Lowering prices—but at what cost?

In the wake of a world-wide recession, the future of high-price, high-quality goods is uncertain

As consumers world-wide scale back on “luxury goods,” how will Starbucks, purveyor of $5 coffees, fare?
As consumers world-wide scale back on “luxury goods,” how will Starbucks, purveyor of $5 coffees, fare?

I’ve visited Starbucks three times within the past week. Each time I entered through the double glass doors, I’ve been able to not only locate the end of the line, but also, and perhaps even more surprisingly, find a seat. At any Starbucks, finding a seat is not an easy task; finding a seat on the weekend, though, is the stuff of legends. What, I wondered, had changed?

With Hyundai offering a deal allowing purchasers to return their new car within a year should they “lose their source of income” and economic analysts reporting a feeling of “contagious economic worry,” even the richest of the rich are cutting back on so-called “luxury goods.”

Starbucks, the multinational corporation and coffeehouse giant, is a name familiar to most. Whether in Canada, Peru or Egypt, Starbucks has made its mark both culturally and geographically.

Originating in Seattle, Washington, Starbucks derived its name from Captain Ahab’s first shipmate in Moby Dick (although an initial option was the ship from the novel—the Pequod—which doesn’t roll off the tongue quite as well). With trendy Italian lingo and indie music, the coffee company has become a symbol of wealth, excess and the upper class. Although it’s hard to go a day without seeing the company’s ubiquitous green mermaid logo, the seemingly infallible corporation—along with a plethora of other suppliers of expensive goods—is heading for some turbulent times.

The “Starbucks Effect” refers to the impact of economic recession on venues that provide luxury goods, a spiraling downturn that has been analyzed by economists and journalists and has resulted in interesting connections and some surprising conclusions.

David Byrne of the Queen’s economics department offered some helpful analysis of the topical phenomenon.

He said the Starbucks Effect was related to the unbalanced effects of a recession on lower- versus higher-priced goods. “The [former] establishments are getting hit hard, while the latter are [likely] benefiting from the economic downturn. It basically boils down to what is known as the ‘income effect’ in economics,” he said.

“The income effect relates consumption behaviour to individuals’ income. If individuals are less wealthy, they will consume less. In the case of Starbucks, there’s an added wrinkle in that there are perceived quality differences between Starbucks and other coffee providers, say Tim Horton’s, McDonald’s, Coffee and Co. and so on.”

Byrne added that when an individual’s income is shocked in a negative way by economic downturn, although their coffee consumption may remain constant, the total perceived quality of consumption falls.

“If you now get coffee at the Tim Horton’s in the JDUC instead of the Starbucks on Division Street because you feel your income is lower, you have essentially made such a ‘coffee quality’ trade off,” he said.

“As people see the effects of a deeper recession, their expected wealth continues to decline. This is bad news for companies like Starbucks as more and more individuals will be willing to forgo the quality of the Starbucks experience for a less expensive cup of java from a lower-quality establishment. Conversely, the opposite should happen if individuals see the recession as becoming less severe.” In contrast, such lower-price and lower-quality companies have been experiencing a rise in sales and consumption. McDonald’s, for instance, has been experiencing stronger-than-expected sales this year, the New York Times reported in January of 2009.

“Basically people are substituting high-quality items sold at venues like Starbucks for lower-quality coffee locations, available at venues like McDonald’s,” Byrne said.

He added that it isn’t just the food and beverage industry being affected this way.

“It is important to keep in mind that there is nothing particular about coffee, for the same story could be told about any higher quality item being substituted by lower quality, and hence, cheaper, products. McDonald’s, then, stands to greatly benefit from the income effect: all the goods with which they are associated with display a relatively cheap, low quality provider—an essential quality in today’s economy.”

Byrne said swearing by the ‘five P’s’ (people, products, place, price and promotion) has guaranteed McDonald’s success in these hard economic times.

“It’s all intertwined with people’s [choice to switch] to lower quality products when their income is falling. A classic example used in Economics 110 is people switching from steak consumption to hot dog consumption when their income falls,” Byrne said, adding that while the Starbucks Effect affects all sectors of the economy, particular patterns emerge in the sale and consumption of food products.

“There is always inelasticity of demand with respect to food consumption—after all, you always need to eat. The only difference is that when your income is lower, you eat less extravagantly, because you can’t afford to eat like you did before and you can’t just stop eating. This intuition carries over directly to the positive impact recessions can have on induced demand for McDonald’s,” he said.

And as for Starbucks, its future remains uncertain in the face of more than 600 store closures in 2008.

“It is not clear at this point what they are doing,” Byrne said.

“The only two P’s they have flexibility over are prices and promotion. My guess is promotion budgets will be slashed. They’ve already established themselves as a high-quality coffee provider, so messing around with prices could result in major loss of consumers who see a price fall as being related to quality fall at Starbucks.”

Following from recent statistics and financial data, there have been several correlations drawn between how many Starbucks locations a country has and the size of its financial troubles. Such a correlation, however, is hard to analyze.

“I can’t deny statistical correlations, but it could very well be that Starbucks saturated the market, reduced its scarcity and therein affected its competitive advantage as a high-price provider,” Byrne said.

“If people see Starbucks everywhere and start seeing it as a chain rather than a boutique or a coffee drinker’s oasis, then they might form an opinion that Starbucks is no different than any other retail food provider, like McDonald’s. If so, the quality image of the company could fall, and individuals could substitute to other ‘high quality’ coffee shops, like local coffee providers.”

The lingering question is rather obvious, then (at least to an economy amateur like myself): Why not cut the price of coffee in a recession?

“The price-point Starbucks operates at is very much realted to the notion of Giffen Goods in economics,” Byrne said.

“Giffen Goods have upward sloping demand curves: if price is higher, then demand actually rises. The idea is that people see higher prices as higher quality, and as a result may actually want more of a product if the price rises. Starbucks relies on its high price and high quality image to maintain its market share and per-customer profitability.”

Because of its status as a Giffen Good, Starbucks might actually see a fall in demand if the chain was to cut its famously high price per cup.

This, in addition to lower per-customer profit margins, could be why Starbucks is hesitant to cut prices as a means of trying to bolster performance, Byrne said.

In Melville’s Moby Dick, Starbuck once declared he would “have no man in [his] boat who is not afraid of a whale.” Reminiscent of its namesake, Starbucks may prove that in these harsh economic times, a fair estimate of the danger ahead is far more valuable than a fearless approach.

Overheard at Queen’s

Girl 1: Hey! You look different today! And you smell nice too. Your smell makes me really hungry!
Girl 2: ...it makes you hungry?
Girl 1: I’m not sure if I’m just hungry right now for food, but I’m pretty sure your smell makes me hungry!
—Cannibalistic first-years in the cafeteria

“We had to invent all these skits, so ours was about, like, one of our housemates who was sleeping with all of our boyfriends at once.”
—The pride of the Queen’s drama department, outside of Theological Hall

“No way. We are not living this far from campus. We are turning around NOW.”
—Frosh, house hunting at Johnson and Division streets

Send your own overheard quotes to journal_postscript@ams.queensu.ca

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