Two weeks ago a 6.0 earthquake hit Napa Valley, the California region famous for making red wine. On Saturday morning the Wall Street Journal published an article stating “About 120 wineries in Napa Valley suffered an estimated $50 million in damage from the magnitude 6.0 earthquake.” This $50 million figure is wrong.
Understanding supply and demand curves, found in chapter 3 of my textbook, shows the value of the wine destroyed by the earthquake will be overstated, even if every winery is trying to be completely honest. The reason the value is wrong is seen in the two pictures below. Both of these pictures show supply and demand graphs with numbers that I made up to explain the situation simply.
Before the earthquake we will assume Napa wineries were selling 15 million bottles a year at $20 each. Before the earthquake the wineries were going to earn $300 million (15 million bottles X $20 per bottle).
The earthquake smashed bottles and broke open barrels of delicious wine. Let’s assume that about 1/3 of all the Napa wine being held in storage (about 5 million bottles) was lost. The wine makers and winery owners have to file insurance claims now and also tell eager reporters the value of what was destroyed. Using the numbers in the above figures they will truthfully file claims for losing 5 million bottles of wine, that they could have sold for $20 a bottle. They will state they lost $100 million, which is a large amount of money.
This loss of good wine made me sad because with less Napa wine available, I know the price will soon go up. The next picture shows that the destruction of good Napa wine shifts the supply curve left by reducing the number of bottles being sold from 15 million to 10 million bottles. With less wine available the price rises from $20 per bottle to $30 per bottle.
Before the earthquake the wineries were expecting to earn $300 million (15 million bottles X $20 per bottle). However, after the earthquake the wineries earn the same $300 million (10 million bottles X $30 per bottle) because even though they are selling less, they are selling it for a much higher price. The actual loss in this example is zero, even though the wineries are honest and claim a $100 million loss immediately after the quake.
In the above picture the wine’s price rises to $30 per bottle. If the price rises, but not as much as shown above the wineries will make a loss. However, even if the price rises just a little the wineries’ loss is less than what appears on the insurance claims and is reported by the media. For example, if the price rises to $25 per bottle, wineries earn $250 million (10 million bottles X $25 per bottle), which is a loss of $50 million, just half of what was expected.
It is possible, though not likely, that the earthquake could even make wineries better off financially. This situation arises if the price of the wine jumps beyond $30 per bottle. For example, if the price rises to $35 per bottle then the wineries actually make $50 million more in sales because of the earthquake’s destruction, than if the quake never happened.
Loss figures based on the current retail price are only accurate if the price of Napa wine does not change. Having purchased Napa wines for many years, I find the idea that prices will not change unrealistic. In the past changes in harvest size caused by weather have often caused large price swings. The upshot is that Napa wine will be more expensive soon. While consumers will not be happy the higher prices ensures wineries will not incur as harsh an economic fallout from the earthquake as is currently being reported.