Products, Services, and Prices in the Free Market Economy Starbucks Corporation (Starbucks) is considering whether to increase or decrease the price of their product in order to increase revenue. Deciding upon which direction to go with the price depends upon the price elasticity of the product. According to the law of demand: “All else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between price and quantity demanded” (McConnell & Brue, 2004, p. 40). Starbucks is a retailer of specialty coffee.
It retails a variety of hot and cold beverages, complementary food items, coffee-related accessories and equipment, teas and other non-food products through retail stores in approximately 39 countries worldwide. The company operates primarily in the US. It is headquartered in Seattle, Washington and employs about 146,000 people. (Starbucks Corporation Overview, 2008) Due to increased cost of ingredients, Starbucks is considering a 2% price increase in order to increase revenue. However, Starbucks is concerned that consumers will be impeded by the price increase and will shop for alternatives to Starbucks specialty products.
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Consumers might stop purchasing the specialty coffees if the products become more of a luxury or too expensive to fit into their budget. The following will analyze the effects of increasing the price of Starbucks coffee. A determination will be made as to the price elasticity of demand of the product and whether the product is elastic or inelastic. A determination will also be made as to how an increase in a consumer’s income would affect the demand for Starbucks products. Using Elasticity of Demand to Increase or Decrease Prices What is Elasticity of Demand?
Starbucks future revenue growth in the coffee market depends on analyzing the current market conditions of the coffee industry. Price elasticity of demand will help Starbucks be able to adjust their coffee prices in order to combat the rise in the ingredients used to make their coffee to maximize their revenue. The way a consumer responds to the price change is measured by a products price elasticity of demand. If the product is an elastic demand the demand will be reflected in the price changes and the elasticity of demand coefficient will be greater than one.
If the product is an inelastic demand a change in the percentage change in the price will result in a smaller percentage change in the demand quantity and the elasticity of demand coefficient will be less than one. If a product is unit elastic, the price and the demand will change by the same percentage and the coefficient of demand will be equal to one. Starbucks coffee is considered to be an inelastic demand. The coffee is inelastic due to the percent of change in the quantity demand divided by percentage of change in the product being less than one.
The percentage of change in the quantity is 1%, and the percentage of change in the price is 2%. Therefore, when 1% is divided by 2%, the elasticity of demand coefficient is only 0. 5% (McConnell & Brue, 2004, p 357). The company produces high quality products and customers are having a positive experience on each visit to the establishment. As a result, Starbucks has built a strong brand image. People are willing to the pay for the quality and the reputation (“Starbucks Corporation,” 2008). Raising the price Assume Starbucks raises their coffee prices by 2%.
This will result in a 1% decrease in the demand for the coffee. The price is still rising by more than the demand is decreasing, therefore, the company can increase their revenue. The main ingredients such as coffee, milk, and sugar have been rising, and Starbucks is currently absorbing much of the costs to prevent raising the prices on the menu (Han, 2008, para. 10). This small 2% increase can help increase revenues by $286,575 a day. These additional revenues can help offset other uncontrollable costs. Customer’s Income Change and the Effect on Starbucks Income elasticity of demand measures the degree to which consumers respond to a change in their incomes by purchasing particular goods” (McConnell & Brue, 2004, p 368). Percentage change in quantity demanded of good X divided by the percentage change in real consumers’ income. Elasticity discussed here is highly dependent on type of goods such as normal goods (necessities, luxuries) and inferior goods. “Normal Goods have a positive income-elasticity, meaning that more of them are demanded as incomes rises” (McConnell & Brue, 2004, p 368).
A product is a normal good if its income elasticity is positive. This means that when income rises, quantity demanded rises. Most goods are normal goods. Normal goods have two different types, necessity and luxury. A good is a necessity if its income elasticity is positive, but less than 1. This means that if income rises by 10%, quantity demanded rises by less than 10% – therefore, as people’s income rises, they spend a smaller percentage of their income on necessities. A good is a luxury good if its income elasticity is positive, and greater than 1.
This means that if income rises by 10%, quantity demanded rises by more than 10% – therefore, people spend more of their income on luxuries when they have larger incomes. Inferior goods have negative income elasticity. This means that when income rises, quantity demanded falls (Elasticity and its Determinants, 2008). Necessities include the goods in which the demand rises with income but not as proportionate as price increase. This is because the customer has limited need on necessary goods as the living standard rises.
Some examples of necessities include fresh vegetables, instant coffee, natural cheese, fruit juice, utilities, shampoo, toothpaste, detergents, and rail travel (tutor2u, 2008). Luxuries include the goods in which demand is very much related to the average income level. When income rises, prestigious consumption starts to take more of a share of a consumer’s income. Therefore, the income elasticity of luxury goods is higher than the necessity ones. Some examples of luxuries include international air travel, fine wines, luxury chocolates, private education, private health care, antique furniture, and designer clothes (tutor2u, 2008).
Inferior Goods include the goods and services that have a negative income elasticity of demand. Demand falls as income rises. The consumption of cheap products and services made to save sources in personal income decrease, but move to more luxury ones. Some examples of inferior goods are frozen vegetables, cigarettes, processed cheese, margarine, tinned meat, value “own-brand” bread, and bus travel (tutor2u, 2008). Starbucks should be considered a supplier which produces normal necessity goods in which demand rises by income increase but not in the same proportion.
Then the 10% increase in income will make increase obviously less than 10% in coffee demand. Conclusion Starbucks created a brand image that is synonymous with people who have above average income. An increase of 2% in price will not detract from the demand of the product but will impact the company’s revenue. Starbucks has demonstrated an ability to absorb increasing costs of components use in the development of the product. The revenue increase and other cost-containment could possibly absorb a higher price increase.
The products offered by Starbucks include products that are classified as normal necessity that will increase demand at lower rate than the increase in income. Starbucks menu includes items that are considered a luxury which will keep pace with increased income. It has been affirmed through analysis that demand of luxury items, specialty drinks, will not rise in proportion to the rise in income. The strategy and approach of Starbucks is to continue to control costs and minimize price fluctuations to maintain consistent demand and revenue. References
Elasticity and Its Determinants. (n. d. ). Retrieved September 13, 2008 from Louis and Clark College Web site: http://www. lclark. edu/~bekar/Mankiw/ch05/notes. htm Han Jane, (2008). Why Can’t Starbucks, McDonald’s Offer Lower Prices? 10. THE KOREA TIMES. Retrieved September 13, 2008, from http://www. koreatimes. co. kr/www/news/biz/2008/09/123_30459. html Income Elasticity of Demand. (n. d. ). Retrieved September 13, 2008, from tutor2u Online Web site: http://tutor2u. net/economics/content/topics/elasticity/income_elasticity. htm McConnell, Campbell R. , & Brue, Stanley L. 2004). Economics: Principles, Problems and Policies (16th ed. ). New York: The McGraw-Hill Companies. Starbucks Corporation. (2008). DATAMONITOR BUSINESS INFORMATION CENTER, (), 1-27. Retrieved September 12, 2008 from MarketLine Business Information Center Database. Starbucks Corporation Overview. (2008). MarketLine. (), 1. Retrieved September 12, 2008 from MarketLine Business Information Center Database. tutor2u. (2008). Income Elasticity of Demand. Retrieved September 12, 2008, from http://tutor2u. net/economics/content/topics/elasticity/income_elasticity. htm