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Sunday, December 19, 2004

The Vodka Pipeline, and other methods of Vodka Arbitrage

    Posted by Adam Crouch

Source: BBC
Tariffs artificially raise the price of imported goods. If the tariffs are large enough, there can be a big incentive to smuggle otherwise legal goods, in order to evade the tariff and sell the goods at a lower price.

An example: Pakistan's high tariffs and predominantly poor population has led to a massive flow of smuggled goods from Afghanistan. Rather than paying exorbitant prices for a TV, many people will make a trip to the Smugglers' Bazaar on the outskirts of Peshawar, not far from the border with Afghanistan. The scale of this trade is staggering -- US$2.5 billion per year, making up 40% of income generated in Pakistan's NorthWest Frontier Province and tribal areas, and employing tens of thousands of people.

Another example: Cigarette smuggling between states in the US. Smugglers will buy a large volume of cigarettes in states with low tobacco taxes, like Virginia and North Carolina, and resell them in states with high tobacco taxes, like New York and New Jersey. It may seem like cigarette taxes aren't large enough to make it worth the trouble, but a carton of cigarettes that sells for $75 in New York City will only cost $20 in Virginia. Cigarette smuggling has gotten a decent amount of coverage recently, since it has been uncovered that some smugglers funnel the profits to Al Qaeda and Hezbollah.

But the most fascinating case of smuggling legal goods to evade tariffs/taxes is this:

Border guards have unearthed a 3km pipeline used for smuggling liquor from neighbouring Belarus where it can be purchased much more cheaply.
The thin pipe ran just a few centimetres beneath the ground, under several roads and a riverbed, and ended next to a Lithuanian's private home in the village of Eisiskiai.

The AP reports that:

It's the fourth such pipeline discovered since 2002 and the longest.

Vodka, which is much cheaper in Belarus, is constantly being smuggled across the border and distributed in mostly rural areas.

A small bottle of legally imported vodka costs about 16 euros ($US28), but homemade vodka smuggled from Belarus typically sells for 4 euros (US$7) a bottle.

This is a recent phenomenon for Lithuania. When Lithuania joined the EU in May 2004, part of the package was, of course, accepting the EU's trade policy.

(via The Econoclast)

On the subject of Vodka Arbitrage:

Vodka is typically filtered using carbon or charcoal. It removes many of the impurities, and makes it "smoother". When you see "triple-distilled" on a bottle, that's what they're referring to.

Vodka isn't the only thing that carbon is used to filter, however. Water filters from companies like Brita also use carbon.

It seems inevitable that some enterprising alcoholics would put two and two together, and try to filter cheap vodka using a Brita water filter. The result was surprisingly good:

Coming into this experiment, I had some doubts as to the methodology as well as the subjective manner in which the results would be judged, not to mention a healthy distrust for anyone who would voluntarily drink Vladimir vodka warm and straight.

Amazingly, though, after the 4th filtration, I came to a startling conclusion: The Filtered vodka tasted better than the control fluid (Ketel One). It was smoother, and had a very delicate aftertaste. Of course, people may claim that it is the aftertaste that is what really gives vodka its flavor, but if you're drinking Vladimir, I certainly hope you weren't drinking it for taste!

Concerns about their methodology are addressed here.

They performed this experiment on Vladimir Vodka, which was the absolute cheapest vodka they could find. They don't specify how much it costs, simply saying this:

Vladimir is a steal. It is, however, painful to drink, has a repugnant aftertaste, and posesses a bouquet reminiscent of rubbing alcohol.

To an economist, this is very surprising. If it is very cheap and easy to turn bad vodka into good vodka, why don't more vodka producers do it? Why sell bad vodka for $3, when you can sell good vodka for $4, and presumably see huge sales? (The $1 cost differential is completely ungrounded, but it feels like a reasonable estimate)

One answer is that many customers want to buy the absolute cheapest vodka possible, without regard to taste, because they will be using it for mixed drinks, where the taste of cheap liquor may be masked. These customers would actually rather buy the bad vodka for $3, even if they could buy good vodka for only a dollar more.

You would expect to see some $4 premium vodkas, however. There would be no room for a marketing budget, and so consumers might doubt a $4 bottle of vodka that claimed to be "premium". But "Two Buck Chuck" proved that a good product at an ultra-ultra-low price will create more than enough buzz. And that's for wine: a product where price is seen as a quality signal more strongly than for almost any other product.

Is there a "Virgin Vodka" in the works? :)

(Update: Apparently Richard Branson has been there, done that. Virgin Vodka was released in 1996, and there was even "Virgin Vodka Flyer", an alcoholic energy drink. Ultimately it was shut down, because "the market was seen to be too price-sensitive. A move towards commodity status was seen as detrimental to the Virgin brand as a whole, not just the vodka.")

But as a consumer, does it pay for you to do your own filtration, if you want a premium vodka without the price?

They report the price of their "control" vodka, Ketel One, as US$11.09 for a 1.75 litre bottle. So you'd want to keep the cost under $11.

My guesstimate of how much a rock-bottom bottle of vodka costs is $3. A Brita water filter costs $5 (assuming that you already have the pitcher that it goes into, making the pitcher price a sunk cost).

The authors of the "study" believe that a filter is only good for one bottle, though they have not proven this. If that's the case, then you can produce $11 vodka for $8, pocketing the $3 and whatever utility you get from having pulled off such a scheme.

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