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The OCSA vs. The Status Quo

The second of the studies that the Ontario Convenience Store Association released in August is a good deal more broad in scope than the first. It is entitled An Economic Analysis of Increasing Competition In Retail Liquor Sales in Ontario. It is also written by Dr. Anindya Sen from the University of Waterloo. If you really like reading economic papers, you can download it by clicking the title.

I am going to attempt to explain the gist of the paper as best I can given my limited understanding of the economic model employed between pages 18 and 24. I think I get most of it, but if there are any economists out there, you might want to lean in on this one.

This paper is intended as a study to provide information on the possible effects of partial privatization of alcohol sales within the province of Ontario. It is an attempt to provide substantive academic research into the problem. This is something of which I am generally in favour. Too often we argue on internet forums about the likely effects of privatization without any real research to point to.

The initial findings which guide the study are as follows:

1)      The vast majority of the money the LCBO makes is on markup, which is generated in their capacity as a wholesaler. (This is usually true with specific amounts based on product type. Here is a link to the current pricing structure.)

2)      Comparatively speaking, federal excise and federal and provincial ad valorem taxes typically make up a smaller percentage than the markup,

3)      Based on empirical evidence, increased market competition is significantly correlated with an increase in per capita gross income, net income and government revenue generated by the provincial liquor authority.

The arguments that follow are largely based on the concept of consumer and producer surpluses and it basically goes like this:

Say you’re standing in the LCBO at Summerhill, checking out all the groovy new craft beers and thinking about what to drink this weekend. For the purposes of this argument, you’re all about buying a bottle of Panil Enhanced because it looks interesting and you liked the Bariquee that came in last year. You check the price tag and it is $15.00. The absolute most that you’re willing to pay for a single bottle of beer at retail is $16.50. That measure of $1.50 difference counts as your welfare based on consumer surplus.

Now, on the other end of the scale, Panil is trying to sell their beer for as much money as they reasonably can. It’s good beer and they feel they deserve to be paid a premium for it. I don’t know exactly what price the LCBO is buying Panil Enhanced from the importer at, but let’s assume for the sake of argument that it’s about $6.50 a bottle. That’s more than the $5.00 the importer would have taken at a minimum. Their producer surplus is $1.50.

All this means is that the system works tolerably well towards an equilibrium between consumer surplus and producer surplus at $15.00. Also, you go home with a bottle of Panil Enhanced and everyone’s happy.

If you could remove some of the markup that the LCBO adds as a wholesaler from the equation and keep the producer surplus the same, your consumer might suddenly be paying $13.50 for that bottle of Panil, creating additional consumer surplus.

Without competition, there’s no compelling reason for the LCBO to change the equilibrium point in the model. They would make less money in markup, and, because the product is cheaper, the province would take less PST. “Everything is worth what its purchaser will pay for it,” said Publilius Syrus. You’ll pay $15.00 for Panil Enhanced because it’s worth that to you.

There is also a concept here that you should understand that is called Deadweight Loss that’s associated with a monopoly on various products. Since a monopoly allows the retailer to charge the most beneficial price for themselves, some consumers are not able to afford Panil Enhanced at all, resulting in a loss of market utility. They have frowny faces.

Dr. Sen is essentially arguing that the LCBO voluntarily enter into a position in which they are creating their own retail competition.

Theorize that some kinds of alcoholic beverages are available for sale at convenience stores. The study assumes that convenience stores would be allowed to accept a lower markup, resulting in decreased cost to the consumer. For this the convenience store would pay some of the markup as licensing fees. As a result of that move, the majority of rational consumers would shop at the convenience store. This would in turn result in lower sales at the LCBO, which would force them to lower their prices.

This would lead to a significant reduction in government revenue due to the loss of markup and ad valorem taxation. The good news is this: The lowered costs to the consumer mean that the people who counted as Deadweight Loss and could not afford Panil Enhanced at all can now do so and that the people who were experiencing mild consumer surplus on their $15.00 bottle are now paying $13.50 and those suckers are doing backflips of joy in the streets, let me tell you. “Whoopee hoo,” they yell “I’m gettin’ enhanced tonight.”

“The LCBO in the short run is worse off, because of lowered sales and profits generated by its own stores” says the study. “However, it is quite possible that overall LCBO net revenue and transfers to the province will actually increase. Recall that in this model, convenience stores must also transfer their markup revenue to the province. Since they charge a lower price (compared to the LCBO), the total amount of liquor sold is obviously more than the quantity sold by the LCBO as a monopoly retailer. Otherwise, the LCBO would have earned these higher profits as a monopoly retailer by setting a lower price.”

Got that? Convenience stores charge a lower price and the LCBO charges a lower price but ideally the increased volume of sales that results from the decreased prices bridging two sales channels might theoretically increase once you take the additional taxation revenue into account.

I agree completely with Dr. Sen’s finding. That’s exactly what would happen given those conditions.

Those conditions will be met on the day that hell freezes over.

The model depends on a simplified version of the system as it currently exists which thinks solely about the benefit in terms of consumer surplus. The issue is that since the LCBO’s profits and the general tax revenue from the LCBO and Beer Store make up approximately 1.5-2% of the annual provincial budget, the real world also has to take the consumer into account as a citizen who benefits from services derived from that revenue.

The ignored cost implications are staggering. The LCBO’s reduced profitability would probably result in a decreased operational budget and therefore a decrease in staffing. Think about the amount of work that would have to be done in order to figure out what the decreased price structure would look like.

Think about the fact that you as the OCSA are pitching this fanciful study whose empirical data analysis does not account for demographics or trends in the marketplace and a conclusion section which contains a woefully large number of conditional statements. If I’m the government, I’m shutting you down because the LCBO is a guaranteed cash cow in a time of economic uncertainty and you are offering a potential 5% – 9% theoretical increase at some point in the future if everything goes right and there are no unforeseen eventualities.

Peace, order and good government means that “if” and “maybe” and “should” don’t get a seat at the table.

On a final note, consider the main precept of the OCSA model: additional sales. Additional sales mean additional consumption. If the core tenet of your model hands your opponent a social responsibility argument to beat you about the head with, you can’t be surprised when you lose.

6 Thoughts on “The OCSA vs. The Status Quo

  1. Tapsucker on December 7, 2013 at 9:31 pm said:

    I’m interested in how minimum pricing guidelines factor into this. Obviously not on a $15 bottle of beer, but definitely on volume and discount brands. If the corner store is forbidden from going lower, then the perceived extra competition is irrelevant anyway.

  2. Now that’s an interesting question. There’s the distinct possibility that competition results in extra sales even if the Convenience stores are forced to mark the products up more and market it as a “convenience” fee. I think the question is whether the additional revenue would offset the necessary regulatory staff. I suggest to you that it would probably not. There are all these associated costs that would have to be taken into account and those throw a simple economic model into some difficulty.

  3. Anindya Sen on December 9, 2013 at 4:50 pm said:

    Dear Mr. St. John:
    I must complement you on the your above analysis. I think it’s a good break down of the nuts and bolts of more complicated analysis, and I do like it.

    I will, however, draw your attention to a comment of yours on whether my results are valid given that I have not controlled for other factors.

    Specifically, you state “Think about the fact that you as the OCSA are pitching this fanciful study whose empirical data analysis does not account for demographics or trends in the marketplace and a conclusion section which contains a woefully large number of conditional statements”

    This is incorrect. If you look at my model and estimates closely, you will see that government revenue is in per capita population terms. This controls for demographics. The question is what else would you control for? Note that I have explicitly included per capita alcohol sales as a right hand side variable. This variable essentially controls for all other determinants that might plausibly explain why alcohol consumption is higher in some provinces as opposed to others.

    What is important is the identification that I rely on. My study basically uses British Columbia as the key “treatment province” – or the province that experienced a significant change in alcohol policy through partial privatization. When you do this type of statistical analysis, it Is important to use other treatment provinces, and “control jurisdictions” that represent no change in policy. By doing this you are parsing out unobserved differences that are specific to either treatment or control subjects. This is the type of (difference-in-difference) statistical analysis conducted not only by social scientists, but researchers in the physical sciences as well. It passes a pretty high bar.

    My other treatment jurisdiction Is Alberta in which the retail delivery of alcohol is completely privatized. My “control provinces” are Manitoba and Saskatchewan which during the sample period had government controlled retail delivery.

    Controlling for population differences, differences in alcohol sales, the health of the economy, and other unobservables, results from advanced statistical models demonstrate that some amount of privatization is correlated with an increase in per capita gross income, net income, and government revenue generated by provincial liquor authorities. Specifically, the econometric analyses reveals that increased competition is significantly associated with roughly a 5% and 9% increase in net and gross per capita income relative to liquor authorities in provinces with primarily government delivery of retail alcohol products.

    There are no conditional statements. No ifs or buts. These are my conclusions from standard statistical models and I stand behind them.

    Finally, you state: “On a final note, consider the main precept of the OCSA model: additional sales. Additional sales mean additional consumption. If the core tenet of your model hands your opponent a social responsibility argument to beat you about the head with, you can’t be surprised when you lose.”

    But isn’t the provincial government itself encouraging consumption through the opening of more LCBO outlets? So if that’s the case where’s the social responsibility? Is it of lower value relative to more LCBO profits, which the government terms as “the social transfer”?

    Points to ponder upon.

    Best Wishes

    Anindya Sen

  4. The following reply was sent in by the nice people at Roland and Russell, but for reasons pertaining to the weather kerfuffle, it was not posted but submitted by email.

    We are Roland + Russell, importers of Panil and would like to add to this discussion.

    Just to correct the assumption made by the author, the ex-works price for Panil Enhanced is 97 EUR per case of twelve bottles, which translates into ex-works price of $11.75 per bottle (before agency commission, shipping from Parma, Italy to Ontario and, of course all of the levies and taxes are added up).
    We were at Panil a few summers ago and were quite surprised to see that Panil Bariquee was selling at the brewery’s retail store for more than what it was retailed at the LCBO.

    No one will get Panil Enhanced for ex-works price of $6.50 per bottle, let alone $5.

    The LCBO can be criticized for many things, but their pricing structure is certainly not one.

    Being in this industry for ten years or so, we still cannot comprehend where people get the idea that the LCBO pays more for their products than other importers. The truth is quite contrary and we know this is a fact because we regularly get pricing comparisons from our international suppliers. We even know of many of the products that we represent that cost more just over the border where the taxes are probably lower.

    In doing business with LCBO, a foreign producer essentially deals directly with a large retail chain (with over 600 stores) that is capable of placing large orders – there is zero chance that a small, independent retailer would be able to negotiate a better ex-works price or shipping rates. We would end up with US style system where you have a three tier system of importer/distributor/retailer. Considering our taxation for alcohol, it is not unreasonable to argue that prices would in effect rise by 30% or even more for some products.

    As consumers, we are flabbergasted that the OCSA can at all argue about convenience stores promising to offer better prices for alcohol – all we have to do is to check how they do with milk, eggs, and other products. It is clear that they cannot compete with large chains. Convenience stores fail to offer lower or event the same price for thousands of Ontario made products and it beats any logic to accept the argument they will be able to do so with alcohol drinks.

    OCSA members run businesses that primarily offers convenience to its customers, not better prices or more choice.

    Again, speaking as consumers, we would welcome wine, beer and spirits on the shelves of convenience stores across Ontario but would like see this idea to be presented stripped of unreasonable promises.

    Happy Holidays to you all!

  5. Anindya Sen on December 27, 2013 at 6:12 pm said:

    The OCSA study doesn’t say that the LCBO should be done away with. In fact, it acknowledges the benefits that the LCBO enjoys as an exclusive BUYER. By placing bulk orders and minimizing transactiosn costs, it reduces overheads and can buy products at a lower price. This is obvious. HOWEVER – by being an exclusive SELLER, it is able to reap significant profits at the RETAIL level. The OCSA study suggests that overall profits to all sellers, with some privatization, may actually increase, resulting in higher transfers to the province. The OCSA study does not say anything about getting rid of the LCBO as an exclusive buyer.

  6. Delaney on February 2, 2014 at 9:15 am said:

    The LCBO is the largest buyer of wine spirit etc in the world and as such benefits from better prices and an ability to bring a more diverse product offering to Ontario wine beer and alcohol consumers. If the model is broken up as happened in Alberta, you would get an initial influx of vendors followed by most of them going out of business, with the emergence of fewer, larger vendors, an increase in pricing and a decrease in variety of product. The LCBO is not a bad thing at all. Try shopping in the liquor stores in other provinces (other than Quebec where the sin taxes are lower and tastes tend more toward wine) you will be surprised at the higher prices and lower selection.

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