Question

HOW STARBUCKS USES PRICING

STRATEGY FOR PROFIT

MAXIMIZATION

In January 2020, Starbucks raised their beverage prices by an average of 1% across the U.S, a move that represented the company’s first significant price increase in 18 months. I failed to notice because the price change didn’t affect grande or venti (medium and large) brewed coffees and I don’t mess with smaller sizes, but anyone who purchases tall size (small) brews saw as much as a 10 cent increase. The company’s third quarter revenue rose 25% to $417.8 million from $333.1 million a year earlier, and green coffee prices have plummeted, so what gives?

Starbucks claims the price increase is due to rising labor and non-coffee commodity costs, but with the significantly lower coffee costs already improving their profit margins, it seems unlikely this justification is the true reason for the hike in prices. In addition, the price hike was applied to less than a third of their beverages and only targets certain regions. Implementing such a specific and minor price increase when the bottom line is already in great shape might seem like a greedy tactic, but the Starbucks approach to pricing is one we can all use to improve our margins. As we’ve said before, it only takes a 1% increase in prices to raise revenues by an average of 11%.

Value Based Pricing Can Boost Margins

For the most part, Starbucks is a master of employing value based pricing to maximize profits, and they use research and customer analysis to formulate targeted price increases that capture the greatest amount consumers are willing to pay without driving them off. Profit maximization is the process by which a company determines the price and product output level that generates the most profit. While that may seem obvious to anyone involved in running a business, it’s rare to see companies using a value based pricing approach to effectively uncover the maximum amount a customer base is willing to spend on their products. As such, let’s take a look at how Starbucks introduces price hikes and see how you can use their approach to generate higher profits.

An Overview of the Starbucks Pricing

Strategy:

The Right Customers and the Right Market

While cutting prices is widely accepted as the best way to keep customers during tough times, the practice is rarely based on a deeper analysis or testing of an actual customer base. In Starbucks’ case, price increases throughout the company’s history have already deterred the most price sensitive customers, leaving a loyal, higher-income consumer base that perceives these coffee beverages as an affordable luxury. In order to compensate for the customers lost to cheaper alternatives like Dunkin Donuts, Starbucks raises prices to maximize profits from these price insensitive customers who now depend on their strong gourmet coffee.

Rather than trying to compete with cheaper chains like Dunkin, Starbucks uses price hikes to separate itself from the pack and reinforce the premium image of their brand and products. Since their loyal following isn’t especially price sensitive, Starbucks coffee maintains a fairly inelastic demand curve, and a small price increase can have a huge positive impact on their margins without decreasing demand for beverages. In addition, only certain regions are targeted for each price increase, and prices vary across the U.S. depending on the current markets in those areas (the most recent hike affects the Northeast and Sunbelt regions, but Florida and California prices remain the same).

Product Versioning & Price Communication

They also apply price increases to specific drinks and sizes rather than the whole lot. By raising the price of the tall size brewed coffee exclusively, Starbucks is able to capture consumer surplus from the customers who find more value in upgrading to Grande after witnessing the price of a small drip with tax climb over the $2 mark. By versioning the product in this way, the company can enjoy a slightly higher margin from these customers who were persuaded by the price hike to purchase larger sizes.

Starbucks also expertly communicates their price increases to manipulate consumer perception. The price hike might be based on an analysis of the customer’s willingness to pay, but they associate the increase with what appears to be a fair reason. Using increased commodity costs to justify the price as well as statements that aim to make the hike look insignificant (less than a third of beverages will be affected, for example) help foster an attitude of acceptance.

on Wednesday April 8, Starbucks announced that it expects its fiscal second-quarter earnings to be cut nearly in half as the coronavirus pandemic causes sales to plunge in its two largest markets.

What is the type of Starbucks’ market?

What are the main conditions of this market

What is the shape of Starbucks’ demand curve?

What is the degree of price elasticity of demand of Starbucks? Why?

Did Starbucks make a good economic decision in raising the prices? Why?

What are the Starbucks’ maximum profit conditions?

What are the main three items groups that contribute to Starbucks variable costs?

What would happen to Starbucks’ profit if the prices of all three go down, holding other things fixed?

On Wednesday April 8, Starbucks announced that it expects its fiscal second-quarter earnings to be cut nearly in half as the coronavirus pandemic causes sales to plunge in its two largest markets. What would be the right pricing strategy to maximize revenues for Starbucks in the current circumstances?

If you have your own business, what do you learn From Starbucks case study?

Answer 1

Answer 1

The type of Starbuck's market is monopolistic competition. Monopolistic competition refers to a market structure where there are a large number of sellers selling differentiated products or services due to which those products or services are closely related but not perfect substitutes. Those products or services are similar but not completely identical. Here also, Starbuck's and other firms like dunkin donuts etc. sell closely related products but they are differentiated products for customers.

Answer 2

Main conditions of monopolistic competition market structure are:

1. Large number of buyers and sellers: There are large number of buyers and sellers in the market. The sellers are selling closely related but differentiated products. Each firm captures some share of the market and has some amount of control over the market price as it can influence the price of it's product or service. Large number of firms also leads to competition in the market to capture larger market share.

2. Product differentiation: Each firm sells a closely related but differentiated product. A product may be differentiated on the basis of brand, colour, shape, size, texture, flavour, smell appearance etc. Product differentiation enables buyers to differentiate between same product produced by different firms and therefore, they are willing to pay different price for these differentiated products. This gives an individual firm a kind of monopoly power to set different prices for their products despite the competition in the market.

When there is high degree of product differentiation i.e. brand image enables the firm to capture loyal customers, then the firm faces fairly inelastic demand due to which it has the power to charge higher price than it's competitors without losing the market.

3. Selling costs: Firms in monopolistic competition market structure create product differentiation and make the consumers know about these differences through advertisements and marketing. Firms incur a lot of cost to make a favourable impression about their product in the mind of the potential buyers. Also, they justify their prices through these advertisements.

4. Non-Price competition: The firms under monopolistic competition market structure not just engage in price competition but also in non-price competition like giving offers, free gifts etc. to retain the customers.

5. Lack of perfect knowledge: Perfect knowledge about market conditions is not available to the buyers and sellers. Due to this, sellers are able to create artificial superiority of it's products in the minds of the buyers and buyers cannot find actual costs of the products. Due to this, consumers might buy a particular product of higher price even if similar product is available at a lesser price and of similar quality. Firms are able to manipulate consumer perceptions by these selling costs.

Answer 3

Starbuck's demand curve will be a very steep, nearly vertical downward sloping demand curve as it faces a fairly inelastic demand. Due to this, a given amount of price change will not change demand by huge amount. Due to this firm would be able to earn higher revenues by increasing the price of it's product. It might happen that demand does not change at all with a change in price in which case it's demand curve will be completely vertical in which case it's demand will remain same irrespective of price change.

Answer 4

The degree of price elasticity of demand of Starbuck's is less than 1 as it has fairly inelastic demand. Starbuck's deters the price sensitive customers out of it's customer base by increasing it's prices leaving the price insensitive buyers as it's customers. It caters to loyal higher income consumer base that perceives these coffee beverages as an affordable luxury and depend on their strong gourmet cofee. They are price insensitive customers. Even when Starbuck's raises the price of it's coffee, the demand of these customers does not change at all or changes by a very small amount relative to the price change. Due to this, a small price increase can have a huge positive impact on it's profits without decreasing the demand for beverages. Also, Starbuck's raises the price of specific drinks and sizes and not of the entire lot due to which it's customers just shift from one coffee size to another or from one flavour to another but do not shift to another seller. Hence, the price elasticity of demand for Starbuck's coffee is less than 1 i.e. due to a change in price, the quantity chnages by a lesser proportion.