Thursday, April 20, 2006
Why we cough up for a cup of coffee
Posted by David Smith at 10:00 AM
Category: David Smith's other articles

A review of The Undercover Economist, by Tim Harford.

The question why a cup of coffee costs so much has engaged philosophers and pundits, particularly in America, for years. How did Starbucks get people to pay $2 for something they were used to paying 25 and 50 cents for? The answer, of course, has implications beyond caffeine. Without the $2 cup of coffee there would not be a Starbucks (and similar coffee chains) in every town and mall in America. And without that, it is doubtful the coffee phenomenon would have spread to Britain and around the world.

Tim Harford, in his entertaining application of economic principles to everyday life, takes us back to David Ricardo, the great English classical economist, to explain coffee prices.

Successful coffee bars, those that charge a lot, are in prime locations such as railway stations or busy shopping streets. Those areas charge steep rents. Therefore, coffee prices are high. Or not. Harford demonstrates, citing Ricardo, that coffee-shop owners will only pay high rents because consumers are prepared to pay through the nose for coffee.

Next time a friendly local store closes down to make way for a Starbucks, in other words, we coffee buyers have only ourselves to blame. And next time you pay £1.55 (or more) for a coffee on Waterloo station, knowing you could probably get it cheaper round the corner, recognise that you are paying for scarcity value (the limited number of outlets on the station) and convenience.

We are, as Harford shows, victims of the clever application of economic principles by coffee shops and retailers. Their goal is to extract the maximum price from each customer. That is likely to differ between customers. I may be prepared to pay no more than £1.50, while the next person is willing to shell out £3. Harford demonstrates how Starbucks achieves this; small variations — adding a little froth or flavouring — producing big variations in the price.

Those who were prepared to pay a high price anyway buy the coffee with all the trimmings. We easily fall into the traps laid for us.

All this Harford pulls off with a light touch, also showing how Marks & Spencer is able to practise price discrimination — in other words how it varies prices for the same products in stores only 500yd apart. He shows, too, that when coffee bars charge a premium for fair-trade coffee, or shops for organic produce, the main benefit is to their bottom line, with barely any going to the growers.

He draws on George Akerlof’s wonderful paper, The Market for Lemons; lemons in this case being used cars, and the difficulty for buyers being distinguishing the good ones from the duds. The only safe assumption is that they are all duds, in which case nobody tries to sell a good second-hand car because you don’t get a decent price for it, so the market becomes duds-only. I have used Akerlof, but I’m not sure it supports the conclusion that “second-hand cars tend to be cheap and of poor quality”. Better car reliability may have rendered the theory of lemons obsolete, at least in this particular context. This is all good fun, but probably not a revelation to the canny consumer armed with a copy of Which?

Do we need another book on popular economics? There is a branch of economics called imitation theory, which deals with the conscious or unconscious copying of others as part of rational decision making. And there is a branch of mathematics that effectively models the phenomenon of “bus-bunching”; in other words why do they always come in threes?

How else to explain, hard on the heels of last year’s surprise success, Freakonomics by Steven D Levitt and Stephen J Dubner, the arrival of Harford’s The Undercover Economist? They join a growing list of “popular” economics books of recent years, including The Armchair Economist by Steven E Landsburg; Naked Economics by Charles Wheelan; Sex, Drugs & Economics by Diane Coyle; two books by John Kay (The Truth About Markets and Everlasting Light Bulbs); my own Free Lunch; and pretty much anything by Paul Krugman. Each tends to be greeted with the same refrain (“At last somebody has written a book on economics everybody can understand”) and then forgotten, until the next one turns up.

I’m not suggesting that Harford has copied his predecessors — his approach is original — and I hope his book does well. It has a great title, taken from his regular pieces in the Financial Times, though the book is being marketed in a more sober way in Britain than in America, where the undercover economist is depicted as a Raymond Chandler-style private dick. It also comes on the back of the success of Freakonomics, which you either loved or hated.

I hated it, so have no hesitation in saying that Harford has written a better book. But is it a good book? The chapters that live up to the title, where Harford is genuinely delving into everyday economic conundrums, work better than the later “macro” chapters, such as Why Poor Countries Are Poor and How China Grew Rich, which read like padding. For an FT journalist, he is also a bit cavalier with facts. London’s population, for example, is 7.2m, not 6m.

There is, too, something of a Catch-22 with books of this kind. They have to be written for the general reader with no background knowledge of economics. But many of the people who buy them do so because they have an interest in and some knowledge of the subject. The former group, if it can be tempted to buy it, will find this book an entertaining and informative way into economics. Those in the latter group, I suspect, will find little that they did not already know.

From The Sunday Times, April 16 2006

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