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Case 1

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Coffee: “Buy Low and Sell High”

In 2000, overproduction in the international coffee market caused the price of coffee to drop below production costs. In December 2001, coffee prices reached a low of 41.5 cents per pound, the lowest price in more than 30 years. Farmers in countries such as Angola, Honduras, Sri Lanka, and Zimbabwe even stopped tending their coffee trees in an effort to save on spending for fertilizer and maintenance. Part of the problem was the usual cyclical swings in price caused by the movements of supply and demand. Recall our discussion of the short- and long-run movements in price. In response to a high price, supply increases. There is often a tendency for supply to overshift to the right, causing prices to plummet. The “long-run adjustment” of supply with demand is rarely, if ever, as smooth as depicted in textbook diagrams. With coffee prices so low, it is believed that consumers would benefit with a lower price for a cup of coffee. However, as readers well know, not all cups of coffee are created equal. While coffee prices kept falling, specialty coffee retailers such as Starbucks were charging its customers $3.50 for a “tall skinny latte.” Despite the fact that Starbucks is usually located in high-rent areas, we can imagine that the markup on these specialty drinks, given the wholesale price of coffee, definitely helps pay the rent and more. This shows that, although the wholesale market for coffee may be subject to the vagaries of shifting supply and demand, the retail market provides a better opportunity for sellers to exert market power by catering to the tastes and preferences of those who prefer a higher-quality product and are willing to pay for it. Starbucks is a company that until now has played with the forces of supply, demand, and market power like a virtuoso: It buys low in the depressed wholesale market and sells high in the differentiated specialty retail market.

In mid-2004, wholesale prices started to move upward, increasing by about 30 percent between May and June. The effects of the farmers who had stopped or reduced production due to low prices had started to make an impact on the market.

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(Imagine a leftward “long-run” shift in the supply curve.) There was also a drought and unusually low temperatures in Brazil, the world’s largest coffee producer.1° (Imagine a leftward “short-run” shift in the supply curve.) Big coffee sellers, unlike Starbucks and other specialty retailers, had not been able to raise prices during the past 4 or 5 years because of the overall depressed market for coffee beans. Now the cost pressures from the higher price of wholesale beans have finally enabled them to justify the raising of their prices to restaurants and other away-from-home customers. What will consumers do in the face of rising prices for nonspecialty coffee. As is explained in great detail in chapter 4, the demand for coffee is considered to be relative inelastic. Therefore, industry analysts expect coffee drinkers to consume about the same amount as they always have. As a 10- cup-per-day consumer interviewed by a newspaper reporter stated, “I hate that the price might go up, but I got to have my coffee.”11 Interestingly enough, Starbucks actually welcomes the higher wholesale price of coffee. As explained by its CEO, Rin Smith, “We are paying higher prices for coffee, which we think is a good thing. One of the consequences of the low prices is that a lot of farmers have gone out of business and that threatens our long-run [emphasis added] supply.” This statement shows that sometimes continuity of supply can be as important as the purchase price. If higher coffee prices help keep coffee farmers in business, then buyers like Starbucks are willing to pay the higher price. Moreover, as stated earlier, differentiated sellers such as Starbucks are in even better positions to raise the price than the processors who sell coffee to restaurants. In fact, in September 2004, Starbucks announced that it was raising the average price of its beverages by 11 cents, citing “increases in the cost of coffee and sugar