The Undercover Economist

Published in 2005, Tim Harford's The Undercover Economist is a witty and intelligent book that explores the economics of everyday life. Using a number of both micro and macro examples — e.g., why wine is so expensive in restaurants, how trading permits can reduce environmental pollution, the impact of government corruption in Cameroon, and why used cars are generally lower in quality — Harford shows how thinking like an economist can open our eyes to all kinds of things going on in the world around us.

In an especially strong section, Harford uses the example of Costa Coffee's high-traffic location near the London Eye to show all at once how businesses set prices, why commercial rents are so high, and how companies devise creative strategies to maximize profits:

As the only coffee provider beside the London Eye, the Costa coffee bar wields plenty of scarcity power over the customer. It’s not innate to Costa but is reflected glory from the amazing setting. As we know, because customers will pay high prices for coffee in attractive locations, Costa’s rent will be high. Costa’s landlords have rented out some of this scarcity value to a coffee bar, just like the owners of Manhattan’s skyscrapers, or train stations from Waterloo to Shinjuku. Scarcity is for rent — at the right price.

But how should Costa exploit the scarcity they are renting from the London Eye? They could simply raise the price of a cappuccino from £ 1.75 (about $ 3) to £ 3 (nearly $ 6). Some people would pay it, but many would not. Remember the Millennium Dome: scarcity gives you power, but not limitless power. Alternatively, they could cut prices and sell much more coffee. They could cover wages and ingredients by charging as little as 60 pence ($ 1) a cup. But unless they were able to increase their sales dozens of times over, they’d not make enough to cover their rent. That’s the dilemma: higher margins per cup, but fewer cups; or lower margins on more cups.

It would be nice for Costa to sidestep that dilemma, by charging 60p to people who are not willing to pay more and £ 3 to people who are willing to pay a lot to enjoy the coffee and the view. That way they would have the high margins whenever they could get them and still sell coffee at a small profit to the skinflints. How to do it, though? Have a price list saying, “Cappuccino, £ 3, unless you’re only willing to pay 60p”? It does have a certain something, but I doubt it would catch on with the coffee-buying public of London’s South Bank. So Costa has to be more subtle.

For a while, Costa hit upon an elegant strategy: Costa, like most other coffee bars these days, offers “Fair Trade” coffee; theirs comes from a leading fair trade brand called Cafédirect. Cafédirect promises to offer good prices to coffee farmers in poor countries. For several years, customers who wished to support third-world farmers—and such customers are apparently not uncommon in London—were charged an extra ten pence (about eighteen cents). They may have believed that the ten pence went to the struggling coffee farmer. The evidence suggested that almost none of that money went anywhere but Costa’s bottom line.

Cafédirect paid farmers a premium of between 40 and 55 pence (up to a dollar) per pound of coffee. That relatively small premium can nearly double the income of a farmer in Guatemala, where the average income is less than $ 2,000 a year. But since the typical cappuccino is made with a quarter-ounce of coffee beans, the premium paid to the farmer should translate into a cost increase of less than a penny a cup.

Of the extra money that Costa charged, more than 90 percent was going missing between the customer and the farmer. So either Costa and Cafédirect were wasting the money (through higher costs) or it was being added to profits. Fair trade coffee associations make a promise to the producer, not the consumer. If you buy fair trade coffee, you are guaranteed that the producer will receive a good price. But there is no guarantee that you will receive a good price. The truth is that fair trade coffee wholesalers could pay two, three, or sometimes four times the market price for coffee in the developing world without adding anything noticeable to the production cost of a cappuccino, because coffee beans make up such a small proportion of that cost. Charging an extra ten pence gave a misleading impression of how much it really cost to get hold of that fair trade coffee. After some inquiries by a certain Undercover Economist, Costa worked out that the whole business gave the wrong impression, and at the end of 2004 began to offer fair trade coffee on request, without a price premium. Costa abandoned the premium of fair trade coffee because it was bad public relations, not because it was unprofitable. But why was it profitable to charge a higher markup on the cost of production on fair trade coffee than on normal coffee? Certainly not because Costa objected to the whole idea of fair trade and tried to discourage such idealistic behavior with their pricing. The reason has nothing to do with fair trade at all: it’s because fair trade coffee allowed Costa to find customers who are willing to pay a bit more if given a reason to do so. By ordering a fair trade cappuccino, you sent two messages to Costa. One message interested them very little: “I think that fair trade coffee is a product that should be supported.”

The second message is the one that they were straining to hear: “I don’t really mind paying a bit extra.”

This immediately gave Costa the information they were looking for. They know that socially concerned citizens tend to be less careful with their cash in coffee bars, while unconcerned citizens tend to keep their eyes on the price.

Costa’s strategy was designed to get maximum value out of the scarcity power they’ve rented from the London Eye. They are torn between raising prices and losing customers, or lowering prices and losing margins. If they have to charge the same price to every customer, they will simply have to guess the best tradeoff between the two options. But if they can charge a high price to the lavish (or concerned) and a low price to the thrifty (or unconcerned), then they can enjoy the best of both worlds. And there is no need to worry on Costa’s behalf that this strategy has now been denied to them. Costa has plenty of alternative ways to identify customers for a price increase. Nor is there anything unusually Machiavellian about Costa Coffee. Any well-run business would seek to charge each customer the maximum price he’d be willing to pay—and they do. Take a Starbucks, any Starbucks. For the sake of argument, take the Starbucks on P Street and 14th in Washington DC. The price list looks like this:

  -- Hot Chocolate: $2.20

  -- Cappuccino: $2.55

  -- Caffe Mocha: $2.75

  -- White Chocolate Mocha: $3.20

  -- 20 oz Cappuccino: $3.40

Or, to translate:

  -- Hot Chocolate - no frills: $2.20

  -- Cappuccino - no frills: $2.55

  -- Mix them together - I feel special: $2.75

  -- Use different powder - I feel very special: $3.20

  -- Make it huge - I feel greedy: $3.40

Starbucks isn’t merely seeking to offer a variety of alternatives to customers. It’s also trying to give the customer every opportunity to signal that they’ve not been looking at the price. It doesn’t cost much more to make a larger cup, to use a flavored syrup, or to add chocolate powder or a squirt of whipped cream. Every single product on the menu above costs Starbucks almost the same to produce, down to the odd nickel or two.

Does this mean that Starbucks is overcharging all of its customers? No. If so, a regular cappuccino or hot chocolate would cost $ 3.30, and you could have all the frills you wanted for a dime. Perhaps Starbucks would like to do that, but they can’t force price-sensitive customers to pay those prices. By charging wildly different prices for products that have largely the same cost, Starbucks is able to smoke out customers who are less sensitive about the price. Starbucks doesn’t have a way to identify lavish customers perfectly, so it invites them to hang themselves with a choice of luxurious ropes.

He also shows us how to be better consumers and avoid some of the games that retailers play:

Have you noticed that supermarkets often charge ten times as much for fresh chili peppers in a package as for loose fresh chilies? That’s because the typical customer buys such small quantities that he doesn’t think to check whether they cost four cents or forty. Randomly tripling the price of a vegetable is a favorite trick: customers who notice the markup just buy a different vegetable that week; customers who don’t have self-targeted a whopping price rise.

I once spotted a particularly inspired trick while on a search for potato chips. My favorite brand was available on the top shelf in salt and pepper flavor and on the bottom shelf, just a few feet away, in other flavors, all the same size. The top-shelf potato chips cost 25 percent more, and customers who reached for the top shelf demonstrated that they hadn’t made a price-comparison between two near-identical products in near-identical locations. They were more interested in snacking.

Admittedly, for some people the difference in flavors is important. Some will notice the higher price for salt and pepper flavor and, irritated, pay anyway. Others will prefer the different flavors and count themselves lucky that they have inexpensive tastes.

But this is an example of a universal truth about supermarkets: they are full of close (or not so close) substitutes, some cheap, some expensive, and with a strong random element to the pricing. The random element is there so that only shoppers who are careful to notice, remember, and compare prices will get the best bargains. If you want to outwit the supermarkets, simple observation is your best weapon. And if you can’t be bothered to do that, you really don’t need to save money.

[...]

As a matter of verifiable fact, when you compare the prices on the same goods, Wholefoods is just as expensive as Safeway. Safeway and Wholefoods charge exactly the same for bananas. Exactly the same for a carton of cherry or grape tomatoes... Wholefoods is not expensive in the sense that it charges more for the same good. It is expensive because of where its price-targeting policies are focused: prices for the basics may be competitive, but the selection in Wholefoods is aimed at customers with a different view of what the "basics" are... 

That is why a basket of goods from Wholefoods can cost so much more than a basket of goods from Safeway. It’s not because Wholefoods is “expensive” and Wholefoods customers are stupid. It’s because Wholefoods offers additional, expensive choices, which Wholefoods shoppers are willing to take because they perceive the quality premium is worth it.

So here’s my advice: if you want a bargain, don’t try to find a cheap store. Try to shop cheaply. Similar products are, very often, priced similarly. An expensive shopping trip is the result of carelessly choosing products with a high markup, rather than wandering into a store with “bad value,” because price-targeting accounts for much more of the difference between prices than any difference in value between one store and another. 

Along with Paul Krugman's early work and perhaps Steven Levitt's Freakonomics, this is one of the better introductions to the power of economic reasoning. Highly recommended, especially for high school and college students who are new to the subject.