Exercise 6-2: Competing as Starbucks

I am not sure if we can talk about the coffee shop market to be perfectly competitive. However, the "fast-food" coffee is certainly not a public good. In Canada, there are a few companies in this business, however I would say the industry is dominated by the big two: Tim Horton's and Starbucks. On the outside looking in are McDonald's (McCafe), Second Cup, Timothy's and a few even smaller chains.

Reading through the email send by CEO Howard Schultz (see the email here) I agree with the Starbucks experience being on the declining side of things. In a matter of fact, my wife and I used to go to Starbucks and sit there and drink our coffee. We haven't done this in a while and I do agree that it used to be nice to see how our beverage get's prepared and see the barista preparing it. The new machines do block the sight and I had no idea they actually grind coffee there too. In a matter of fact, after ordering the beverage, you can't see much until you actually get it at the receiving end of the shop.

This is how Starbucks started to built it's brand and it has gone away from that in order to be faster. Starbucks should stand for it's quality and the experience though while McDonald's is less about the experience and more about fast food and the children play-ground.

I can understand the closure of some of the Starbucks stores in 2008 and 2009. Because people didn't have as much money and were worried about their job's, they would substitute the "expensive" Starbucks coffee for home made coffee. If they cared about the taste of Starbucks coffee they would most likely buy the grinded Starbucks coffee and brew it at home instead of enjoying it in store or at the drive-thru.

This would result in lower quantities of coffee produced in many stores. Some of them, as discussed in these two articles (CBC and The Seattle Times) would operate at or below the break-even price and eventually get to the shutdown price, once the price drops below the average variable cost. Below this point the store won't even cover it's variable expenses anymore and produce losses higher than the fixed costs. This is where stores have to be shutdown, at least temporally.

Personally I do think the coffee at Starbucks is too expensive. I rather go to Tim Horton's and have my coffee there or have a K-Cup machine at home and drink my "fancy" coffee this way. However, there are many fans of Starbucks that support the brand itself. Starbucks seems to almost be a "status symbol" in an office. So is Tim Horton's. I think the brand has such a strong reputation, that people are willing to pay for it.

Exercise 5-5: Long Run Costs and Economies of Scale

This time, I will think about Long-run, Short-run costs and fixed costs for a potential business I might start together with my wife.

She enjoys taking pictures since her childhood and owns an SLR camera. She has taken some online courses, has a software to get the full potential out of every snapshot and, being a mom of a 8 month old, now she has her own model too. (No, her husband doesn't make a good model)

We are now thinking about offering affordable baby photo shoots for parents, at their home.

While there are many professional photo services in town, not too many specialize in at home baby photo shooting. Having a breast fed baby ourselves, we know how hard it is to commit to appointments at an exact time. Let alone the babies mood at the point of the appointment. And who wants a fuzzy baby on their pictures? Our service would offer parents to book a large window during a day for the photo shooting and we would be visiting the young family at their own home, where the babies feel most comfortable, have their favourite toys, aso.

Now, how come we can be competitive in this business?

By having a home-based service business, with the only machinery being the already existing SLR camera, the already existing computer and software, and the also already existing vehicle, we can keep our explicit costs very low. All we need to get started is a website and some business cards.

My wife, being a stay at home mom and able to bring our daugther to the photo shooting will only have gas as her variable cost. The website will be paid annually and is a fixed cost. Same with her "plant". She can modify, review and print pictures right at her desk in our house, which we own anyways.

Even thought it isn't our intention, a way to expand would be to train other mom's the in's and out's in photography and offer courses. If we would decide to offer this new product, in the short-run we would have to do one-on-one sessions, since we don't have a classroom to host more people. This would mean, that our Average Total Cost per unit of lesson would be high, since the quantity of lessons we can provide per day is limited.

If these lessons would become a huge success and we couldn't keep up with the demand, we would have to consider renting an office/classroom somewhere in order to teach several moms (or dad's) simultaneously how to capture their babies milestones. This would increase our fixed costs, since now we would have to pay for rent, but should lower our Long-run cost, since we can now increase the amount of student's significantly. All the time saved driving from one client to another would be saved.

Looking for a similar business, I have found Marie-Helene Bilodeau's business. Here.

She already offers SLR camera classes and her strength seems to be, that she already has a facility available to her (the North Glenmore Community Centre). The one disadvantage comparing her courses with our idea, is probably that her course is more generic, where we would specifically target young parents and keep the sessions to one single class, focusing on their kids.

Exercise 5-3: Diminishing returns to Tobacco Legislation

This week we were asked to write about an article posted by Pierre Lemieux on March 19th, 2001. His full article can be found here.

I am a non smoker myself and have been all my life. As I have seen friends and co-worker smoke in the past, I did often talk to them about their motivations behind smoking and why they wouldn't stop smoking. It was something I have found interesting, since I don't see any benefits in smoking myself, but I wanted to understand why these people would make the choices they do. The answers I have gotten range from "I plan to quit in x days, weeks, months", to "I just enjoy it too much" and "don't care about possible health effects".

Certain points Pierre Lemieux was talking about, I can absolutely agree with:

(1) "...[f]urther reductions in smoking in countries where the health consequences of smoking is widespread will be more difficult" (Prabhat Jha and Frank Chaloupka, Ed., Tobacco Control in Developing Countries, Oxford University Press, 2000)."

(2) "One reason why government intervention against smoking becomes less effective is that smokers who were the most easily persuaded have already quit. The remaining ones are those who value smoking more, and therefore require higher disincentive before they quit..."

I do think, smokers that do get scared about pictures on the cigarette boxes and do realize what they do to their bodies by continuing smoking, have quit already and don't even need to see these pictures anymore. It was a good campaign when it was initially started, but I think it has worn off by now. Also, since most smokers don't have a surgeon or nurse profession, I don't think they even know how a non-smoker lung looks like. So why should a smoker lung picture be intimidating? I certainly haven't seen my lung from the inside yet...

(3) "Too much information may also kill information. As advice, warnings, and threats from authority become more numerous and visible, they tend to be discounted or ignored."

I do remember reading on a cigarette box lately, that smoking kills the equivalent of a small town in Canada every year. While I am sure this is true, probably a series of towns get killed in traffic accidents. Yet we still all drive to work. Someone may suggest most people die in a bed - so should we avoid going to bed? Point 3 goes kind of hand in hand with points 1 and 2. I think the smokers that start reading this information and get scared because of them - they already quit smoking.

(4) "A push towards mild forms of prohibition should not be discounted. Indeed, smoking is prohibited in more and more so-called "public places" – which are generally pieces of private property open to customers."

This is the first point where I disagree with the text. I have elected not to smoke and I think, who ever wants to smoke has to make sure he or she does not affect any non-smoker in any way. There should be designated areas for smokers (and there more often than not are these days), but the non-smokers should not have to "move" or "watch out" for smokers. Also kids should be protected from smokers and be able to go wherever they want without having to be secondary smokers.

I do think that more and more people start to take on a healthier lifestyle. This will most likely cause governments tax income to diminish. Initially this is what governments wanted, to get smoking rates down and possibly save money in health care costs. However, I do think that the extra tax income is missed also, and governments will want to make up for at least a portion of the lost revenue. Increasing the taxes on cigarettes to have the remaining smokers make up for the lost ones will not be a favourable solution in the long-term, as I could see some initial price elasticity by smokers, but eventually some won't be able to afford it anymore.

Two things could happen at that point:

1) More smokers quit and the tax revenue drops even further

2) More cigarettes get smuggled and sold illegally

When I have talked to smokers in the past, some of them were actually realizing the amount of money they light up over the course of a year. One particular person that I have known for years is saving every cent possible for retirement and investments. He still smokes away more than $3,000 a year... He knows it could be a great investment providing him with a nice retirement in 20-30 years down the road, or pay for an amazing vacation - every year. Still, he does enjoy smoking too much to quit.

I do not think that pictures and warnings on the cigarette boxes still help anyone. Smokers ignore them, tobacco companies know about the price elasticity and attitudes of their remaining customers, and the remaining smokers just don't care (anymore).

Exercise 4-3: Demand elasticity in the Oil & Gas industry in Alberta

This week's Assignment had me look into the current state of the Oil and Gas Industry inAlberta. I have an interest in this sector, as I have recently started my new Position at a Power Station with an Oil & Gas company and haven't had any exposure to this industry before. Since our Power Station is powered by natural gas, we actually profit from the current low natural gas prices.

An article from "The Alberta Oil Magazine" (find the article here) suggested that the natural gas prices will remain low for the foreseeable future, which again, is good news in my particular situation, as our input cost at the Power Station will allow for a good profit. But I guess it is safe to say, that Oil and Gas company in Alberta in general would rather see the price come back up.

If we take a look at the price of natural gas in Alberta in the last ten years, we can see how the price spiked and then dropped three times, but every

time it spiked, it actually didn't quite make it the the previous high. What I also find interesting is the fact, that the price seems to have reached a consistent level. In the previous ten years, it has never taken that long, before the prices started to raise at least a little bit:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

On the website of the National Energy Board of Canada, I have also found a forecast for the natural gas demand, which interestingly shows a fairly consistent demand, except for the Energy sector, which will increase it's demand over time. I would assume part of it could be the conversion of many coal powered Power Stations to Natural Gas Power Stations in the future, as well as the raising demand for Power itself:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

The forecast for the demand goes hand in hand with the Energy Board's forecast for the price as seen here:

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

This brings me to my conclusion.

I think there is a fair amount of elasticity when it comes to natural gas. If the gas price would be exploding, there are alternatives on how we produce power as well as how we heat our homes and businesses. Even cars are still mainly powered by gas and the industry is moving towards electric cars. Hydrogen cars are another alternative and I have worked for a manufacturer of Natural gas and Hydrogen vehicle gas tanks before.

This last image clearly shows, that there is more supply than demand right now and it certainly shows, why the Alberta Oil Magazine doesn't expect the gas price to recover anytime soon.

image retrieved on March 5th, 2012 from the National Energy Board of Canada (www.neb.gc.ca)

But all it takes is one really cold year and demand can increase immediately. After all, switching energy sources to warm up our home's can't be done over night either - and most of us would probably rather spend the money, than freeze at home.

Sources:

Alberta Oil Magazine (http://www.albertaoilmagazine.com)

National Energy Board of Canada (www.neb.gc.ca)

Exercise 4-2: Elasticity and Revenue

This week's Exercise is about the relationship between demand elasticity and total revenue. I found an interesting article, about the demand elasticity of hotel rooms. See article on hotelnewsnow.com here.

A study conducted by the Hospitality Sales and Marketing Association International found that discounted hotel room rates do not stimulate enough additional demand to make up for the rate reduction.

In the article, there aren't too many actual numbers available, so I have made up some fictional numbers to graph and demonstrate the situation described in the article.

I have assumed that there are 1000 hotel rooms available at a certain location. As suggested in the article, if a hotel room would cost $1, everyone would suddenly want to stay in a hotel and demand would exceed the 1000 available rooms. Therefore, total revenue would be $1000 at a room price of $1, since every single room would be occupied.

The study found, that demand for hotel rooms is fairly inelastic. This means, as hotel room prices drop, demand doesn't raise significantly. Unless, of course, it comes to the $1 a room extreme. This conclusion tells us, that customers often don't have too many substitutes available. If a business men is on a business trip, chances are he doesn't know anybody in the city he has to stay in, and he probably doesn't want to sign a lease agreement or buy a house for just a couple of days... Most likely renting a camper or using a tent is also not a very convenient option either. So at the end of the day, a hotel room is his only option, at whatever rate the hotels currently charge.

I have assumed the following demand and prices:

Price: Demand:

$50 600

$100 590

$150 580

$200 560

$250 530

$300 490

$350 450

$400 410

$450 380

$500 10

These graphs show the total revenue at the different price and demand levels I have used above:

This graph shows us, that if my assumptions would be true, the hotels total revenue would increase as hotel rates increase, since demand is inelastic up to the point of around $450 per room. If hotels would be charging above the $450, demand drops.

A possible reason could be, that customers would rather rent a car and stay in a city a couple hours away from our "test region". Or now, customers rather sign an apartment lease agreement for a month, than staying in hotel for the price of $450 a night.