How much would you pay for a cup of coffee?
If a filter coffee cost the same as a glass of whiskey, would you drink it as often? If a bag of coffee cost twice as much as it does now, would you still go through one a week? Would you be willing to spend less on other things to be able to afford coffee?
In economics, how purchasing behaviour changes based on differences in price is called “price elasticity of demand”. In the coffee sector, pricing is a contentious and heavily discussed issue. The C price affects farmers, traders, and roasters the world over.
Many argue that coffee farmers need to be paid a higher price to move away from subsistence living and become truly sustainable. But how would specific price changes affect consumption?
Read on to learn more about price elasticity of demand and why it is so important in the coffee sector.
You might also like our article on the early history of the C market.
PRICE ELASTICITY OF DEMAND: A SIMPLE OVERVIEW
In economics, the word “elasticity” is used to describe how behaviour changes because of a change in context.
Price elasticity of demand is just one type of elasticity. It refers to how much more or less of something people would purchase if the price changed.
It is important in the coffee sector, especially for policymakers and major industry actors looking to change the way that the coffee value chain functions.
Many of the world’s estimated 24 million coffee farmers struggle financially, with low prices and volatility often stated as contributing factors. While it’s easy enough to say that paying more could solve the problem, predicting how this would influence the purchasing decisions of consumers is not simple.
The complexity of this task is often underestimated, which means that when decisions are made, they are often based on the assumptions that decision makers or experts have made about expected consumer behaviour.
Sadly, however, these “common sense” predictions are often insufficient. Broadly, they will be based on past behavioural evidence, and therefore be less relevant or biased.
FUNDAMENTAL PRINCIPLES OF PRICE ELASTICITY OF DEMAND
If we accept that historic evidence is not enough to properly predict buyer behaviour, how do you determine what happens to buying behaviour if we raise the price of coffee?
Well, the first step is to grasp the relationships and different factors that influence purchasing decisions. This will help us understand cause-and-effect relationships.
In most markets, we experience something called “negative price elasticity of demand”.
With negative price elasticity of demand, people buy more of something as it becomes cheaper, and less of something as it becomes more expensive. How much more or less they buy against the change in price is the elasticity.
So, if a price change doesn’t alter demand much at all, we consider it to be inelastic. However, if demand is highly dependent upon price, we consider it to be elastic.
With lower price elasticity of demand, the curve above gets steeper; with higher elasticity, it gets flatter, as you can see below.
MARGINAL UTILITY & DIMINISHING RETURNS
Of course, it gets much more complicated than this. From a graph, it’s easy to say that a lower price could increase the quantity demanded to a theoretically infinite point. But do you want a theoretically infinite amount of coffee?
Firstly, we have to consider the law of diminishing returns. The concept that people will consume more of something when it is cheaper assumes that more is “better”.
Are two espressos better than one? For people that enjoy espresso, we can most likely say yes. But what about ten?
After two or three espressos, most people would probably prefer not to drink another, even if it was free. How much a consumer enjoys or appreciates having a product (i.e. drinking an espresso) is referred to as the product’s “utility”. And from this line of thinking, we can conclude that the “utility” they get from the first espresso is likely to be much higher than it is for the fourth. By the time we reach the tenth, it might even be negative.
The additional satisfaction that a buyer gets from one more of something is called “marginal utility”. For an example of how this influences price elasticity of demand, take a look at the graph below.
Another very important concept when predicting the demand for a product is substitution.
“Cross price elasticity of demand” is how much the demand for one product changes according to the price of another product.
To put it simply: if coffee became extremely expensive, people might switch to tea. Conversely, if tea became very expensive, the demand for coffee might well increase.
We calculate consumers’ willingness to accept a substitute for a product as the “marginal rate of substitution”.
If a consumer only gets slightly more satisfaction from tea than coffee, they will be more likely to make the switch if the tea price rises, because they get a similar level of satisfaction from both. Compare this to somebody who loves tea but doesn’t drink coffee, and they’ll be much less likely to make the switch.
Another example: perhaps they get more utility from a coffee than from a biscuit. So, they purchase a coffee, and then a second one. But after the second coffee, they get more utility from one biscuit than the third coffee, so they purchase the biscuit.
The same logic can apply within different markets in the coffee sector. If specialty coffee is US $15 and regular coffee is US $10, a consumer would buy specialty if they consider the additional satisfaction (marginal utility) they get from it to be equal to or greater than US $5.
However, we have to ask another question: is there something else they could purchase with that US $5 that could give them more satisfaction than just having a cup of better coffee? Would they get more satisfaction from just drinking specialty coffee, or would they prefer a regular coffee and a sandwich?
WHAT DOES THIS MEAN FOR THE COFFEE SECTOR?
These various examples illustrate one thing above all else: the question of asking whether or not people would pay more for their coffee has no simple answer. It always depends on the context.
But how does this knowledge of price elasticity relate to the real world? What are the implications for the coffee sector we live and work in?
Coffee as a single product category is generally accepted as being fairly price inelastic in high-income consuming markets. A 2005 paper by Dick Durevall shows that even as coffee has become more expensive over time, its demand has not decreased in a significant or relevant way. There is less information available about price elasticity of demand in lower-income markets, including many coffee producing countries.
We also know that coffee is a very competitive product category in many consumer markets. This means that even if coffee were to become slightly more expensive across the board, it would be unlikely that retailers would drive their prices up accordingly.
This is because if one brand were to raise their prices, consumers would likely shift to buying comparable substitute products at lower prices.
For most large roasters, price elasticity of demand is generally quite high thanks to their ability to make substitutions. If the cost to acquire coffee from every single origin around the world increased, they would likely pay more and adjust their final sale price to reflect this.
However, if the cost of buying coffee from one specific origin was to go up, demand for it would likely fall dramatically, because larger roasters could alter their product lineup correspondingly.
We have also seen in history that amid price spikes, roasters have included higher concentrations of cheaper coffees, such as commodity-grade robustas or lower-scoring arabicas. This has helped them keep costs the same, therefore allowing them to avoid increasing prices for the end consumer and becoming less competitive.
Case #1: Could you raise coffee prices so farmers make more money?
There are several arguments as to why artificially raising prices at the consumer end would or would not lead to desirable outcomes.
When looking at the implications of price elasticity of demand, as mentioned, theoretically raising consumer prices would not lead to significantly reduced demand.
There is also no evidence to suggest that higher retail prices (meaning higher roaster sale prices) would lead to a voluntary increase in green coffee prices.
However, if a green coffee price increase was dictated by producer groups, the downstream supply chain (roasters and retailers) and their customers would theoretically be able to absorb it.
Case #2: Could we promote consumption in coffee producing countries?
There is a popular argument that if the demand for coffee is increased and supply remains stable, then prices will naturally increase.
As demand is price inelastic (i.e. not price sensitive), then in theory the market should consume the same amount even at higher prices. However, since most high-income coffee importing countries are largely saturated with existing brands, many are looking to coffee producing countries to drive new demand.
In some producing countries that export the vast majority of their production and import lower-cost coffee from abroad, we have seen a push to outlaw imports and increase the demand for domestically-produced coffee. In theory, this would put upward pressure on price and cause it to increase.
However, the effectiveness of these measures would depend massively on the price elasticity of demand in the market in question. In lower-income countries, people have less disposable income, so a hypothetical price increase for coffee could cut into budgets for “essential” goods and services such as food, shelter, and clothing.
If people have enough money for coffee, milk, and bread at current prices and coffee becomes more expensive, we need to know if they would buy less milk or bread to drink coffee. Bread and milk are more likely to be considered essential, and therefore offer more utility, linking back to the idea of marginal utility having a relationship with demand.
If a measure intended to increase demand for domestically-produced coffee caused the price to rise, there’s a good chance it could actually inadvertently reduce demand to a degree. This would mitigate the effectiveness of the policy. That isn’t to say it wouldn’t be effective, but it could be less than perfect.
Ultimately, these are just some of the many factors to take into account when evaluating measures that could change or influence the price of coffee.
While these concepts can help business owners, policymakers, and producers alike understand what happens when the price of coffee changes, the reality is that they are still very much theoretical. To truly understand how the market will react when price changes, it’s important to gather as much data as you can and carry out all relevant analysis.