Wednesday, January 6, 2010

Why does coffee at a coffee shop cost so much?

My favorite popular economics writer-- Tim Harford -- discusses this topic in Chapter 1 of his book The Undercover Economist.* I have to admit that I do not own The Undercover Economist, but I read most of it in a Barnes and Noble coffee shop (a strategy I suggest if you like reading hardcover books, but find them more expensive than a cup of coffee).

Back to coffee: Coffee is not that expensive to make on your own. For example, we buy the Costco brand of coffee in the three-pound can. The can costs about $10, and it lasts about 2 months. That's for 60, strong 20-24 ounce cups of coffee. Or, about $0.16 per cup. Of course, there are other costs: milk, cream, the electricity to heat it up, and the time it takes to make the cup of coffee.

But, the cost of the other ingredients is negligible, and if you make coffee as part of a routine in the morning, the time cost is also negligible (or close to it if the alternative use of time is finding the coffee shop and waiting in line). Let's double our previous price to account for these other costs. Therefore, the cup of coffee costs around $0.32.

You would be hard pressed to find a coffee shop that will charge close to $0.32. For a regular cup of Joe, most coffee shops will charge at least five times that. Harford's point in Chapter 1 is that coffee shops are usually placed at very convenient locations, and most of what they charge is a convenience fee (Harford goes on to pinpoint who really gains from the coffee shops presence -- the owners of the location).

In my case, if I pay $1.50 for a cup of coffee at my favorite place (the actual price), I am paying the coffee shop $1.18 for the convenience of not having to walk home (or pack a thermos). That makes sense... and I am glad there is a coffee shop to cater to my convenience. I pay the price happily.

Moreover, the coffee cost story tells a general point about the food industry. That is, most of what we pay for food in the United States is a convenience fee. That's obviously true at McDonalds or Subway, but there's a significant convenience fee even when you shop at the grocery store.

That convenience is in the price even for my $0.32 cup of coffee. Before the advent of sealed coffee cans, ground coffee was not feasible in 3 pound containers (most would lose its flavor). Indeed, the convenience of making my coffee at home is because of this innovation, and I am willing to pay for my coffee to come in a sealed can. I imagine that others feel the same way. Accordingly, it becomes part of the price I pay. At the grocery store, you could tell the story for spinach, milk, ground beef, Lean Pockets, or any product you like (though it is easier to tell the story for Lean Pockets). They all come bundled with some convenience.

That's just something to think about the next time you head to the coffee shop (or grocery store). It's also something to be thankful for. If you're not thankful for this convenience, just consider the alternative (walking home to brew some coffee). In an era where some Americans complain about high prices, we have a saving grace: convenience is cheap.

*The Undercover Economist is not to be confused with Dear Undercover Economist, one of my Christmas gifts this year.

5 comments:

  1. Nice thought. What's your take on the argument that coffee shops charge high prices because the demand for coffee is inelastic: no good substitutes. Tea? Probably not. In other words, why wouldn't they increase revenue if they can

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  2. Inelastic demand is the proximate cause, but not the real reason for high priced coffee. If you offer the explanation that the price of coffee is high because demand is inelastic, a natural follow up question is "why is coffee demand inelastic?" The convenience argument I give in this post is one explanation (but you may have others).

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  3. Hi Tony, I haven't read Harford's chapter, but this seems to ignore the role of the competition. While people may value convenience, there are four coffee shops at the bottom of my building, wouldn't you assume that they would compete away any rents in relation to convenience (as they are close in geographic space). In any case it seems to me that in some sense this is just an empirical question which could be solved by looking at the accounts of the coffee shop. Interested in your thoughts. Regards, Andrew.

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    1. Good argument. i could understand if you are talking about coffee alone. As a matter of fact, substitutes exist, say tea. In such a shop, if coffee is expensive, what is the substitute that has a closer or lower price. Or are you saying there is no substitute to coffee.

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  4. Interesting question, Andrew. The short answer is to say that asserting that there is a market for convenience does not necessarily say that the market for convenience is not competitive. An alternative interpretation of my post is that coffee shop coffee is a bundled good: 1 part coffee + 1 part convenience. If you only price the coffee's inputs, the price seems high, but the convenience has a market price as well. Hence, it helps rationalize high priced coffee to make this point.

    It has been a while since I read the Harford Chapter, but if I recall correctly, he makes another point related to your question -- the coffee shop itself does not necessarily keep the rents from providing convenient coffee, even though the prices are high. In fact, the rents likely are paid to the landowner/property owner who owns the claim on the prime location. The property value (driven largely by convenience) goes into the coffee shop's fixed cost, which could rationalize why the coffee shop's economic profits are near zero -- even though the prices are "high."

    This is to say that competition will only do so much to drive the prices down, even in your building with four coffee shops. My hunch is that the building can support four coffee shops because there is enough demand to do so, but this is speculation rather than empirical work.

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