I'm currently reading Tim Harford's excellent The Undercover Economist. I particularly enjoyed the second chapter--the one dealing with price discrimination as well as product differentiation.
He begins the chapter with a wonderful anecdote--one that makes you wonder how much of the premium price you might be paying for a cup of Fair Trade coffee is actually getting to the poor coffee grower you hope you are helping. In one case, Mr. Harford estimates that over 90 percent of the Fair Trade premium was mysteriously being "lost" between the retailer and the grower.
Since Mr. Harford writes regularly for the Financial Times, they printed this excerpt:
On a sunny day in London you can purchase a cappuccino and sip away as the capsules on the Eye, the capital’s landmark Ferris wheel, rotate high above you, occasionally passing between you and the sun... one of life’s simple pleasures. Everywhere you look around the Eye you can see vendors with scarce resources, trying to exploit that scarcity. There is only one coffee bar in the immediate area, for instance. There is also a lone souvenir shop doing brisk business. But the most obvious example is the London Eye itself. It towers over the majority of London’s most famous buildings and is the world’s largest observation wheel. The scarcity power is clearly considerable, but it is not unlimited: the Eye may be unique, but it is also optional. People can always choose not to go on it.
Further along the river, the Millennium Dome is similarly unique, “the largest fabric structure in the world”, boasts the local authority. Yet the Dome has proved a commercial disaster because uniqueness alone wasn’t enough to persuade people to pay enough to cover the vast costs of its construction. Business with scarcity power cannot force us to pay unlimited prices for their products, but they can choose from a variety of strategies to make us pay more. It’s time for the Undercover Economist to get to work and find out more.
The only coffee provider beside the London Eye wields plenty of scarcity power over the customer. It’s not innate, but is reflected glory from the amazing setting. As we know, because customers will pay high prices for coffee in attractive locations, the coffee bar’s rent will be high. Their landlords have rented out some of this scarcity value to a coffee bar, just like the owners of Manhattan’s skyscrapers, or railway stations from Waterloo to Shinjuku. Scarcity is for rent - at the right price.
But how should the bar’s managers exploit the scarcity they are renting from the London Eye? They could simply raise the price of a cappuccino from £1.75 to £3. Some people would pay it, but many would not. Alternatively, they could cut prices and sell much more coffee. They could cover wages and ingredients by charging as little as 60p a cup. But unless they were able to increase their sales dozens of times over, they’d not make enough to cover their rent. That’s the dilemma: higher margins per cup, but fewer cups; or lower margins on more cups.
It would be nice to side-step that dilemma, by charging 60p to people who are not willing to pay more and £3 to people who are willing to pay a lot to enjoy the coffee and the view. That way they would have the high margins whenever they could get them, and still sell coffee at a small profit to the skinflints. How to do it, though? Have a price list saying, “Cappuccino, £3, unless you’re only willing to pay 60p”?
It does have a certain something, but I doubt it would catch on with the coffee-buying public of London’s South Bank. However, for years, the previous incumbent coffee bar, Costa Coffee, appeared to have achieved this. Costa, like most other coffee bars these days, offers “Fair Trade” coffee - theirs comes from a leading fair trade brand called Cafedirect. Cafedirect promises to offer good prices to coffee farmers in poor countries. Fair trade coffee associations make a promise to the producer, not the consumer. If you buy fair trade coffee, you are guaranteed that the producer will receive a good price. But there is no guarantee that you will receive a good price. For several years, customers who wished to support third-world farmers - and such customers are apparently not uncommon in London - were charged an extra 10p. They may have believed that the 10p went to the struggling coffee farmer. Almost none of it did.
Cafedirect paid farmers a premium of between 40p and 55p per pound of coffee, and that premium was reflected in the price they charged to Costa. That relatively small premium can nearly double the income of a farmer in Guatemala, where the average income is less that $2,000 a year. But since the typical cappuccino is made with just a quarter-ounce of coffee beans, the premium paid to the farmer should translate into a cost increase of less than a penny a cup.
Of the extra money that Costa charged, more than 90 per cent did not reach the farmer. Cafedirect did not benefit, so unless using the fair trade coffee somehow increased Costa’s costs hugely, the money was being added to profits. The truth is that fair trade coffee wholesalers could pay two, three or sometimes four times the market price for coffee in the developing world without adding anything noticeable to the production cost of a cappuccino. Because coffee beans make up such a small proportion of that cost customers might have concluded that the extra 10p was to cover the cost of the fair trade coffee, but they would have been wrong. A certain Undercover Economist made some inquiries and found that Costa worked out that the whole business gave the wrong impression, and at the end of 2004 began to offer fair trade coffee on request, without a price premium.
But why had it been profitable to charge a higher mark-up on fair trade coffee than on normal coffee? Because fair trade coffee allowed Costa to find customers who were willing to pay a bit more if given a reason to do so. By ordering a fair trade cappuccino, you sent two messages to Costa. The first was: “I think that fair trade coffee is a product that should be supported.” The second was: “I don’t really mind paying a bit extra.” Socially concerned citizens tend to be less careful with their cash in coffee bars, while unconcerned citizens tend to keep their eyes on the price. Perhaps another price list saying, “Cappuccino for the concerned £1.85. Cappuccino for the unconcerned £1.75”?