Friday, March 30, 2007

The Economics of The Price of Coffee

After oil the most frequently traded commodity in the world is coffee. Coffee is an important export for many developing countries and coffee bars have become increasingly popular as an alternative to the old fashioned pub. Coffee is big business.

The price of coffee can vary hugely. I am currently writing this essay at Café Nero in Blackwells Bookshop Oxford. For a small cappuccino it cost me £1.95. On the one hand this is expensive; especially if you consider the raw materials of coffee and milk cost less than 4p. How do Costa Coffee justify charging such a high profit margin?

1. We are not just paying for the coffee but for the opportunity of sitting in a pleasant environment for up to 1 and half hours. Not only can I spend as long as I want but I can also consult books to help me write essays. (1) From this perspective £2 to stay in a premium location in the centre of town for 1 hours seems quite a good deal.

2. Coffee shops have to deal with low volume. A pint of beer in a pub used to have a low profit margin, but customers would regularly drink several pints. Lower profit margins worked because they were able to sell quantity. Coffee is not the kind of drink where you consume more than 1 or 2. With lower volume coffee shops need a higher profit margin to maintain profitability.

3. Price Discrimination. Like any firm coffee shops are seeking to charge the profit maximising price. Many consumers have a very inelastic demand for coffee. This is because there are few close alternatives to coffee and it is a relatively small % of income. If the coffee had been £3.00 I probably would still have paid it. The challenge for coffee shops is to find a way to charge to more to people like me without putting off customers who are sensitive to price changes.

4. Charging for Extras. This idea of price discrimination can be viewed in more detail by looking at how coffee shops charge for extras. One example is the extra price charged for the “fair trade” version. Fair trade coffee involves paying poor farmers a premium for their coffee. This can help them to gain a decent living. Café direct pay a premium to farmers of about 45p per pound. However to make a cappuccino requires only ¼ an ounce of coffee. Therefore the extra cost should be equal to less than 1p. However most coffee shops charge a premium of at least 10p. (1) This means most of the extra price goes in higher profit to the coffee shops.

However there are many customers who are price insensitive therefore they do not mind paying an extra 10p. In effect they are paying a premium for enjoying coffee with a conscience. From the firms point of view they are grasping consumer surplus from those with inelastic demand.

Other extras on offer at Costa coffee.
5 oz Soya milk (instead of milk) 30p
Decaffeinated 30p
Syrup 40p

(1) Tim Harford The Undercover Economist p33.

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