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

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).

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.


The Wan Tan Mee Uncle presents : A lecture in the application of the Law of Diminishing Marginal Utility in Business

My father, being a street-food connoisseur (an informal one at that), has his fair share of stories involving famous street hawkers. As the story goes, there is a Wan Tan Mee uncle who refuses to sell individual customers more than 4 “sui kaos” (dumplings) at a time. Of course, not all customers are chuffed, and some are grudgingly tolerating the apparent “arrogance” of the uncle.

On a very superficial observation, it seems like the uncle is acting in a very irrational manner, if people want as much dumpings as they want, then he should supply as much dumplings as demanded right? After all, Revenue = Price x Quantity, and since Price is fixed, then he should strive to maximise his profit by increasing the quantity sold.

It turns out that the Wan Tan Mee uncle, like the proverbial Kung Fu Masters you watch on TV, knows what he is doing. Better yet, he is an expert in what he is doing. My dad’s friend, amused (or maybe annoyed) with the antics of this uncle, asked him about the “quota” for customers. The wise uncle explained that he did not (and still does not) want his customers to feel “sickened” by the food as a result of having too much of it.

Unintentionally, the Uncle has applied a Microeconomics Principle – The Law of Diminshing Marginal Utilities. Sui Kows are normally a side dish to Wan Tan Mee, so the “usefulness” as in satiating your hunger is not really that much. However, it derives its utility from “satisfaction.” So you gain quite a sum of utility from your first Sui Kow. Assuming that the “usefulness” of the Sui Kow is fixed in terms of satiating hunger, then the “extra” or marginal utility from consuming another Sui Kow stems from your satisfaction. The problem is, you derive less satisfaction from consuming more Sui Kows.

Algebraically, the satisfaction you get from consuming an additional sui kow(for example) is
S(x) = 1 – 0.05(x)
Where X is the number of Sui Kows you consume and S(x) is your marginal utility for consuming one additional unit of Sui Kow.
So by the time you consume 2o sui kows, your marginal utility (for satisfaction) is 0. Any more than that, and you have a negative “satisfaction” (This is when you start hating Sui Kows).

So ultimately, it seems like the uncle is not being irrational after all. He is a competent entrepreneur who applies Microeconomics Principle well.

P/S: The satisfaction model is constructed on the basis that “usefulness” and “satisfaction” under the concept of Utility are mutually exclusive.(When satisfaction increases, usefulness decreases. Case in point: Do you really need 10 pairs of high heels?) That means P(U) + P(S) = 1. Hence to get the function of satisfaction, simple algebra will give you P(s) = 1 – P(U).
Of course, not everybody’s “full” threshold (capacity for food) is same, it varies among individuals. Still, the conclusion is the same. I.E. in mathematical terms, the satisfaction function is a family of function with infinite number of members.

Let’s play Monopoly..in a bigger scale?

I think, no word in Economics could have invoked more fear, outrage and rare enough, a consensus among Economists that its existence is detrimental than MONOPOLY. Those who have taken the Principles of Microeconomics of the “dismal science,” can easily tell you that Monopolies offer lower total utility(or a negative one) to the community and is a form of market failure. (Unless of course, if it is a form of natural monopoly, in which this will be regarded as much more “desirable).

P/S Bear with the unless of course, on the other hand, and sentences like then again…this is a perennial trait of economists or would be economists.

Firms can morph into a monopoly, and governments around the world have enacted laws to safeguard or enforce market competition and to prevent monopoly. The spirit of competition laws then is to preserve market competition (again, in the exception of natural monopolies, though the shift of paradigm might change this).

So if governments around the world share the consensus that market competition should be safeguarded or enforced for the benefits of all, is it safe to conjecture that the same notion should be enforced in the global level? China is gradually morphing into the equivalent of a monopolistic player in the global arena source , and its unbridled growing capacity is creating a great sense of unease.

Will China’s rise be detrimental to everybody else? There seems to be no spillover effect to some of its neighbours, and rising negative sentiments from disenchanted neighbours and other nations are starting to jeopardise the growth brought about by China’s export oriented model. With the demise of free-spending American consumers, China is finding it increasingly difficult to sustain this promising double digit economic growth. Factoring in its weak domestic consumption, a net flow of jobs towards a region where most of the population in its vast rural areas are incapable of spending on items that aremore than necessary, what we see is a bleak picture for all the players involved in free trade. (This argument is not new, for those who have read my essays, papers or attended the seminar in class where my partner and I presented on the topic of globalisation and outsourcing).

So back to the ultimate question, should the WTO, the body “overseeing” international trade, introduce the equivalent of competition laws to safeguard and enforce competition among nations in the global arena, in view of China’s monopolistic dominance? I could foresee some arguments against such a move, and it will mostly be based upon the logic that the reason why China is able to dominate is because of its comparative or absolute advantage in producing what the world needs. My response is : Really? Just how much of China’s growth is because of relative factor endownment(the abundance of natural resources) or relative factor intensity( the availability of necessary infrastructure and labour with skills to keep it easy)? True, the aforementioned factors played a huge role, the question is do these factors play a bigger role or is it more because it is a bubble fueled by an artificially and forefully devalued currency? I reject the notion that China is the country that has the comparative or absolute advantage in producing everything (this is a truism).

Hopefully, the question on whether or not to introduce the equivalent of an international competition law provides motivation to study this issue in international trade and to enhance global and public discourse on China’s monopoly.