Answer all questions.
Extract 1: Coffee prices on the rise
Coffee prices hit a record 14-year high this month, and it's only a matter of time before coffee lovers will have to pay more in stores and coffee shops. A series of bad news has affected the market for coffee – bad weather in South America is threatening crops; Brazil and Vietnam are talking about hoarding their stocks; and US stockpiles are reportedly at 10-year lows. Moreover, the current behavior of prices reflects uncertainties concerning short-term coffee supplies. As uncertainties persist, investors are placing significant bets on where prices are headed.
Adapted from CNNMoney.com (February 2011)
Figure 1: Coffee prices (cents per pound)
Source: Starbucks, Bloomsberg news
Extract 2: Starbucks gears up for slowing consumer traffic in the US
Premium coffee-chain Starbucks is offering promotions in stores across the US especially in areas hardest hit by the financial crisis a year before to counter the decline in domestic store traffic that led to a decision to close 600 stores. It is giving away 12-ounce iced coffees to customers who present a "iced brewed coffee card" voucher distributed in stores and newspaper inserts. It has also introduced Via, a new instant coffee product to rump up its profit level.
Lots of people still favour Starbucks coffee, but coffee selection is improving elsewhere too. McDonald’s has introduced an improved coffee blend aimed at drawing away Starbucks' customers. In addition, Dunkin' Donuts is gaining popularity over Starbucks as a coffee destination with ample seating and a tasty menu board that grows incrementally.
Adapted from USAToday.com and Forbes.com (2009)
Extract 3: Venezuela maintains strict price regimes on basic foods
Since 2003, the Venezuelan President has maintained a strict price regime on some basic foods like coffee, beans, sugar and powdered milk. But this measure designed to curb inflation has alienated Venezuela's coffee importers who say their profit margins have been reduced to nothing.
For at least a week, there has been no roasted coffee available on the shelves of Venezuelan supermarkets as wholesalers and coffee importers have been withholding their coffee from sale. The situation is so bad that authorities have successfully stepped in to seize coffee which is deliberately being withheld from sale.
Yet several food stores in Venezuela's capital city Caracas say the coffee raids are not addressing the fact that shops are also running low on sugar, maize, powdered milk and beans. Store managers insist they are not being supplied with new stock from wholesalers and importers.
Three days ago, street sellers working in the country's black market were still able to provide the roasted coffee that the supermarkets were not stocking. However, even they have since admitted defeat.
Adapted from the BBC (January 2006)
[Turn over
Extract 4: Colombian government extends subsidies to the coffee sector
In South America, despite a budget deficit, the Colombian government announced a subsidy package in November 2008, aimed at controlling the escalating price of coffee. The subsidy package includes assistance to farmers by extending discounts of up to 50% on fertilizer to farmers and provision of cash credits to farmers for the replacement of old and poor-yielding coffee trees with newer and higher-yielding varieties
Adapted from USDA Foreign Agricultural Service Report (April 2009)
Questions
(a) / (i) / From Figure 1, describe the trend in the price of coffee since 2000. / [2](ii) / With the aid of a diagram, account for the change in the price of coffee in 2011. / [6]
(b) / (i) / Using relevant data, account for the difference between Starbucks’ revenue and profit levels. / [2]
(ii) / Compare the different demand elasticity concepts. / [2]
(iii) / Discuss the usefulness of demand elasticity concepts in explaining the strategies adopted by Starbucks to maximise its profit level. / [8]
(c) / Discuss whether the different forms of government intervention in the coffee market have met the objectives of the Colombian and Venezuelan governments. / [10]
[Total: 30 marks]
C1 H2 Economics Case Study (The Market for Coffee) suggested answers
(a) / (i) / From Figure 1, describe the trend in the price of coffee since 2000. / [2]General direction: Generally increase [1m]
Meaningful refinement: There was a decrease from 2000-2003 before an increase thereafter. [1m]
Examiner’s Comments
Quite a number of students did not get both marks. Many students observed that coffee prices fluctuated. This is not a meaningful observation given that in real world most data would fluctuate. Also, some students lost a mark by not describing the general trend.
(ii) / With the aid of a diagram, account for the change in the price of coffee in 2011. / [6]
Since the question asks for the price of coffee in 2011, students should use the evidence found in Ext 1 (note the date of the extract) to explain the change in price.
â supply of coffee
§ Supply shock - Bad weather in South America is threatening crops – producers are less willing and able to produce at a given price, ceteris paribus.
á demand for coffee
§ Consumers expectations - Brazil and Vietnam are talking about hoarding their stocks. So there is no cut back in supply of coffee yet. What this does is to drive up current demand for coffee as consumers panic buy.
§ Investors are placing significant bets on where prices are headed. This suggests speculative demand for coffee where investors intended to buy-low-sell-high to earn profit.
§ More willingness and ability of consumers to buy at a given price, ceteris paribus
Supply of coffee is price inelastic:
US stockpiles are reportedly at 10-year lows, so there may not be much spare capacity amongst coffee producers in the short run. Coffee is a primary commodity that needs to be grown. Hence quantity supplied is unable to respond fast to the high coffee price.
Demand for coffee is price inelastic
For coffee lovers, demand for coffee will tend to be price inelastic due to its addictive nature. Hence for any increase in price of coffee, the quantity demanded will fall by less than proportinately.
Diagram:
Figure 1: Market for coffee
Make reference to diagram: With reference to Fig 1, when supply of coffee decrease from SS1 to SS2 and demand for coffee increased from DD1 to DD2, this results in an increase in price of coffee from P1 to P2. The price inelastic nature of supply has
Examiner’s comments:
§ Given that Extract 1 says coffee prices in 2011 is at a record high, students are expected to use DD-SS as well as elasticity concepts to account for the phenomenon.
§ Another common pitfall is the lack of use of evidence from the case material.
§ Evidence is not mere lifting from the extracts. You need to convert them into economics i.e. explain using economics terms
§ ‘Talking about hoarding’ is NOT ‘hoarding’
§ Fall in supply capacity is NOT fall in supply of coffee
§ Increase in price is NOT increase in general price level or inflation. General price level and inflation are macroeconomics concepts, whereas price is a micro concept.
(b) / (i) / Using relevant data, account for the difference between Starbucks’ revenue and profit levels. / [2]
State the difference [1m]:
From Fig 2: Revenue increased gradually OR remained relatively stable
From Fig 3: But profit levels dipped drastically over the quarters.
Reason [1m]:
Fig 1: Price of coffee has gone up sharply during 2008.
This has increased cost of production significantly for Starbucks. Since profit = total revenue – total costs, with sharp increase in costs higher than increase in revenue, profits hence dropped drastically.
Examiner’s comments:
§ To score both marks for this question students have to observe that profit fell despite revenue remaining at a stable level this must be due to increase in cost of production, and support with evidence from the case material why cost of production has increased.
§ Evidence to suggest that cost of production of Starbucks has increased must come from the rising price of coffee given in Figure 1.
§ Many students used information in Extract 2 to justify the increase in Starbucks’ cost instead. This is incorrect as the period is between Q42007 – Q42008 and Extract 2’s information is in 2009.
§ Some students failed to read the time axis of Fig 2 & 3 properly, thinking that they were 2007-2011, when they are actually from 2007Q4 – 2008Q4.
(b) / (ii) / Compare the different demand elasticity concepts. / [2]
Similarity:
All three demand elasticity concepts relate to the degree of responsiveness of quantity demanded to a change in one of its determinants, ceteris paribus
Difference:
The difference lies in the determinants. For PED, it’s the price of the good itself; for YED, it’s the income levels of consumers and for CED, it’s the price of related goods.
Examiner’s comments:
§ The key would be to point out explicitly the similarity and difference, and not to simply link the various definitions with connecting words like ‘whereas’, ‘while’, ‘however’.
§ Many forgot about ‘ceteris paribus’
(iii) / From Extract 2, discuss the usefulness of demand elasticity concepts in explaining the strategies adopted by Starbucks to maximise its profit level. / [8]
Approach to the question:
1. Identify the strategies adopted by Starbucks
2. Thesis: Relevant demand elasticity concepts can be used to explain the strategies. This means that not all demand elasticity concepts, so only choose the relevant ones.
3. Antithesis: Other reasons, apart from demand elasticity concepts, can be used to explain the strategies.
4. Evaluation/Stand/Judgment: Limited extent, due to the fact that ceteris paribus is not held in reality. Also, to maximise profit, cost considerations is necessary.
Introduction
Relevant demand elasticity concepts will be examined to discuss whether and to what extent strategies adopted by Starbucks will be effective in maximising its profit level. Demand elasticity concepts are used to maximise total revenue.
Strategy: Offering various promotions to maximise profit
Dd elasticity concepts are useful / Dd elasticity concepts are NOT useful§ CED is useful (definition & state application). Assuming that the promotions are reaction strategies to rival’s pricing policy, and if successful, it may reduce the positive CED value (i.e. degree of substitutability) between Starbucks and its rivals. This means that its demand will be less affected and hence total revenue. Ceteris paribus, profit will not fall less.
§ Even if there is no info on rival’s pricing policy, CED is useful because promotions aim to further differentiate Starbucks from McDonald’s and Dunkin’ Donuts products, hence reducing the CED value.
Note: YED is not useful here as YED indicates output decisions, not the launch of promotions
Note: Promotions are not pricing strategies. So PED is not useful here. / § Since no info is given on rival’s pricing policy, CED may not be useful.
§ Ceteris paribus condition is not met – other factors have led to increase in profit. Promotions essentially mediate the decrease in demand for its coffee, which is suffering as demand for luxury products like Starbucks’ coffee falls during a recession. Such strategies aim to favourably influence the taste and preference of consumers and hence increase the demand for the coffee. Total revenue for Starbucks will increase. Hence, profit will also rise, assuming no change in costs.
Evaluation:
§ Whether Starbucks can eventually maximise revenue and hence profit from promotions will depend on the relative success of rivals’ strategies. From Ext 2, para 2, rivals are also trying to distinguish themselves from Starbucks via non-price competition – improved coffee blend from McDonalds and tasty menu from Dunkin’ Donuts.
Strategy: Introduction of new instant coffee product to maximise profit
Dd elasticity concepts are useful / Dd elasticity concepts are NOT useful§ YED is useful (definition & state application). Financial crisis led to recession in the US which led to a fall in consumer incomes. Instant coffee may be considered to be an inferior product relative to premium store-brewed coffee due to its lower quality since it is not freshly brewed. Hence YED < 0: demand for such inferior products increase as incomes fall, ceteris paribus. Total revenue for Starbucks will increase. Ceteris paribus, profit will also rise. / § Ceteris paribus condition is not met. Demand for instant coffee may not be high due to consumers’ tastes and preference. Instant coffee may not be well-received by consumers who prefer or are addicted to store-brewed fresh coffee. Hence the strategy may not yield much demand and hence profit.
§ Cost considerations not factored in. If the cost of producing instant coffee is high and there is lower than expected demand for it, then profit will not be maximised
Evaluation:
The introduction of Via is to enable Starbucks to tap into another market, so that they can increase their revenue. So regardless of recession or not, Starbucks would have launched the new product. Perhaps it is purely coincidental that the timing of the launch matches a recession.
Strategy: Closing down of 600 stores to maximise profit
Dd elasticity concepts are useful / Dd elasticity concepts are NOT useful§ YED is useful. Given the recession and that Starbucks coffee is considered to be of premium grade, hence YED > 1. The strategy is therefore to reduce output by closing down stores in the area worst hit by the recession, since demand for its coffee will fall more than proportionately. / § Nothing to do with YED, but rather the closure is to reduce costs of production since there is no need to pay rent for the premises or wages to workers. Ceteris paribus, profit will rise.
Evaluation:
Closure of the stores is likely to help Starbucks minimise costs, rather than maximise revenue.
Overall evaluation / Stand
Demand elasticity concepts can only explain Starbucks’ strategies to maximise profit to a limited extent. Other factors can also explain their strategies.
Ext 2 para 2: “Lots of people still favour Starbucks”. There is still demand for Starbucks’ coffee. But in order to raise profit, it must also look into its cost structure, the costs of the strategies incurred, as well as to identify the root cause of the fall in profit.