Coffee Prices
The Game Theory Behind Starbucks'
Big Coffee Price Cut
By Kyle Stock
April 12, 2013
Good news for the caffeinated masses: Starbucks (SBUX) is cutting prices, starting May 10, on
its bags of coffee sold in grocery stores. The $1-per-bag discount represents a 10 percent
discount on its eponymous beans, a 12.5 percent drop on its cheaper Seattle’s Best brand.
At Starbucks’ scale, this is big. Last quarter the company collected about $380 million from sales
outside its cafés at an operating margin of 25.5 percent. At that level, the coffee empire is
making a profit of about $2.55 per bag. Take away $1 per, and Starbucks would have to sell 65
percent more bags to book the same amount of profit.
It’s not clear Starbucks will sway that many customers quickly. But the company could be
betting on widening income inequality—what academics call “the hourglass economy.” The
theory is: Major retail growth has been—and will continue to be—at the low and the high ends
of the socioeconomic scale. Starbucks already has plenty of $6 barista-brewed drinks to capture
the top of that market, but a bag of $10 coffee is very much in the middle, according to Rita
McGrath, a professor at Columbia Business School.
Incidentally, this may also be why Starbucks isn’t cutting prices in its cafés, even after a
controversial price increase in many of its shops last year.
Cutting prices on its bags of coffee also takes a swing at the competition’s knees. Starbucks is a
supply-chain machine. There are massive economies in its scale, and it aggressively hedges the
costs of its coffee, dairy, and fuel. At the end of the year, it had $816 million in coffee beans
sitting around its warehouses.
And here’s where a little game theory comes into play. Coffee prices are hovering at three-year
lows, a drop that prompted such brands as Folgers (SJM), Dunkin’ Donuts (DNKN), Maxwell
House (KRFT), and others to cut their prices earlier this year.
By committing to lower prices (and not using coupons or sales), Starbucks is sending a signal,
McGrath says. It’s serious about the low end of the market; Dunkin’ Donuts, Folgers, and other
competitors can either trim their margins further or give up volume. Either way, they lose.
So does Starbucks, at least in the near term. But with savvy hedging and customers lining up for
expensive lattes—including increasing crowds in China—it can stand the pain for a while. And it
is betting it is more efficient than its competitors. As McGrath says: “If you can run
economically enough to make money at the lower price, you’re simply taking money out of your
competitors’ pockets.”