The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor--and Why You Can Never Buy a Decent Used Car! - Couverture souple

One

Who Pays for Your Coffee?

The long commute on public transportation is a commonplace experience of life in major cities around the world, whether you live in New York, Tokyo, Antwerp, or Prague. Commuting dispiritingly combines the universal and the particular. The particular, because each commuter is a rat in his own unique maze: timing the run from the shower to the station turnstiles; learning the timetables and the correct end of the platform to speed up the transfer between different trains; trading off the disadvantages of standing room only on the first train home against a seat on the last one. Yet commutes also produce common patterns — bottlenecks and rush hours — that are exploited by entrepreneurs the world over. My commute in Washington, D.C., is not the same as yours in London, New York, or Hong Kong, but it will look surprisingly familiar.

Farragut West is the Metro station ideally positioned to serve the World Bank, International Monetary Fund, and even the White House. Every morning, sleep-deprived, irritable travelers surface from Farragut West into the International Square plaza, and they are not easily turned aside from their paths. They want to get out of the noise and bustle, around the shuffling tourists, and to their desks just slightly before their bosses. They do not welcome detours. But there is a place of peace and bounty that can tempt them to tarry for a couple of minutes. In this oasis, rare delights are served with smiles by attractive and exotic men and women — today, a charming barista whose name badge reads “Maria.” I am thinking, of course, of Starbucks. The café is placed, inescapably, at the exit to International Square. This is no quirk of Farragut West: the first storefront you will pass on your way out of the nearby Farragut North Metro is — another Starbucks. You find such conveniently located coffee shops all over the planet and catering to the same desperate commuters. The coffee shop within ten yards of the exit from Washington’s Dupont Circle Metro station is called Cosi. New York’s Penn Station boasts Seattle Coffee Roasters just by the exit to Eighth Avenue. Commuters through Shinjuku Station, Tokyo, can enjoy a Starbucks without leaving the station concourse. In London’s Waterloo station, it is the AMT kiosk that guards the exit onto the south bank of the Thames.

At $2.55 a tall cappuccino from Starbucks is hardly cheap. But of course, I can afford it. Like many of the people stopping at that café, I earn the price of that coffee every few minutes. None of us care to waste our time trying to save a few pennies by searching out a cheaper coffee at 8:30 in the morning. There is a huge demand for the most convenient coffee possible — in Waterloo Station, for example, seventy-four million people pass through each year. That makes the location of the coffee bar crucial.

The position of the Starbucks café at Farragut West is advantageous, not just because it’s located on an efficient route from the platforms to the station exit, but because there are no other coffee bars on that route. It’s hardly a surprise that they do a roaring trade.

If you buy as much coffee as I do you may have come to the conclusion that somebody is getting filthy rich out of all this. If the occasional gripes in the newspapers are correct, the coffee in that cappuccino costs pennies. Of course, the newspapers don’t tell us the whole story: there’s milk, electricity, cost of the paper cups — and the cost of paying Maria to smile at grouchy customers all day long. But after you add all that up you still get something a lot less than the price of a cup of coffee. According to economics professor Brian McManus, markups on coffee are around 150 percent — it costs forty cents to make a one-dollar cup of drip coffee and costs less than a dollar for a small latte, which sells for $2.55. So somebody is making a lot of money. Who?

You might think that the obvious candidate is Howard Schultz, the owner of Starbucks. But the answer isn’t as simple as that. The main reason that Starbucks can ask $2.55 for a cappuccino is that there isn’t a shop next door charging $2.00. So why is nobody next door undercutting Starbucks? Without wishing to dismiss the achievements of Mr. Schultz, cappuccinos are not in fact complicated products. There is no shortage of drinkable cappuccinos (sadly, there is no shortage of undrinkable cappuccinos either). It doesn’t take much to buy some coffee machines and a counter, build up a brand with a bit of adver- tising and some free samples, and hire decent staff. Even Maria is replaceable.

The truth is that Starbucks’ most significant advantage is its location on the desire line of thousands of commuters. There are a few sweet spots for coffee bars — by station exits or busy street corners. Starbucks and its rivals have snapped them up. If Starbucks really did have the hypnotic hold over its customers that critics complain about, it would hardly need to spend so much effort getting people to trip over its cafés. The nice margin that Starbucks makes on their cappuccinos is due neither to the quality of the coffee nor to the staff: it’s location, location, location.

But who controls the location? Look ahead to the negotiations for the new rental agreement. The landlord at International Square will not only be talking to Starbucks but to other chains like Cosi and Caribou Coffee, and D.C.’s local companies: Java House, Swing’s, Capitol Grounds, and Teaism. The landlord can sign an agreement with each one of them or can sign an exclusive agreement with only one. She’ll quickly find that nobody is very eager to pay much for a space next to ten other coffee bars, and so she will get the most advantage out of the exclusive agreement.

In trying to work out who is going to make all the money, simply remember that there are at least half a dozen competing companies on one side of the negotiating table and on the other side is a landlord who owns a single prime coffee-bar site. By playing them off against each other, the landlord should be able to dictate the terms and force one of them to pay rent, which consumes almost all their expected profits. The successful company will expect some profit but not much: if the rent looks low enough to leave a substantial profit, another coffee bar will be happy to pay a little extra for the site. There is an unlimited number of potential coffee bars and a limited number of attractive sites — and that means the landlords have the upper hand.

This is pure armchair reasoning. It’s reasonable to ask if all of this is actually true. After I explained to a long-suffering friend (over coffee) all of the principles involved, she asked me whether I could prove it. I admitted that it was just a theory — as Sherlock Holmes might say, a piece of “observation and deduction,” based on clues available to all of us. A couple of weeks later she sent me an article from the Financial Times, which relied on industry experts who had access to the accounts of coffee companies. The article began, “Few companies are making any money” and concluded that one of the main problems was “the high costs of running retail outlets in prime locations with significant passing trade.” Reading accounts is dull; economic detective work is the easy way to get to the same conclusion.

Strength from scarcity

Browsing through the old economics books on the shelf at home, I dug out the first analysis of twenty-first-century coffee bars. Published in 1817, it explains not just the modern coffee bar but much of the modern world itself. Its author, David Ricardo, had already made himself a multimillionaire (in today’s money) as a stockbroker, and was later to become a Member of Parliament. But Ricardo was also an enthusiastic economist, who longed to understand what had happened to Britain’s economy during the then-recent Napoleonic wars: the price of wheat had rocketed, and so had rents on agricultural land. Ricardo wanted to know why.

The easiest way to understand Ricardo’s analysis is to use one of his own examples. Imagine a wild frontier with few settlers but plenty of fertile meadow available for growing crops. One day an aspiring young farmer, Axel, walks into town and offers to pay rent for the right to grow crops on an acre of good meadow. Everyone agrees how much grain an acre of meadow will produce, but they cannot decide how much rent Axel should pay. Because there is no shortage of land lying fallow, competing landlords will not be able to charge a high rent . . . or any significant rent at all. Each landlord would rather collect a small rent than no rent at all, and so each will undercut his rivals until Axel is able to start farming for very little rent — just enough to compensate for the landlord’s trouble.

The first lesson here is that the person in possession of the desired resource — the landlord in this case — does not always have as much power as one would assume. And the story doesn’t specify whether Axel is very poor or has a roll of cash in the false heel of his walking boot, because it doesn’t make any difference to the rent. Bargaining strength comes through scarcity: settlers are scarce and meadows are not, so landlords have no bargaining power.

That means that if relative scarcity shifts from one person to another, bargaining shifts as well. If over the years many immigrants follow in Axel’s footsteps, the amount of spare meadowland will shrink until there is none left. As long as there is any, competition between landlords who have not attracted any tenants will keep rents very low. One day, however, an aspiring farmer will walk into town — let’s call him Bob — and will find that there is no spare fertile land. The alternative, farming on inferior but abundant scrubland, is not attractive...

"Required reading."
—Steven Levitt, author of Freakonomics

"A playful guide to the economics of everyday life, and as such. . . something of an elder sibling to Steven Levitt’s wild child, the hugely successful Freakonomics."
—The Economist

"A book to savor."
—The New York Times

"The Undercover Economist is a book you must pick up if you want a fresh perspective on how basic ideas in economics can help in answering the most complex and perplexing questions about the world around us."
—Business Today


“[Harford] is in every sense consumer-friendly. His chapters come in bite-size sections, with wacky sub-headings. His style is breezy and no-nonsense. . . . The Undercover Economist is part primer, part consciousness raiser, part self-help manual.” --Times Literary Supplement

"Anyone mystified by how the world works will benefit from this book – especially anyone confused about why good intentions don’t, necessarily, translate into good results."
—The Daily Telegraph (UK)

"Harford writes like a dream – and is also one of the leading economic thinkers of his generation. From his book I found out why there’s a Starbucks on every corner, what Bob Geldof needs to learn to make development aid work properly, and how not to get duped in an auction. Reading The Undercover Economist is like spending an ordinary day wearing X-ray goggles."
—David Bodanis, author of E=mc2 and Electric Universe

"Popular economics is not an oxymoron, and here is the proof. This book, by the Financial Times columnist Tim Harford, is as lively and witty an introduction to the supposedly 'dismal science' as you are likely to read."
—The Times