Coffee, Part 2

So I was grilling the local Starbucks employees today about their prices.

("Watch out," they must be thinking. "Here comes the crazy business professor!")

Anyway, it turns out that the firm raised some prices, kept some the same, and lowered others. The price of a 12-ounce regular coffee fell from 1.65 to 1.50. The 16-ounce coffee rose from 1.80 to 1.90, and the 20-ounce rose from 1.95 to 2.10.

On a per-ounce basis, things work out like this:

Under the old pricing, the first 12 ounces cost 13.75 cents per ounce. Now those ounces cost 12.5 cents per ounce.

Under the old pricing, the next 4 ounces cost 3.75 cents per ounce. Now those ounces cost a whopping 10 cents per ounce.

Under the old pricing, the next 4 ounces cost 3.75 cents per ounce. Now those ounces cost 5 cents per ounce.

This is a really interesting illustration of second-degree price discrimination. For this pricing to make sense, the firm must have decided that the weak economy and increased competition has made consumer demand for the first few ounces more elastic, but made the residual demand curve (that is, the demand for additional ounces past the first 12) less elastic.

It would be cool to know what data the firm used to come to these conclusions, but I think any MBA ought be to able to at least sort out how you'd design an experiment to measure these elasticities.

I also learned that many customers were quite upset by this pricing change. Apparently there was some yelling at employees (who, of course, had nothing whatsoever to do with the decision to raise prices), and more than a few angry phone calls to the district manager.

So I managed to learn some cool economics, even standing in a coffee shop. The whole conversation was nearly as entertaining as the time that two biz-economist friends of mine and I wandered into a shoe store in Maine (long story) and managed to get a really interesting lesson in mystery shopping and performance evaluation in retail.

Coffee Prices Are Making Me Jumpy

Awesome article in the NYT about Starbucks raising coffee prices.

Will the Hard-Core Starbucks Customer Pay More? The Chain Plans to Find Out

Starbucks, facing competition from McDonald's, seems have decided to raise prices.

Wait a minute... don't firms usually offer lower prices when facing competition? What's going on here?

What's going on here is that Starbucks and McDonald's coffee are vertically differentiated. That is, there's a quality difference between the products --- most customers would prefer Starbucks if the prices were the same. The only way that McDonald's can get customers, therefore, is by offering prices that are so low that customers are willing to accept the lower quality.

So which Starbucks customers quit the brand to instead shop at McDonald's, and which stay loyal? The price-sensitive ones and quality-insensitive ones leave... and the price-insensitive and quality-sensitive ones stay.

This means the following: Prior to McD entry, Starbucks is serving both price-sensitive consumers and price-insensitive consumers. It would like to raise prices for the price-insensitive consumers, but doing so would cause the price-sensitive consumers to stop drinking their coffee.

When McDonald's enters, the price-sensitive consumers immediately stop going to Starbucks --- they now have a lower-priced alternative, and they're happy to give up on quality to save on price.

So who's left shopping at Starbucks? Only the price-insensitive consumers! And this means that Starbucks' customer group has, as a whole, become much less sensitive to prices. And when you have price insensitive consumers it makes sense (and cents) to raise prices.

To stuff this back into economics-y jargon... Competition, in this case, has caused Starbucks demand to become less elastic. And less elastic demand translates to higher prices.