Starbucks: Perfect Competition?

The assumptions of a perfect competition market are:

1. A large number of buyers and sellers with no control over prices
2. Products are identical
3. Few entry and exit barriers
4. Perfect information

Do these assumptions fit Starbucks, making it part of a perfect competition market?  Yes and no. It depend on what portion of the Starbucks business you are examining.  If you consider their participation in the coffee bean market as buyers, then yes Starbucks appears to meet the 4 assumptions of perfect competition.  Despite Starbucks' apparent size, they are a relatively small consumer of coffee beans world wide overall, so they are price takers with very little influence on the price of coffee beans.  Coffee beans are essentially identical within the two major varieties (Arabica 80% and Robusta 20%).  Starbucks has access to the same information as any other coffee bean purchaser.  Essentially anyone can purchase coffee beans so there are few is any entry and exit barriers to the coffee bean market.

However, as a seller of coffee beverages (restaurant industry), Starbucks does not fit the assumptions of a perfect competitor.  Starbucks does have control over the prices they are able to charge for their product, coffee, which is higher than most other coffee sellers such as Tim Horton's and McDonald's.  Are these prices too high?  If they were, then nobody would buy it and Starbucks would go out of business.  The reason that Starbucks is able to charge higher prices for coffee is that they have differentiated their product from all others.  They offer not only premium coffee, but a complete coffee experience.  If Starbucks lowered prices, they would reduce their profitability even further.  Costs would remain the same, but revenue would decrease. 
As indicated in the articles from 2007 below, the massive, rapid expansion that Starbucks undertook resulted in too many locations and a change in equipment removed the coffee making experience that differentiated Starbucks from their competitors.  The memo from Starbucks Gossip clearly recognizes this shift away from the coffee experience to just coffee as a product as a major challenge for Starbucks future.  Starbucks realizes what distinguishes them from their competitors, but is trying to maximize profits by increasing the quantity of product they can produce and sell (number of locations), while reducing the costs of production (more efficient equipment).  However, this strategy has produced the opposite result.  By having too many stores too close to each other, the amount of revenue hasn't increased to the same degree as their costs.  In economic terms, Starbucks has experienced a decrease in marginal revenue per store.  Therefore, the only practical decision was to close a large number of stores in order to reduce their total costs, with minimal reduction in total revenue, thereby increasing overall profitability.  In the short-run, the costs to close the stores may have exceeded the savings in fixed and variable costs due to lease cancellation obligations and employee severance pay.  But in the long-run, these unprofitable stores will no longer continue to siphon off profits from the more profitable stores, thereby allowing Starbucks to return to profitability.


Citations

Starbucks Gossip(http://starbucksgossip.typepad.com/_/2007/02/starbucks_chair_2.html)
CBC News(http://www.cbc.ca/money/story/2008/07/01/starbucks-closures.html)
 The Seattle Times(http://seattletimes.nwsource.com/html/businesstechnology/2008028854_starbucks02.html)

Long Run Costs and Economies of Scale

   I am a scuba diving instructor and would love to operate my own diver center or chain of dive centers.  The goal of the dive center is to provide a complete package of sales and service to divers and other related customers.  This would include certification from the entry level to the instructor level, equipment sales and service, and organizing dive travel charters.  A dive center serves a relatively small but specialized market, therefore a relatively small number of operations typically serve a relatively large geographical area (especially in land locked, northern regions).  However, the potential market could be increased by expanding the scope of products offered to related water sports such as snorkeling, swimming, surfing, and kayaking.  This would allow continuous sales throughout the year (especially in more northern regions that experience seasonal trends).  However, the scope could be expanded much further to include all sports equipment, such as has been done by the Sport Chalet (http://www.sportchalet.com/category/scuba.do).
   I envision starting out with a single location, building a loyal client base and a reputation for excellent service. Once a steady cash flow has been established, I would begin strategically opening or purchasing additional dive centers in the same metropolitan area and expand into other major markets.  This would provide the advantage of an economy of scale in purchasing power with suppliers.  Like most retail businesses, when you purchase in larger volumes, quantity discounts are available, which allow you to reduce prices, while maintaining profit margins in order to be more competitive with other dive centers.  This would be unlikely to create a monopoly situation, but it could reduce the number of smaller competitors who are unable to match the lower retail prices.  Additional cost savings can be achieved through specialization of the workforce.  Sales staff will become more familiar with the features of equipment they are selling and service technicians will become more efficient at servicing equipment. 
   The Professional Association of Scuba Diving Instructors (PADI) is the largest dive training certification agency in the world and one of its primary mandates is to promote scuba diving as a fun and safe sport.  As a member of PADI, I would receive the benefit of an external economy of scale in the form of marketing support. Local marketing could involve radio ads, community newspaper ads, sponsoring and becoming involved in local environmental events (beach cleanups), and sponsoring local dive clubs.  Overall, scuba diving is a fairly social activity and providing a center for the social gathering of divers to exchange information and experiences is an important aspect of a dive center.
  

Fixed Costs	Short Run Costs	Long Run Costs
Rent	Advertising	Cost to build/purchase new stores
Utilities	Inventory	Replacement of rental equipment
Pool Maintenance	Contract Instructor pay	Lawyer and real estate agent commissions
Wages for key staff	Deposits for travel charters	Major equipment (compressors and pools)
Membership/Association Fees
Rental Equipment Maintenance

The Sport Chalet (http://www.sportchalet.com/category/scuba.do), with over 50 locations, has demonstrated the effectiveness of expanding their economy of scope to include all sporting goods as well as financial economy of scale by having a very large asset base from which they can leverage additional financing.  The Sport Chalet would also enjoy economies of scale in regard to purchasing power from their suppliers in all departments.  However, regardless of the benefit of the economies of scale experienced by the Sport Chalet, sports enthusiasts can be extremely loyal to businesses that provide superior service and expertise, therefore there is still the possibility of smaller businesses competing with them, so it's important to maintain excellent quality of service and instruction.

The Law of Diminishing Returns: The war on Tobacco

   In the article, The Diminishing Returns to Tobacco (Lemieux 2001), the argument is made that there is a diminishing return to the efforts of government regulation and taxation to the decrease in tobacco usage.  Governments around the world have implemented extreme taxation and advertising campaigns that include so called panic pictures on cigarette packages, in an effort to persuade smokers to quit the potentially lethal habit.
   When a product like cigarettes has a very inelastic demand, even a large increase in cost will not significantly alter the demand. This is demonstrated by the fact that an increase in price of cigarettes of 52% only resulted in a decrease in demand of 18%, from 1985 to 1995 (Lemieux 2001).  This small decrease in demand, relative to the increase in price, is indicative of the portion of the population of smokers, that are relatively easy to convince to stop (casual smokers or smokers wanting to quit already).  This is essentially the point of diminishing returns for the government.  The portion of the population of smokers that continue to smoke are those that smoke more heavily and are unable to break the nicotine addiction.  These people are much more likely to engage in smuggling of cigarettes, due to the quantity required and the cost, they are willing to accept the risk of being caught and fined.  In other situations, smokers are well aware of the health hazards and have either disregarded or minimized the risk posed to themselves.  The appearance of cigarette package covers to cover the panic images intended to convince smokers to quit begs the question as to how effective these images are.  Consumers have become over saturated with information regarding the negative health effects of smoking, which has lead to this type of scare tactic becoming mostly ineffective.
   Compared to forcing panic pictures to be printed on cigarette packages, a more effective solution that may increase the government's success compared to their costs could be providing subsidized treatment programs or tax incentives for the cost of treatment.  The cost of cigarettes is a know to consumers, whereas the cost of treatment can vary and could end up costing more than the cigarettes themselves.  These programs could be funded by the government and offered through employee assistance programs or through health insurers.
   I think that the statement "...health bureaucrats have become addicted to power." doesn't lend any credence to this argument.  I don't think the health bureaucrats have any desire to have power over smokers, but they are experiencing the law of diminishing returns, which makes their mandate to reduce the consumption of cigarettes much more difficult to achieve and are now resorting to seemingly extreme efforts.
   With regards to supply and demand for tobacco, the decrease in demand already achieved by government taxation and advertising campaigns would result in a surplus of tobacco which would lead to a decrease in the price obtainable by producers.  This could result in a reduction of the number of producers willing to grow tobacco as a cash crop or a consolidation of tobacco producing land under a smaller number of producers. This could actually result in cigarette manufacturer's realizing an increase in their profit margin.  The cost to consumers would remain relatively unchanged since most of the cost of a package of cigarettes is tax which must be paid and in this case, it is paid by the consumer.
   I don't think that prohibiting cigarettes would be an effective method of eliminating smoking.  This would only lead to increased smuggling and create another illegal trade opportunity, similar to the prohibition of alcohol in the US during the 1920's and 30's.  This could lead to prices for cigarettes that are even higher than with the high government taxation levels due to the increased cost of covert transportation and interception by law enforcement.  This could also increase crime rates, for those that still require cigarettes but are no longer able to afford them without engaging in criminal activities.
   Due to the inelastic demand of cigarettes, the government taxation on cigarettes is in effect a sin tax.  The increase in revenue for the government is easily calculated since an increase in price of a product with inelastic demand results in a very small decrease in demand and therefore the revenue increases proportionately to the increase in tax rate.
   In conclusion, governments have reached the point of diminishing returns with regard to cost effectively reducing the consumption of cigarettes.  Any further increase of taxation will produce a relatively small decrease in demand.  The effectiveness of panic pictures on cigarette packages appears to be minimal due to avoidance and dismissal by consumers.  A possible solution for governments to shift the point of diminishing returns is providing a monetary incentive to smokers to quit, through subsidized treatment programs or tax deductions for treatment.

Citations
Pierre Lemieux (2001) The Diminishing Returns to Tobacco Legislation Retrieved December 27, 2011 from http://www.pierrelemieux.org/artdiminish.html

Tourism Industry in Canada: Elasticity

   Tourism in Canada is a top ten export with respect to revenue generated (over $15 Billion per year) and also contributes to the earning of the title of No. 1 country brand (by Futurebrand).  To say that tourism is an important industry in Canada would be an understatement.  However, like most industries, tourism is not immune to the economic turmoil currently occurring throughout the world.  Despite the volatility in the economy in most parts of the world, there are some countries that are actually seeing an above average increase in gross domestic product (GDP).  This translates into higher incomes and hence more discretionary income to spend on things like international travel, which involves the concept of income elasticity.  Also, like other industries, there are competitors in the tourism industry and they are other countries.  The choice of which "product" you will purchase is greatly affected by the cost of your product (influenced by currency exchange rates) as well as of competing products, which also brings the concept of cross elasticity into consideration when discussing the current state of the tourism industry in Canada.
   The largest increases in visitors to Canada from 2010 to 2011 were from China (23%), Brazil (10%), Mexico (7%), and India (6%).  Despite this increases from some countries, overall tourism is down 2% from 2010 to 2011.  These "developing" countries have all demonstrated above average GDP growth (3.1 - 9.5 %).  A higher GDP will translate into proportionately higher incomes for the residents of these countries, which means more people will be able to afford international travel (positive income elasticity) and Canada is one of many countries that they may choose.  The United States is one of Canada's main competitors in the tourism industry and has seen larger increases from China (37%), Brazil (27%), Australia (19%), and France (16%) and overall, the United States saw a 4% increase in tourism from 2010 to 2011.
   The reason for this disparity may be the "cost" of travel to the United States.  With the weakening of the US dollar, it is relatively less expensive to travel to the United States compared to Canada and other countries.  This is a good example of cross elasticity of demand.  When the price of one product (US tourism) decreases compared to another (Canadian tourism), with the consumers income staying constant (within a given time period), the demand for the less expensive product increases. 
   In conclusion, despite the increase in discretionary income in many countries allowing more people to partake in international tourism and travel, Canada has been unable to capture a significant portion of these due in part to the higher "cost" of travel to Canada due to the strength of our dollar.

Acknowledgements
Canada Tourism Commission (2010) Tourism Snapshot. Retrieved December 23, 2011 from http://en-corporate.canada.travel/sites/default/files/pdf/Research/Stats-figures/International-visitor-arrivals/Tourism-monthly-snapshot/tourismsnapshot_2011_09_eng.pdf

Inelastic demand for gasoline results in record profits for oil producers.

The relationship between price elasticity of demand and total revenue is such that when the demand is inelastic an increase in price results in an increase in total revenue.  A prime example of this is the increased profits of oil companies due to the inelastic demand for gasoline.  As you can see in the graph below, the demand curve for gasoline is very steep indicating that any increase in price results in very small reduction in demand.  This demand curve represents only the lower inelastic portion of the total demand curve for gasoline.  This graph represents the change in demand over a relatively short time period (one year). For example, from April 2007 to April 2008, the price of gasoline increased 75%, yet there was only a 1.8% decrease in traffice on roads and highways in the US with only a 2.6% decrease in total miles travelled. However, in the long term (30 years) per capita gasoline consumption has actually decreased primarily to a 70% increase in fuel economy of passenger vehicles.  In the short term, gasoline has inelastic demand, but over the long term, it has elastic demand linked to developments in vehicle efficiency and fuel economy.  Despite the increased price of oil and thus gasoline, producers such as Husky Energy are reporting record profits (doubled from $261 million to $560 million in one quarter) despite an increase in gasoline prices, clearly representing inelastic demand for gasoline and other oil based products.

http://delicious.com/gfines/

Citations

Vincent Geloso. (2008, July 24). Inelastic gas; Economists expected a sharp reaction to the rise in oil prices. Here's why it hasn't quite happened. National Post,FP.13. Retrieved November 27, 2011, from Canadian Newsstand Core. (Document ID: 1518806601).

Oil profits up on prices, oil-sands output; Canadian firms shrug off debt crisis in Europe. (2011, November 4). National Post,FP.5. Retrieved November 27, 2011, from Canadian Newsstand Core. (Document ID: 2504235921).

Changes in Demand: Why do you buy things on sale?

What do you think of when you hear the word "demand"?  Do you think of it as meaning something you're being asked to do?  Or do you think of it as meaning something that you would like to have?  In an economic sense it is the amount of some product that you as a consumer are willing and able to purchase.  Have you ever thought about why your demand for a product changes over time?  A few of the underlying factors that typically cause changes in demand for a product are a change in preferences, change in income, the price of related products, and future expectations.  Graphically when demand changes for a product there will be a shift in the price, the quantity supplied and the quantity demanded.  As we can see in Fig. 3-3 when there is an increase in the demand for wool sweaters due to a long cold winter in Odessa, the demand curve for wool experiences a rightward shift (from D1 to D2).  This results in a greater quantity demanded than can be supplied producing a shortage of wool.  The shortage causes an increase in price and a decrease in demand until a new equilibrium price ($700) and quantity (70 tonnes per year) is reached.

 When you look back at old photos of your family, you will clearly see a change in preference for clothing fashions.  As trends come and go, preferences for clothing styles change.  As new materials that reduce or eliminate the need to iron your clothes, you preferentially buy these iron free clothes.  As new technology is introduced you abandon your trusty flip phone for a new touch screen smart phone.  Over time preferences change and this will alter the demand for various products.
As you progress through your career, you will invariably increase your income.  This may reduce your demand for inferior products (students living on macaroni and cheese) and increase your demand for normal products (beef tenderloin).  Alternatively, if we hit a speed bump in our career and our income is reduced, we will have to save money by reverting to inferior products and reducing our consumption of normal products.  Additional increases in income may also increase our demand for products that are we previously couldn't afford and are not essential to live, such as vacations to tropical locations or private violin lessons.  Income is a very important factor when considering the demand for products.
The price of related products will affect demand.  Products may be substitutable (Coca Cola or Pepsi) or complementary (cars and gasoline).  When prices in one substitutable product increase due to manufacturing or transportation costs, the demand for it's substitute may increase as people are not willing to pay more for what in their mind is the "same thing".  An increase in price for a complementary product such as gasoline, may cause an increase in demand for smaller, more fuel efficient cars.  Next time you are at the grocery store and are about to choose a jar of pasta sauce, think about the reasons for purchasing the brand you do?  Does it have anything to do with the price of the other brands?
Finally, future expectations on the available supply, price, quality, or selection may change the demand for products.  If a price decrease (lower production costs or a sale) is expected, you may choose to delay your purchase which then alters the current demand for a product.  If you find a pair of shoes that fit really well, and you are not sure if they will still be available when you are ready to replace them, would you buy a second pair now?  When natural disasters are approaching (hurricanes or blizzards) people will demand more water, food, batteries, shovels, generators, and other emergency equipment.
In summary, have you ever been in the grocery store standing in line waiting for the person in front of you to pay for their order when they start questioning the cashier on what the price for an item should have been because they thought it was on sale?  When the cashier pulls out the flyer and explains that it was the jumbo size that was on sale not the family size, the person will say that they only wanted it because it was on sale.  Have you ever purchased anything just because it was on sale and was a good deal?  Then your demand for that product has been changed.  Next time ask yourself if you just want something or really need it?  But that's for another discussion.

Economic Games: Farmersi

To gain an understanding of economic principles you can read text books and look at graphs, but another useful tool is playing games utilizing economic principles.  One example is Farmersi (http://www.farmersi.net), which is based in the 1800's during the expansion into the west by the young United States.  This game demonstrates a limited mixed economy in that you typically have a choice to produce a grain crop or livestock as a farmer.  With a variety of economic conditions in each scenario (commodity prices, transportation costs, land costs and availability), you have to carefully choose what product to produce and when and where to sell which products.  The age old adage of buy low and sell high is very readily apparent.  When you first start a gamer of Farmersi, there is abundant public land available at a low price.  You should buy as much land at these low rates as possible (capital goods) to invest in future production (consumer goods).  Specializing in producing one product is another decision that must be made.  If you think producing only one product is a good idea because of the price for it, other competitors may have the same thoughts and this could increase supply above the current demand which then lowers the price for everyone.  With a limited amount of land available for your own use, you must decide what to produce depending on the cost of production and the price for the product on the local and export market.  Transportation costs must also be factored in when considering the exportation of goods.  If you try to maintain a mixed production, you may be able to use the sales of one product with a lower, but more consistent price to maintain income when the typically higher priced, but potentially more volatile product, drops to increases in supply or decrease in demand. 
  Demand and supply is of course the basis of most economic thinking and this game really demonstrates this relationship well.  As you produce and sell more of a product (wheat) the local price decreases.  If you were to export the wheat to another market, thus reducing the supply in the local market, the prices will increase in the local market.  You can also reduce supply by simply storing the wheat in a granary, which causes an increase in price as well.  Differences in supply and demand between the two markets (local and export) also gives you the option to do some price arbitrage, whereby you buy wheat in the local market at a lower price and sell it for a higher price in the export market.  Of course you have to take into account transportation cost to determine if this will be profitable.  You can increase supply of grain and livestock by investing in technology and education, which increases the efficiency of your production.  Profits can also be increased by technology and education by reducing production costs.  The earlier you can implement these improvements, the more time for them to be in effect and the greater their effects.
  When you try this game my advice is to invest in land first and then invest in technology and education to maximize your production efficiency.  Then you need to carefully consider local and export market prices and take into account transportation costs to determine where to sell your product.  In some instances you may be better off to sell only enough to cover costs in order to restrict supply and thus the prices in the future.  Good luck!

Production Possibilities Curves: The cost of education

In economics, production possibilities curves are used to model the outputs of an economy assuming there is full employment, the use of the best technology, and production efficiency.  Through these models it is also possible to visualize the law of increasing costs and the effect of technological change and capital accumulation on future growth.
The law of increasing costs, in the context of a whole economy, states that as the production on one item increases, the cost of producing each additional item of the same type increases.  The reason for this is that resources are scarce and some resources are better suited to the production of certain items.  If you are already using the best suited resources to produce an item, it will be more difficult or costlier (in wages, time, or quality) to recruit less well suited resources to produce more of that item.  You would then have to choose whether it is worth producing that one more item at the increased cost.  For example, by choosing to take distance education course to increase my education in accounting, I have chosen to give up some of my free time (i.e. time to spend with my family).  The more courses I take concurrently, the less free time I will have, but the greater my education in accounting will be (Fig. 1).

Technological changes and capital accumulation affect production possibilities curves by causing a shift in the curve to the right resulting in increased future growth.  The downside is that the investment in the future growth comes at the cost of current production, so the more you invest in technology or the production of capital goos, the lower current production of consumer goods will be, but the greater future growth will be (Figs. 2 & 3).  For example, if I were to stop my education after completing only the accelerated accounting certificate I could get a better paying job than I currently have now.  However, if I invested more in my education by completing the CGA program, I would qualify for a significantly better paying job further in the future.