Coffee?

When Starbucks first appeared on these shores, (on the King’s Road,1988) they were hailed as the murderers of the independent coffee shop. The plan to open 4000 stores worldwide (30,000 it turns out) was seen as the death knell for what had been the preserve of the independent, mostly Italian coffee shops that arrived with Italians after WW2. With Starbucks’ Economies of Scale (the ability to purchase ingredients and materials at huge discount, the ability to negotiate lower rents than the sole trader) and with their marketing spend that allowed them to reach out across the globe, how could the local independent cafe survive? Their ability to compete with the tall frappuccinos and grande lattes was found wanting. Quite aside from the new language of coffee, their interiors and sometimes brusque service couldn’t compete with the apparently glamorous Seattle cup.

Indeed the number of small, coffee shops did indeed fall in the early years of Starbucks growth. But at the same time, we saw the emergence of Cafe Nero (1997) and Costa Coffee (now the UK’s largest and most visited chain). This was seen by some as the end of the sole trader: large corporate chains charging £3 + for coffee and froth seemed to be very popular.

But look what has happened since. If you look around your own local high street, you might notice the re-emergence of the smarter, trendier, shiny new independent coffee shops and they are doing a brisk trade.

My local coffee shop serves beetroot latte

How has this happened? First, Starbucks and co have actually increased our taste for good coffee. Over the last few years we have demanded stronger, smoother coffee with a good independent vibe. Now 35.9m people use coffee shops in the UK and our taste for coffee has created space for more coffee shops, not less. Topic: Cafés and coffee shops in the United Kingdom (UK)

Second, we can understand the market for coffee shops using a model called Monopolistic Competition. In this model there are lots and lots of firms making a given type of product — so it is competitive — but that each firm makes a product that is slightly different from everyone else’s, so there is an element monopoly too. Hence the name! Each firm is a monopoly provider of its own particular brand of product and because of this consumers will be loyal to that product if they value those particular features. You can see how this applies to coffee shops. Yes all coffee shops are basically the same — they sell coffee. But they are also all different in subtle ways that we appreciate. We each prefer one coffee shop over another: it does good vegan cakes; it has friendly staff; the décor matches our sense of style and so on. All coffee shops are NOT the same — there is differentiation between them. And because they are different there is Brand Loyalty among consumers. This means that if a coffee shop raises its price for a flat white by 10p above that of its rivals its demand will fall, as some people will go elsewhere, but it will not fall to zero as customers who are loyal to the staff, taste, décor etc will be prepared to pay the extra price. And so we do find in our towns that the price of coffee does vary, and we are not surprised if the hipster vegan artisan coffee shop charges just that bit more than everyone else.

It is also very easy for firms to enter and leave this industry. We say there are low barriers to entry and exit. Does this fit coffee shops? Absolutely. A vacant store can be quickly and cheaply converted to selling coffee — especially as coffee machines can be hired. And if things go badly the shop can close just as easily too!

The model predicts that most coffee shops will just about break even. That means they can pay their rent, their staff, their suppliers, and make a reasonable profit for their owners. But that’s about it. The reason is ease of entry. Imagine that a coffee shop hits on some winning formula, some special coffee-chocolate fusion drink; (mine sells prosecco too). At first custom booms and they make lots of profits. But what happens next? Obviously other firms want to copy the new product and new coffee shops enter the town in the hope of making high profits. What is the result? Demand for the initiating firm declines, there is downward pressure on price, and soon profits are back at the normal level they began with. Quite simply: no matter how many coffee shops in our town centres, there is always the prospect of setting up and cornering a part of the market and maybe making a high profit for a little while. But it won’t last: more and more coffee shops crowd in, demand is spread more thinly, and everyone is just about breaking even. And Starbucks themselves will tell you — they don’t make a profit in the UK.

What happens can be illustrated in the following diagrams. The first diagram shows a coffee shop that is doing well in a particular town. It faces a downward sloping demand curve for its product (when it raises price demand falls and vice versa) and like all profit maximising firms it produces where the extra cost of the last unit produced (MC) equals the extra revenue it brings in (MR). So its output is Q1, and the price of its coffee P1. Since price P1 is above Average Cost, the coffee shop is making a Super Normal Profit shown by the shaded area.

Figure 1 — short run super normal profits

Figure 1. The Short-Term Profit Maximising Output of the Firm

Alas these profits are like honey to a bee. Soon other coffee shops will enter the town hoping to do equally well. As they enter there will be more competition for customers and the existing firms will find some of their customers being drawn away. The result, for our firm, will be that the demand curve it faces for its product will shift inwards — it will sell less at any given price. This continues until the Super Normal Profits are competed away and Average Revenue equals Long Run Average Costs (AR=LRAC). This equilibrium for the firm is shown in Figure 2.

Figure 2 — long run normal profit

As will be seen, at output OQ2 the firm is profit maximising as LRMC=MR. It is making only Normal Profits at this output as AR(P)=LRAC. This means that each coffee shop is just about breaking even. If a shop really DID prosper then the model of Monopolistic Competition tells us new firms will enter and the high profits will be competed away. And this is why there are so many coffee shops on our highstreets. Time for a coffee break!

Passionate about using economics to understand the everyday https://www.facebook.com/Everyday-Economics-104573444978165