Economic issues of Starbucks

1. Background information

Starbucks has expanded rapidly since 1995. Yet, as a result of the economic crisis causing a decline in sales, Starbucks was forced to take measures that enable it to cope with this economic crisis. (Jannarone, J. June 14 2010)

2. Effect of Starbucks expanding

2.1 Effect on the PPF(Production Possibilities Frontier) curve Starbucks has expanded at a very fast rate, adding stores in the US at an annual rate of 27% from 1995 to 2005.( Jannarone, J. June 14 2010)This would cause the PPF(Production Possibilities Frontier) curve for the goods of Starbucks to shift outwards as shown in the diagram below due to the increase in the quantity of resources being put into the production of goods since stores are categorize under capital resources.

(Assume that Starbucks produce only two goods, coffee and cake)

2.2 Effect on the market demand and supply curve

The expansion also caused the supply curve of the goods of Starbucks to shift to the right due to the increase in the number of suppliers (shops). This has resulted in an increase in supply of the goods of Starbucks. The equilibrium market price would fall while the equilibrium quantity would increase as shown in the diagram below. The blue thin lines indicate the equilibrium price and quantity.

Q-quantity, P-price, E-equilibrium point, S-supply

3. Market structure of Starbucks The market structure that Starbucks is operating in is oligopoly. The following are the reasons which lead to the conclusion.

3.1 Number of sellers in the market

Starbucks is a large firm operating in a many different countries. It supplies most of the speciality coffee in the world. There are also very few competitors such as MacDonald and Coffee Bean which are competing with Starbucks for its customers whom are mainly well-off working professionals.

3.2 Substantial barriers to entry for new firms

It is very difficult for a newcomer to set up a speciality coffee chain in the world as cost is very high. For example, advertising the new coffee product would take a huge amount of money. Researching and coming up with a new coffee product may take years and cost about a few million to a billion dollars. Moreover it is very hard for newcomers to compete for customers with established firms like Starbucks as these firms already have an established brand name. As such customers would rather drink the coffee at these firms instead of others as they trust the quality of the coffee there.

3.3 Mutual interdependence Some of the actions taken by Starbucks’ competitors depend on the actions taken by Starbucks. It means that firms in an oligopoly weigh the effects of its own behaviour on the other firms’ behaviour. For example as a result of Starbucks having espresso-based drinks, McDonald decided to launch espresso-based drinks too. (Jannarone, J. June 14 2010)

3.4 Type of oligopoly

Starbucks is a differentiated oligopolist due to the fact that evidence in the newspaper articles seems to suggest this. For example McDonald has launched espresso-based drinks but this has hardly affected Starbucks’ sales. (Jannarone, J. June 14 2010). This is due to the fact that Starbucks’ espresso-based drinks may have different physical qualities such as a better taste compared to the ones offered by McDonald. Therefore Starbucks is likely to be less sensitive to any price changes of its competitors’ products as the products it offers are different compared to its competitors’ products.

4. Behaviour of Starbucks

Starbucks practices non-price competition which means that it designs itself to increase its share of the market without changing the price of its products. This can be seen from the fact that when McDonald launched espresso-based drinks, Starbucks’ sales at stores swung positive in the past several months even though it did not decrease the price of its products. (Jannarone, J. June 14 2010) Here are some of the possible ways Starbucks practice non-price competition through product differentiation.

4.1 Physical differences

Starbucks’ products are of better quality compared to its competitors. An example could be that Starbucks’ espresso-based drinks have a better taste compared to McDonald coffee. This can be seen from the fact that even though McDonald launched espresso-based drinks in 2009, Starbucks’ sales at stores swung positive in the past several months. (Jannarone, J. June 14 2010).This shows that generally Starbucks’ products are of better quality compared to its competitors’ products.

4.2 Location

Starbucks’ outlets are normally located at areas where the competitors’ outlets are not located. This can be seen from the fact just 23% of US Starbucks’ locations have a McDonald’s outlets within a quarter-mile radius. (Jannarone, J. June 14 2010)This makes it difficult for their regular customers and even future customers to switch to other alternatives.

4.3 Product image

Starbucks has also fostered in people’ mind that it provides coffee that is of the highest quality. This is done through advertising.

4.4 Reasons for Starbucks’ behaviour

Starbucks is doing this as it does not want to have a price competition with its competitors. This is because if a price war occurs, Starbucks would be forced to lower the prices of its products, causing the price to be lower than the marginal cost of producing each of its products. This would cause it to lose a lot of revenues and the total revenue earned may be much lower compared to the total cost incurred. As such Starbucks would be operating at a loss and might even close down.

5. Effect of economic recession on Starbucks

5.1 Income elasticity of customers of Starbucks

Starbucks’ customers’ demand for the goods of Starbucks is income elastic. This is because during the economic recession where many of Starbucks’ customers suffer a decrease in their incomes, sales of Starbucks goods began to weaken, resulting in a 9% decrease. (Cain Miller, C. January 28, 2009)It came to the point where Starbucks was forced to retrench. (Jannarone, J. June 14 2010) As such in conclusion, the absolute value of the income elasticity of demand of customers of Starbucks for the goods of Starbucks is above 1.This shows that customers of Starbucks are very responsive to any change in their income in their demand for Starbucks’ goods. As a result, the demand curve for Starbucks’ goods would shift to the left by a lot.

5.2 Starbucks closing down stores

Starbucks has closed down 300 stores, causing about 700 of its employees to lose their jobs in 2009. (Cain Miller, C. January 28, 2009)This is because in the short-run, at the point of output where the marginal revenue is equal to the marginal cost, the price per output of Starbucks is below the average variable cost. As such Starbucks is not able to cover part of its variable costs and its total fixed cost. Therefore Starbucks’ loss would be part of its variable costs that it is not able to cover and its total fixed cost if it decides to continue on production. However if Starbucks shut down its stores, its loss would be just the total fixed cost. Therefore to minimize loss, Starbucks has decided to close down some of its stores.

Starbucks PPF(production possibilities frontier)curve would shift inward as the quantity of resources being put into the production of its goods is decreased since retrenching will reduce the amount of labour being employed and closing down stores would reduce the amount of capital being put into the production of Starbucks’ goods. This can be seen from the diagram.

(Assume Starbucks produce only two goods, coffee and cake)

5.3 Effect of recession on demand for Starbucks’ goods

In the first quarter of 2008, Starbucks’ revenue has decreased from $2.77 billion to about $2.6 billion and sales at Starbuck’s stores decreased by about 9% (Cain Miller. January 28, 2009). This is due to the fact of expectations of its customers. Starbucks’ customers expect their money income to decrease as a result of the economic recession. As a result, they would buy less of Starbucks’ goods as a result of their anticipation of a decrease to their money income. This would cause the demand curve for Starbuck’s goods to shift to the left, resulting in a decrease in the equilibrium price and quantity.

5.4 Starbucks cutting down on cost

Starbucks also has tried to cut down on cost. This include cutting down on variable costs such as reducing the salaries of employees such as Mr.Schultz , cutting down on fixed costs by renegotiating prices with landlords and suppliers. (Cain Miller, C. January 28, 2009). This would cause the supply curve of Starbucks to shift to the right as a result of the decrease in resource price such as labour, as a result of this, market equilibrium price would decrease and the equilibrium quantity would increase due to decrease in the cost of production. Starbucks is doing this so as to reduce its total cost by about $400 million to $500 million. (Cain Miller, C. January 28, 2009).

This also has enabled Starbucks to increase its operating profit margins from 0.6% to about 4.5 % (Cain Miller, C. January 28, 2009). Such measures has enabled Starbucks to increase it’s (total revenues-total cost) difference. As such gap between total revenues curve and total cost curve would be larger due to the decrease in cost.

6. Conclusion

6.1 Economic profits

Starbucks is an oligopolist; it would in the long-run have an economic profit due to substantial barriers to entry such as a high start up costs and the presence of established brand names. As a result, lesser firms would enter the market that Starbucks is operating in. Lesser number of Starbucks’ customers would get snatched away, therefore demand for Starbucks’ goods would not reduced by a lot, as such Starbucks would still earn an economic profit

6.2 Allocative efficiency

Starbucks cannot attain allocative efficiency as the price of its goods are larger compared to the marginal cost associated with producing that good. This show that consumers are paying an amount that is larger compared to the additional cost of producing a unit of Starbucks’ good. Therefore consumers would be better off if Starbucks produce more of its goods.

6.3 Challenges faced by Starbucks

Starbucks faced a declining demand for its goods as consumers now prefer healthier drinks. However Starbucks emphasizes on milky, sugary drinks, hurting its image as an authentic coffee house. (January 28, 2009)

This would result in Starbucks’ demand curve shifting to the left due to the taste and preferences of consumers, resulting in the decrease of equilibrium price and quantity.

Starbucks has also expanded by a lot; this has resulted in it experiencing diseconomies of scale as more layers of management are needed to coordinate the Starbucks’ operations. This would result in a higher cost for Starbucks as a larger amount of resources is required to coordinate and manage resources such as labour.

Starbucks may have also experienced the law of diminishing returns which is as more and more variable inputs are added into the fixed resource of Starbucks such as its stores, marginal product of the additional variable input would ultimately decline due to congestion and crowding. This is shown when the marginal physical product curve is decreasing from its maximum point. This would also result in it experiencing increasing marginal costs as shown in the diagram. This is shown by the marginal cost curve increasing from its minimum point.

6.4 Starbucks’ strategies

Starbucks has shown that it is capable of adapting to situations. For example, during the economic recession, it cut down on cost. It also attempted to attract more customers and retain existing ones by giving special offers such as giving loyalty cards that provide discounts and coming up with breakfast combination meals. (Cain Miller, C. January 28, 2009).

Starbucks has also attempted to widen its market reach by opening new stores in new markets such as China. Many of those stores have matured and operating profits could soon be earned from them. (Jannarone, J. June 14 2010)

To cut down on cost as well as diseconomies of scale, it also has shut down 300 stores. (Cain Miller, C. January 28, 2009)

6.5 Future of Starbucks

Starbucks has proven itself to be capable of adapting to situation while attempting to take the initiative in taking advantage of new opportunities. This shows that despite challenges such as declining demand for its products, Starbucks is still capable of remaining competitive.