## I think I volunteered to have myself ripped off(price discriminated)

December 30, 2009 5 Comments

Update: Joshua, who used to work as a Barista told me that Starbucks does not use extra coffee when drinks are upsized. In general a shot of espresso is used to prepare any given drink (unless you pay for extra shots).

The conclusion is still the same, what this means is that the profit margin is understated.

If you are reading this, I am in a grave need of your help. I am in peril…THEY GOT ME! Well actually, if I have time to write a blog post, the reality is, I am physically safe. The only thing damaging to my psyche is…I think I might have volunteered to have myself ripped off.Well maybe ripped off is too strong a word, I volunteered to have myself price discriminated is much more technical and correct.

I like that Seattle-based coffee chain(you know,the one named after a character in Moby Dick), but their marketing strategy is way too clever, that even some economics students will be fooled. This is the problem, when you frequent one of the chains of this Seattle-based coffee company there are myriads of coffees to choose from, with 3 different “sizes” that you can opt for. (Actually there are four, do you know that you have the option of telling the Barista you want it “short”?The “short” sized coffee is around 8OZ at roughly 15% cheaper than the smallest of the 3 size available on the menu.Something to think about for another day.)

The difference between each size of coffee is RM1. The difference between each size of coffee is 4 OZ. A tall sized Frapucinno(12 Oz) costs RM13.50, a grande one (16Oz) RM14.50 and a Venti (20Oz) one RM15.50.

The “rational” ones would go, hey if I wanted a 16Oz Frapucinno, I should pay RM14.50 to get a grande one. The “rationale” is that since RM13.50 buys a cup of 12Oz coffee, then one Oz should cost RM1.125. If one wants 16 Oz of coffee, he is willing to pay RM18. However, now that he can get the same amount of coffee for RM14.50, he has saved RM3.50. Talk about Consumer Surplus! Thanks, Starbucks!

On second thought, did the “rational” guy who saved RM3.50 got himself a “good deal”? First, understand what you drink. So it seems like the drinks are essentially made of the same ingredients, coffee beans, steamed milk (or hand foamed milk, which in essence are still milk), and water. So why is a Capucinno priced differently from a latte? Maybe I am wrong, because a Mocha uses an extra ingredient – chocolate, that is why it is priced differently, right?

The question in, how much “extra” cost is imposed on this coffee chain to add the chocolate to your coffee, and come to think of it, how much extra coffee beans must they use to add in the extra 4Oz of coffee to your grande sized order? This is when the math comes in.

The cost for your cup of coffee has two components, the fixed cost and the variable cost.

Total cost for a given cup = fixed cost+variable cost.

The fixed cost includes the premium for the rental of the shop, and maybe the allowance for depreciation of the capital goods (blender, fridge,etc). The employees work across shifts as the shop has a standard operating hour, so I consider the wages to be a form of “fixed” cost.

The variable cost on the other hand is of course chiefly the price of the ingredients, from coffee, to milk and sugar and utility bill.

As the name suggests, the fixed cost is constant. The variable cost on the other hand, changes. If you order a venti sized coffee, then it costs Starbucks just a little bit more of coffee beans, water,sugar and milk to produce your drink.

If we ASSUME the fixed cost for a given cup of coffee to be RM5 and the marginal “variable” cost for each additional 4 Oz of ingredients,including coffee,milk,water and chocolate to be RM0.15, then the function for the differently sized coffees are

Tall: RM5+3(RM0.15)

Grande: RM5 +4(RM0.15)

Venti: RM5+ 5(RM0.15)

So the cost of one the respective coffees are

Tall: RM5.45

Grande: RM5.60

Venti: RM 5.75

So the profit for selling the different sizes of coffee are

Tall: RM8.05 (RM13.50-RM5.45)

Grande: RM8.90 (RM14.50-RM5.60)

Venti: RM9.75 (RM15.50-RM5.75)

The profit margin (Profit/Retail Price) sheds light on how much are consumers who order differently sized coffee charged differently adjusted for the size of the coffee they order.

If A orders a Tall Coffee, the profit margin for the coffee shop for that transaction is 59.63%.

When B orders a Grande Coffee, the profit margin for the coffee shop for that transaction is 61.38%.

When C orders a Venti Coffee, the profit margin for the coffee shop for that transaction is 62.90%.

So why am I made to pay more,adjusted to the size of my order compared to another consumer who ordered differently?

In short, the coffee shop makes more profit from me compared to the next guy who ordered a size or two sizes smaller than my venti coffee. (In other words, it also means that for every additional RM1 I spend to upsize my drink, the coffee shop makes an additional RM0.85).

Thoughts:

First of all, I wasn’t forced to buy the coffee anyway (actually I bought two blended drinks in one go, a Toffee Nut Frap and a Chocolate Cream Chip, both Ventis). The truth is, I enjoyed the coffee and I value my experience in the coffee shop to be much more higher than the money I paid (Nice view, relaxing, great ventilation,using the WiFi to check my university application and so on). Since this transaction is a non-zero sum game, I think I have made a net gain (sort of) from it.

Secondly, the marketing strategy of this chain is amazing, talk about the wonderful and stealthy application of price discrimination, I believe the profit margin could have been higher for some “special drinks” – Mocha for instance. That said, I think it will be correct to attribute the exploration of this topic to the Undercover Economist – Tim Harford though I haven’t read his book. (I think it was Hobart who introduced this book to me when I was 16).

Thirdly, the fact that the profit margin the coffee chain for someone who orders a larger sized or more “special” drink compared to another who doesn’t does not mean that the coffee chain is evil. It is pretty pragmatic in making people who want to pay more to pay more and vice versa. (There is always the short option).

Finally, the fact that I have ordered 2 Ventis in a go suggests I have a long long way to go to financial prudence. Just in case any family member or relative is reading this, I was verifying the Law of Diminishing Marginal Utility.