AN INDUSTRY STUDY:

THE COFFEE INDUSTRY Industrial Economics

Mairin M. O'Connor

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Introduction

The coffee industry is built upon an intricate web of economic relationships and

transactions. This paper will focus on two segments of the coffee industry: the growers and the

retailers. The majority of the global coffee trade is supplied by Brazil; therefore, any change in

their supply has a monumental global effect on the global coffee prices and industry. Although

coffee is an extremely important commodity, the roaster-grower relationship is characterized by

a monopsony, which has created a cycle of underpayment and debt in the producing countries.

The in-depth study of Starbucks in the United States demonstrates how economic transactions

define our daily experiences. It is proven how each decision that a firm makes, from their logo to

in-store experience, affects their success in a highly competitive market. There is an increasing

demand for the coffee as global consumption rises, but the global supply does not match the

projected demand. Therefore, the industry will be faced with a challenge as the global supply

struggles to meet the increasing global demand for coffee in the future.

Industry Overview

Coffee is the world’s second most valuable traded commodity, which makes it a driving

factor in our global economy (Global Exchange, 2011). Therefore, in order to understand the

commodity, which is such a huge driver in our world’s economic activity, one must conduct an

analysis of the economic factors that control the industry. The coffee industry is divided into

three segments: the growers, the roasters and the retailers. There are many different influential

factors that control the simple cup of coffee that people enjoy every day. The export and import

aspects of the industry are drivers in the amount of coffee that is produced daily.

The production side of coffee exporting is a major part of the industry; 11 million

hectares of the farmland in the world are utilized for coffee farming (Global Exchange, 2011).

Additionally, Brazil is one of the major players in the world’s coffee production, followed by

Colombia, Vietnam, Indonesia and Mexico (Global Exchange, 2011). Due to the fact that Brazil

is the leader in coffee production, any factors that affect their coffee production affect the coffee

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industry as a whole. According to Statista, in 2012, Brazil led the world’s coffee production with

3 million metric tons of coffee (2015). There are many driving factors that affect the industry as a

whole: the weather, the changing economic climate, people’s willingness to buy, etc.

One of the main focuses of this paper will be the retail segment of the coffee industry in

the United States. Before analyzing the retailers, one must understand the foundation and

structure of the industry within the United States.

Market Structure: Economic Factors in the Coffee Industry

The commodity chain of coffee is broken down into various small factors: producers,

middlemen, exporters, importers, roasters, retailers and consumers (Global Exchange, 2011).

This is divided into three major segments: the growers, roasters and retailers. With the purpose

of understanding the underlying economic structure of the coffee industry, it is necessary to

distinguish between the interaction of various players within each segment and the resulting

effects that each of their actions have. Additionally, due to the various players in the industry,

the resulting market power of the coffee industry has a large effect on the global economy.

In studying the continued increase in the global demand for coffee, one significant factor

is the price elasticity of demand. This is an extremely important factor in analyzing the

consumer’s role in the coffee industry, as it allows one to compare the single moment when

someone is willing to spend a large sum of money at one time, as compared to the amount of

times the consumer utilizes this good. When examining the daily customer at a retailer, such as

Starbucks, and evaluating their price sensitivity and the price elasticity of demand, one must

consider that this is a good that is consumed on a daily basis. The effect of coffee being

considered a luxury good is demonstrated by the fact that during the economic crisis of 2008,

coffee consumption decreased significantly (IBISWorld, 2012). During this time period, revenue

declined at a rate of 6.6%, from 27.8 billion to 25.3 billion (IBISWorld, 2012). As the world

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rebounded from the recession, the opportunities within the industry were expected to grow with

the expected increase in consumer spending. There are also further external factors that affect

the demand for coffee in this segment of the retail industry: health, access, changes in tax and

interest rates, labor market growth and consumers’ desire to spend money (IBISWorld, 2012).

The trends in the coffee industry have created what is referred to as a coffee paradox:

where the prices and profits are rising in the consuming countries, but the prices and income in

the producing countries are decreasing (Riley, 2015). The coffee trade has created a unique

economic problem: commodity dependency in some countries. This indicates that, for some

countries, a majority of their economic activity is concentrated in the coffee industry (Riley,

2015). In Burundi and Uganda, coffee totals 75% and 54% of total exports, respectively (Riley,

2015). Additionally, 25 million farmers worldwide depend upon coffee sales for their livelihood,

and most of these farmers are small-scale farmers with limited financial resources (Riley, 2015).

This creates an economic limitation for these farmers, as they cannot physically diversify their

products, so they cannot benefit from diverse economic benefits.

The first segment of the coffee industry, the growers, account for the supply portion of

the global coffee market. As stated earlier, the main country that is involved in coffee

production is Brazil; it is the swing producer in the coffee market. Hence, any factor that affects

coffee production in Brazil affects both the global supply of coffee and the global price of coffee

(Riley, 2015). Due to this, when assessing the coffee market, one must not only consider

Brazil’s production, but also all of the factors that affect their production. One of these major

factors in their production is the weather: any sort of drought or frost creates a shortage of

coffee, which results in increased international price (Global Exchange, 2011). Recent climate

changes, due to global warming, are predicted to have a large impact on coffee prices, driving

them up (Cooke, 2014). As Brazil produces about 40% of the world’s coffee, the warming that

Brazil has experienced from 1960-2011, has had an adverse effect on the quantity and quality

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of the coffee that is produced (Cooke, 2014). Therefore, as global warming increases

temperatures, prices for coffee are predicted to increase.

The supply portion of the coffee industry is fragmented, as there is a large amount of

small-scale producers (Riley, 2015).Therefore, the coffee roasters who purchase these raw

coffee beans have the market power within this segment of the industry (Riley, 2015). The

supply side of the market is extremely fragmented, while the roasting industry is extremely

concentrated. Due to this concentration, roasters obtain the market power in their interactions

with the growers (McLaren, 1992). This type of market structure is a monopsony, which signifies

that the roasters have purchasing power and therefore have control over the prices that they

pay to the farmers for the coffee produced by the growers (Riley, 2015). The economic side

effects of this type of market power, when the roasters hold all of the power, is that many of the

coffee growers live in poverty and it is difficult to achieve sustainable development in these

places that are dependent on the production of coffee. When the coffee farmers receive prices

for their beans that are below the costs of production, they are forced into a cycle of poverty and

debt (Global Exchange, 2011). Due to the issues created by the market power that the roasters

hold, there were previously price controls in place in the coffee industry: The International

Coffee Agreement. The International Coffee Agreement implemented a buffer-stock system that

controlled the prices in the coffee market (Global Exchange, 2011). Although there are

disadvantages to controlling prices, instead of allowing them to be decided by the market, there

is also an advantage to this, in that it prevented the growers from experiencing the problems

that they currently have as a result of the price control by the roasters. However, as there are no

longer price controls in the coffee market, the prices over the past ten years have been

extremely volatile (Riley, 2015).

Currently, there are about 1200 roasters in the United States, which typically sell to large

retailers (Global Exchange, 2011). Additionally, the roasters have the highest profit margin

within the value chain in the coffee industry, which makes them an extremely important link in

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the commodity chain (Global Exchange, 2011). Retailers will typically purchase their packages

of coffee from roasters; however, in a profit maximizing environment, the retailers have begun to

cut costs and roast their own beans (Global Exchange, 2011). The costs and benefits of this

process are further studied later in the company review of Starbucks.

Additionally, one of the important economic side effects of the coffee industry is the

negative externality produced by coffee farms. Coffee was originally farmed in the shade, as

well as with other crops. However, in the 1970s and 1980s, during the Green Revolution, the US

Agency for International Development gave $80 million dollar for plantations in Central America

to utilize sun cultivation techniques for coffee farming (Global Exchange, 2011). The first

negative externality that was produced as a result of this economic activity was the destruction

of forest and biodiversity. Sun farming is a practice that involves cutting down trees, mono-

cropping, fertilizers and using pesticide (Global Exchange, 2011). Therefore, in the effort to

produce more coffee, the natural environment surrounding these farms experiences negative

effects, as well as all of the people that have a connection and interaction with this environment.

These coffee farming techniques are producing pollution that has a negative effect, and the

people that are involved in coffee production are most likely to be impacted by these effects.

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In order to comprehend the factors that drive the coffee industry, one must examine the

global supply and demand for coffee. One can see in the figures below the global coffee

production and consumption figures (International Coffee Organization, 2015):

A key number in the production figure is the 1.4% increase in the global coffee

production in 2015/2016 as compared to 2014/2015. This is a reaction to the 2.5% increase in

the annual growth rate in global coffee consumption since 2011. Additionally, the .1% decrease

reduction in Arabica coffees can potentially be attributed to the driving factor of global warming.

Furthermore, the figure that demonstrates the global demand shows that, overall, the demand

for coffee is expected to increase, particularly in emerging markets. Therefore, the supply is

going to have to continue to increase to match this growing demand. This will potentially give

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more power to the roasters within the monopsony structure that exists, allowing them to

continue to undercut the farmers that produce the coffee.

Company Study: The Economics Underlying the Starbucks’ Experience

Coffee is such a powerful global commodity, because it is a product that most people

interact with in their daily lives. One of the main market segments that people interact with on a

daily basis is the coffee retailers. In the United States, consumers spend about $21.32 on coffee

each week (Statista, 2015), making it a product that is always in high demand. Recently, coffee

chains are increasing in popularity among consumers that buy take-away coffee. In the United

States, the manner in which most people interact with the coffee industry is through these major

coffee retailers, such as Dunkin Donuts and Starbucks. In 2011, Starbucks and Dunkin Donuts

had 50% of the market share of this portion of the coffee industry (Statista, 2015). Starbucks

has flourished in the coffee industry, recently reporting its fourth quarter and 2015 fiscal year

earnings results; this included comparable sales growth in every geographical area, with a

global comparable sales growth of 8% (Team, 2015). This was the 23rd consecutive quarter

where Starbucks reported over 5% comparable sales growth (Team, 2015). Although Starbucks

and Dunkin Donuts held 50% of the market share in 2011, Starbucks dominated this with 32.6%

(not only has Starbucks flourished, but they are continuing to expand their strength, as well as

their brand).

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As one can see in the graph below, Starbucks’ revenue has increased from 2003-2015 (Statista,

2015), which demonstrates their strength and ability to flourish in the retail division of the coffee

industry:

As examined in the earlier overview of the industry, retailers face many external factors that

drive the demand in the coffee industry. There are also many internal factors that are important

to consider before entering the industry. Three main internal factors are: the franchising of

coffee retailers in the United States, the ability to have a distinct market position as compared to

one’s competitors and store location (IBISWorld, 2012).

One of the foundations of the coffee industry is the various market structures that exist,

including the previously discussed monopsony between growers and roasters. The retail portion

of the coffee industry in which Starbucks operates is characterized by a monopolistically

competitive market structure. This type of market structure is characterized by aspects of both a

perfectly competitive industry and a monopolistically competitive industry. One of the main

defining characteristics of this type of competition is that there are multiple firms that offer

comparable, but not identical products (Investopedia, 2015). With this type of market structure,

there are multiple firms competing for the same customers. This, in turn, leads to elastic

demand, as the consumers have many products to choose from. Therefore, if one company

increases their prices too much, then a consumer can easily go to another company. Another

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aspect of monopolistic competition is the widespread knowledge among customers; this

signifies that consumers can review all of the products that they are being offered before they

make any final choices about their product decision (Economics Online, 2015). However, the

knowledge that the consumers have is not perfect, as one cannot completely decide if they

prefer a product until they have experience with the said product. Therefore, the retailers need

to adopt strategies that will allow them to stay relevant in this type of environment.

Additionally, a unique characteristic of this type of competition is the fact that all of the

firms competing in the industry have very similar, low degrees of market power, but these firms

are also price makers (Investopedia, 2015). As demonstrated in the graph below, one can see

that in the short run, the firms produce at the level where marginal revenue is equal to marginal

cost and they also sell at the maximum possible price, P (Economic Weblog, 2016):

Due to the profits that these firms make, new businesses enter the industry. This is easy for new

businesses to do, because in a monopolistically competitive environment, there are extremely

low barriers to entry, and therefore there are low barriers to exit (Economics Online, 2015).

Therefore, some firms lose consumers that they previously had, because they can be

substituted by these new entrants. In the long run, the demand for the original firms decreases

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until the new firms stop entering; one can see this displayed in the graph below, as the demand

curve shifts below the average total cost curve (Economic Weblog, 2016):

Then, the profit moves from P to P1, and in the long run the firms make zero economic profit.

Additionally, another main characteristic of monopolistic competition, is the fact that firms are

price makers, as they are faced with downward sloping demand curves (Economics Online,

2015). All of the firms make unique products, which enable them to charge higher or lower

prices than their rivals, based upon their own costs. Therefore, this creates a downward sloping

demand curve. Furthermore, each of these firms are assumed to be profit maximizers

(Economics Online, 2015).

One of the main features of monopolistic competition that people interact with every day

is the need for product differentiation, which includes physical product differentiation, marketing

differentiation, human capital differentiation and differentiation through distribution (Economics

Online, 2015). These are all extremely important characteristics for Starbucks’ success in a

highly monopolistically competitive market. By physically differentiating a product, a firm must

utilize size, design, color, shape, features and performance to make their products appealing to

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consumers (Economics Online, 2015). One can see how Starbucks used this strategy in their

store and cup design. Each store looks similar, providing the consumer with a familiar

environment in which they find comfort. Additionally, the cups with the green logos are

extremely distinct, with no other brand resembling Starbucks. By doing this, Starbucks has

physically differentiated their products from the rest of their competitors.

Additionally, marketing differentiation plays an extremely important role in the success of

retailers in this monopolistically competitive market. Firms must use different packaging and

promotions that make them stand out in their industry (Economics Online, 2015). Once more,

Starbucks’ logo and color choice makes them unique in this aspect, as one can easily

differentiate a Starbucks’ package of coffee, or a Starbucks reusable cup. Furthermore, through

human capital differentiation, a firm can stand out among their competitors by training their

employees in certain manners, strengthening particular skills (Economics Online, 2015). This is

one of the most distinct aspects of Starbucks’ success. As reviewed in Forbes, although the

price for a cup of small coffee is about $2.00, there is a bigger allure than the coffee for

consumers to come to Starbucks (Hennessey, 2012). The baristas are trained to ensure that the

consumers have the best experience possible, that their drink is made exactly as they prefer,

that their experience is consistent and that the lines move quickly. Consumers are not only

paying for their coffee, but they are also paying for their experience, which is a driving factor in

the economic transactions that result. One of the direct results of Starbucks’ successful

marketing and product differentiation is the in-store experience that is tailored and detailed,

down to the country that one is in (Chibba, 2013). As stated by Geereddy, “Starbuck’s brand

equity is built on selling the finest quality coffee and related products, and by providing each

customer with a unique “Starbucks Experience”, which is derived from supreme customer

service, clean and well-maintained stores that reflect the culture of the communities in which

they operate, thereby building a high degree of customer loyalty with a cult following”

(Economics Online, 2015). Furthermore, the fourth form of differentiation is the distribution that

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the firm employs. Starbucks successfully undertakes this strategy through their mobile

application and email marketing campaigns, which are highly effective in engaging consumers

and capturing a large market share.

Monopolistic competition creates contestable markets, as there are not many significant

barriers to entry (Economics Online, 2015). Additionally, the product differentiation that is

necessitated by this type of market structure is advantageous for consumers, as it forces the

firms to tailor their products to provide the highest possible customer satisfaction. Furthermore,

this type of market is more efficient than a monopoly, but less efficient than perfect competition

(in reference to allocation and production). However, this may be counteracted by the dynamic

efficiency that is created by the innovation that is required to create new products (Economics

Online, 2015).

Due to the fact that monopolistic competition creates a highly competitive market, in

which the firms make zero economic profit in the long run, firms need to employ methods that

cut costs down as much as possible. As shown in the figure below, one can see the breakdown

of those in the coffee and snack shop industry, where the firms are only making a 5.8% profit as

compared to their costs (IBISWorld, 2012):

One main way to cut costs is through utilize vertical integration. By vertically integrating,

a company owns as much of the supply chain as possible that is involved in the production of its

final good. This involves the merging of two companies that are located at different points in the

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supply chain (The Economist, 2009). This is beneficial for firms because it enables them to

control the access to inputs; subsequently, they are able to also control the cost, quality and

delivery time of each input (The Economist, 2009). By doing so, a firm such as Starbucks, is

able to cut its costs and charge more due to their product differentiation, therefore making a

profit. In analyzing vertical integration, it is important to note that this strategy is difficult for

companies to successfully execute, because it is both expensive and also difficult to reverse if it

is too costly (The Economist, 2009). However, when done efficiently, it allows firms to

outperform their competition.

In 2013, Starbucks began to expand its presence into the coffee farming industry,

enabling it to manage the supply chain, ensuring that the coffee beans are of the highest quality

(Cho, 2013). If Starbucks is able to generate a profit through farming, they are hedging against

the volatility of coffee bean prices through self-production (Cho, 2013). One advantage of

Starbucks initiating this process of vertical integration is that they can use their farms to grow

coffee beans of higher value, allowing them to save a lot of money and making higher profits

(Cho, 2013). Additionally, the coffee beans that Starbucks’ farms produce have an immediate

market--their coffee shops--which already price their coffee at a higher price than the equilibrium

price that is generated by the futures exchange (Cho, 2013). A further analysis of Starbucks’

vertical integration strategy demonstrates that Starbucks utilized backwards vertical integration

through: purchase agreements with coffee growers, company owned bean roasting plants,

company owned warehousing and distribution facilities and through the purchase of coffee bean

farms in Costa Rica and China (Gibson, 2015). By doing this, Starbucks took on a lot of risks, as

it introduces more complexities into its business structure, through additional capital acquisition

and an increase in the amount of employees. However, these risks are outweighed by the

benefit that Starbucks reaps through achieving its main goal of maintaining high quality

throughout the value chain (Gibson, 2015).

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The retail segment of the coffee industry is expected to experience increased growth,

fueled by an increase in consumer spending, due to elevated disposable incomes and more

confidence in the economic future of the United States (IBISWorld, 2014). Consumer spending

and the consumer confidence index have grown at rates of 2.2% and 11.2%, respectively, from

2009-2014 (IBISWorld, 2014). Therefore, other than completely vertically integrating their

operations in order to cut costs, Starbucks will need to adopt other strategies in order to

increase their profits. One aspect of their plan to increase their sales and therefore have higher

profit margins is to expand their menu over the next five years through increased offerings of

nontraditional, healthier menu items (IBISWorld, 2014). Furthermore, they are also planning on

penetrating new emerging economies, capturing the market share in order to attain long-term

growth goals (IBISWorld, 2014).

Starbucks faces intense competition in the retail segment of the coffee industry, as well

as multiple other risks that can affect their success, such as: price elasticity of demand,

increasing costs, decrease in coffee consumption, etc. However, the study of Starbucks’

business strategy demonstrates that they have been able to employ a business strategy that

enables them to make increasing profits and capture a large share of the market in a perfectly

monopolistic environment. As Gulati, Huffman and Neilson quoted, “Mr. Schultz and his senior

executives express the wish to “grow big and yet stay small” — and they look to Starbucks’

unique culture and relationships with its customers, employees, suppliers, and alliance partners

as the driving force that will sustain the company as it grows” (2002). The proof of this success

is demonstrated in the previously stated figures, which showed that Starbucks has only

increased their revenue and comparable sales growth over the past five years.

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Future of the Industry

As one can see in the figure below, since 2011, the consumption of coffee has grown at

a rate of 2.5% (International Coffee Organization, 2015).

Additionally, the bar graph below demonstrates that as a general trend, coffee exports

for 2015/2016 are increasing as opposed to 2014/2015 (International Coffee Organization,

2016):

Furthermore, as discussed in this paper, the prices of coffee in the market are extremely

volatile, which is shown by the following graph (International Coffee Organization, 2016):

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The demand for coffee is expected to increase by 25% over the next five years, with

annual consumption expected to increase from the present quantity of 141.6 million bags to

175.8 million bags of beans by 2020 (Bariyo, 2015). However, this is going to be difficult for the

growers to meet, as the current supply of the industry is constrained due to a historic drought

that Brazil recently experienced (Bariyo, 2015). This drought and a plant fungus that is

preventing high output in Central America have caused a projected drop of coffee production

from 146.7 million bags to 141 million bags (Bariyo, 2015). Additionally, the increasing

consumption of coffee, indicates that global production must increase by an extra 40-50 million

bags over the next 10 years (Bloomberg, 2015). Therefore, it will be hard for the suppliers to

meet the increasing global demand for coffee.

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Conclusion

It is important to understand the economic foundations that are the basis of producing

goods that are consumed in daily life. This paper conducts an in-depth study of the global coffee

industry, focusing in on the flourishing business of Starbucks within the retail segment of the

United States coffee industry. The coffee industry is divided into three main segments: the

growers, the roasters and the retailers. As demonstrated earlier, the global demand for coffee

has been increasing over the past few years and is projected to increase in the coming years,

which will be difficult for the suppliers to meet. There are two main economic market structures

that control the coffee industry: the monopsony between the coffee growers and the roasters,

and the monopolistic competition of the retailers. Within the monopsony, the roasters are price

setters and create poor economic conditions for the growers. Additionally, it is important to study

a firm, such as Starbucks, that is able to flourish and achieve increasing success in a

monopolistically competitive environment. Through the adoption of vertical integration strategies

and successful product differentiation, Starbucks successfully cuts costs, offers coffee as an

input of the Starbucks experience and has established themselves as a luxury coffee brand.

The projected statistics for the global coffee industry predict continuous positive economic

growth. Therefore, in order to take full advantage of these projected increases in global

demand, Starbucks will need to continue to create and implement business strategies that

enable them to continue to succeed in a monopolistically competitive market.

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