craft brewer created several recipes. He also developed a business plan and borrowed large sum of money to get his brewery up and running. Unfortunately, the three-tier model forced him to deal with wholesalers and distributors to ship his products. In other words, he cannot let a customer buy a bottle or two (or even a six-pack) directly from his brewery so that he can pocket the money immediately. Instead he had to wait for 60 to 90 days for the money to come in. Naturally this can put a huge crunch on his financial position.

While the above scenario may sound a little trifling, it does explains what the opponents of a three-tier system claim. Thus the system has continued to be challenged all over the country, albeit, with mixed success.

It is interesting to observe that the critique of the system has also spilled across America’s borders. In a broader sense, the globalization of the alcoholic beverage industry and the consolidation of the international producer conglomerates is the main external factor that is putting the current pressure on the U.S.’s beverage industry. Unlike the U.S.’s alcoholic beverage industry, the rest of the international business world operates in a competitive environment where markets are only lightly regulated. So any restraint on free trade, like the one imposed by U.S.’s three-tier model, are frowned upon. Generally speaking, the international producer conglomerates do not tolerate restrictions especially when such restrictions are not directly related to important social purposes such as restricting sales to minors, temperance and tax collection. In their own view, the U.S. three-tier system hamper efficient distribution systems and unnecessarily inflate the prices of alcoholic beverages. In other words, they see U.S.’s cumbersome three-tier distribution system as anti-competitive and unfairly favoring local interests. To them, by unfairly favoring local producers, the U.S. system violates international free trade treaties (Schorske & Heckathorn, 2005).

It should be noted here that the three-tier critics abroad has many sympathizers here in America (including my humble self). As a matter of fact, the reigning heavyweights of the marketplace, which include the big box retailers, share their perspective on the U.S. three tier system. The main arguments of these powerful American firms is that many aspects of the three-tier system violates antitrust laws and the Constitution. No wonder they are threatening to challenge the system in the court of law (Schorske & Heckathorn, 2005).

Finally, when it comes to direct shipment of wine, industry members and consumers are gaining momentum in their efforts to eliminate the middle tiers. Significant legal victories have been won by small wineries and wine lovers in their guerilla wars on the three-tier system. Also, the Federal Trade Commission (FTC) itself – the U.S. agency that promotes consumer protection and prevent anticompetitive business practices – has taken a stand on the wineries’ side of the battle. To most wineries, these victories are simply successes in opening new markets for direct shipping. The significant point to remember here is that the implications of the victories go much farther. In considering those cases pragmatically, we will discover that the legal principles that resulted from them show that the 21st Amendment to the Constitution did not cast the three-tier system in stone. Parts of the three-tier system that anti-competitively discriminate in favor of local economic interests have been consistently overturned in recent direct shipping cases (Schorske & Heckathorn, 2005).

I will now take a brief look on the three-tier system vis-à-vis consumer safety to better counter proponents’ arguments on how the system protect consumers and the public

Three-Tier System and Consumers Safety

According to the proponents of the three-tier model, the system helps to ensure consumer safety as well as public safety, by safeguarding against tainted and fake alcohol. In their view, the U.S.’s state-based three-tier alcohol regulatory system is the main reason the country has so few problems with counterfeit and tainted alcohol. They also argued that the system is very effective in terms of balancing alcohol availability, price and promotional practices (Erickson, 2013; National Alcohol Beverage Control Association, 2015). I do not believe that these individuals, who seem to have an allergy to liberalism, are correct. My reason for saying this is simple: the United States can prevent tainted alcohol from entering the marketplace without using the three-tier model. As a matter of fact, the Constitutional amendment that repealed Prohibition also empowered the states to regulate alcohol. Thus, the states can still protect consumers from tainted product using a good regulatory regime that would require that each dealer in alcoholic beverages must be licensed and accountable for their products. In other words, the three-tier model, which inadvertently enables distributors to skew the free market sale of alcoholic beverages is not the most efficient way of achieving this important feat.

Proponents of the three-tier system also claimed that the major issues in other countries that did not adopt the model, including the Czech Republic and the United Kingdom, is that lots of citizens often get seriously injured after drinking tainted, inexpensive and readily available alcohol (Erickson, 2013; National Alcohol Beverage Control Association, 2015). Again, this is also a fallacy: in any country where alcohol is not properly regulated, there is bound to be high incidents involving of fake alcoholic products that can cause deaths, social unrest, and marketplace disruptions, among other adverse outcomes. Note that my argument is not that the U.S. market did not need regulations. Far from that: we do need a regulatory system that would effectively police production, importation, distribution, and retail sales of alcohol. What we do not need is a regulation that would distort the market, such as the three-tier model.

Conclusions

As an ardent believer in economic liberalism and free trade, I am convinced that the three-tier model is not good for the America’s alcoholic beverage industry. What America need is free trade in alcoholic beverages and, of course, with effective regulation. And I know that both the large corporations as well as the smaller craft distillers and brewers will agree with me. This is because, with a free trade regime they would enjoy the right to ship their products direct to the consumers, free from burdensome and excessive compliance regulations, excise and sales taxes, and of course the distributors’ piece of the action. It is thus not an exaggeration to say that free trade will bring lots of good changes to the U.S. alcoholic beverage industry – an industry that has been protected from competitive forces by excessive regulation via the three-tier system.

What lessons should be drawn from this analysis? First, market regulation via the three-tier system means that new smaller craft distillers and brewers may have a difficult time landing a distribution contract without first establishing their place in the market. This implies that in states where self-distribution is not allowed, these new smaller craft distillers and brewers may not have access to the retail market.

Second, in states operating the three-tier model, the wholesalers are another hand in the chain of distribution that needs to get paid. This, of course can lead to higher prices to the end consumers as well as less profits for the producers.

Third, an effective regulatory system can do a better job of protecting the health and diversity of America’s alcoholic beverage industry while, at the same time, protects the interests and safety of the consumers. The bottom line here is that even though the three-tier model might have served its purpose immediately after Prohibition, the situation facing America’s alcoholic beverage industry has changed drastically in the last eighty decades. Also, as a country the United States has changed a lot since the passage of the 21st Amendment 82 years ago. Examined against this background it becomes clear that both the smaller craft distillers and brewers and the large corporations should be allowed to sell to their patrons (or customers) directly, whether that’s on site or through their own distribution method, if America really want to foster competition in the industry and protect the interests of the consumers.