By Dylan Mortimore
Despite my degree supposedly equipping me with the economic insights of Smith, Keynes, Pigou & friends, the market for coffee has always troubled me.
To provide some context, my confusion first began when I noticed the sheer number of outlets serving coffee in Brisbane’s CBD. In particular, I looked to compare the price of a 12oz (regular) flat white at various institutions. The prices between cafes seemed to be fairly consistent (around $4.80 across the board, which seemed pretty high for a 250ml beverage). Economic theory would suggest that there are two possible explanations for this:
- The market is competitive, all firms have an identical cost structure, and the marginal cost of producing a 12oz flat white is indeed $4.80; or
- The cafes are engaging in collusive practices and have agreed to ‘fix’ the market price at $4.80 (above their marginal cost) to extract maximum rents from unknowing consumers
However, both possibilities were swiftly debunked when I discovered that all 7-Eleven outlets were selling a regular flat white for $2.
Seeing that this represented a substantial discount to other retailers in the area, my ECON3440 knowledge told me that all consumers would purchase their coffee from the 7-Eleven. As a result, all the cafes would be completely unprofitable and have no choice but to exit the market immediately, leaving the most efficient operator with a monopoly. Then I turned up the next day and was utterly flabbergasted to see that all the cafes were still in operation – and they had customers.
As it turns out, my first mistake was (incorrectly) assuming that coffee retailers are producing a homogeneous product; any connoisseur would tell you that not all coffees are the same. In fact, they would probably assert that consuming a $2 flat white from the 7-Eleven actively destroys their utility. Flavour, texture and aftertaste are all sources of differentiation. This is the intuitive demand-side explanation for variation in coffee prices: individuals are willing to pay a premium for coffee that is better, as per their preferences. However, pursuing differentiation also affects the marginal cost that each producer faces: using higher-quality beans or a different brand of milk are ways to achieve this differentiation. These are the more obvious factors that affect observed coffee prices. Despite this, coffee supply actually tends to be fairly unresponsive to volatility in related commodity prices. For example, 2017 saw record-high production of Arabica coffee beans, but the observed price of takeaway coffee increased throughout the year (Featherstone, 2017).
Where the market becomes particularly interesting, however, is in the more subtle elements of consumer preferences that allow cafes to charge prices which my non-coffee drinking friends consider absurd. These factors are well-explained by so-called ‘coffee economist’ Wayne Fowler, whose company produces the ‘Cappuccino Price Index’. It is Fowler’s argument that only 35% of the purchase price can be attributed to the coffee that actually goes into the cup. Instead, what many people pay for is an experience: a person who sits in a café and has a conversation with a friend over coffee may see that coffee as more valuable than someone who simply picks it up on the way into work (Iliffe & Halpin, 2016).
This also highlights the additional value people derive from drinking coffee in a social setting. Taste aside, it is conceivable that individuals prefer the experience of meeting for a $4.80 barista-made coffee, as opposed to the $2 alternative from the 7-Eleven. Perhaps this characterisation of consumer preferences makes the most sense in the context of corporate coffee culture – for example, a BAFE student engaging in the practice of ‘networking’ would not elect to meet with their prospective employers for a $2 flat white at the Edward Street 7-Eleven.
It is such factors which have no doubt enabled the price of a 12oz flat white to ascend into the $4.50+ realm – and remain there for what seems like quite some time. The question is how such pricing will evolve into the future. With drinking coffee possessing such ingrained cultural significance, the good is more of a staple than a discretionary purchase for those who consume it. In this sense, demand is somewhat inelastic. Interestingly, experts in the field suggested in 2017 that $5 would represent an ‘upper limit’ for the price of a cup of coffee, a threshold beyond which the purchase is no longer a matter of mere ‘loose change’ (Featherstone, 2017).
I’ve certainly seen this threshold surpassed in recent times – particularly by beverages that are of the ‘iced’ variety…
Are coffee drinkers forgoing their chance to buy a house, or is it OK to pay more than $5 a cup? UQES Publications welcomes reader correspondence on our articles. If you wish to reply to points raised, or believe a perspective has been missed, feel free to send respectful responses to email@example.com. We will endeavour to publish correspondence in subsequent articles.
Featherstone, T. (2017, July 6). Would you pay $5 for a cup of coffee? Sydney Morning Herald
Iliffe, D., & Halpin, T. (2016, April 1). The economics of a cup of coffee: how much are you willing to pay? ABC News