KEY POINTS:
In his book The Undercover Economist, Tim Harford explores the hidden story behind such mysteries as how Starbucks prices its drinks, why it's impossible to buy a good used car and Amazon's share prices.
How should the bar's managers exploit the scarcity they are renting from the London Eye? They could simply raise the price of a cappuccino from £2.75 to £5. Some people would pay it, but many would not.
Alternatively, they could cut prices and sell much more coffee. They could cover wages and ingredients by charging as little as 60p a cup. But unless they were able to increase their sales dozens of times over, they'd not make enough to cover their rent. That's the dilemma: higher margins per cup, but fewer cups; or lower margins on more cups.
It would be nice to sidestep that dilemma, by charging 60p to people who are not willing to pay more and £5 ($14) to people who are willing to pay a lot to enjoy the coffee and the view. That way they would have the high margins whenever they could get them and still sell coffee at a small profit to the skinflints. How to do it, though? Have a price list saying, "Cappuccino, £5, unless you're only willing to pay 60p?"
* Cappuccino for the lavish: £5.
* Cappuccino for the thrifty: 60p.
It does have a certain something, but I doubt it would catch on with the coffee-buying public of London's South Bank. So coffee bars have to be more subtle.
For years the incumbent coffee bar was Costa Coffee, which had an elegant strategy: Costa, like most other coffee bars these days, offers "fair trade" coffee; theirs comes from a leading fair trade brand called Cafdirect. Cafdirect promises to offer good prices to coffee farmers in poor countries.
If you buy fair trade coffee, you are guaranteed that the producer will receive a good price. But there is no guarantee that you will receive a good price. For several years, customers who wished to support third-world farmers - and such customers are apparently not uncommon in London - were charged an extra 10p.
They may have believed that the 10p went to the struggling coffee farmer. The evidence suggested that almost none of that money went anywhere but Costa's bottom line.
Cafdirect paid farmers a premium of between 40p and 55p a pound of coffee, and that premium was reflected in the price they charged Costa. That relatively small premium can nearly double the income of a farmer in Guatemala, where the average income is less than US$2000 ($2800) a year. But since the typical cappuccino is made with just a quarter-ounce of coffee beans, the premium paid to the farmer should translate into a cost increase for Costa of less than a penny a cup.
Of the extra money that Costa charged, more than 90 per cent did not reach the farmer. Cafdirect did not get a cut, so the money went to Costa's bottom line - unless using the fair trade coffee somehow increased their costs hugely.
The truth is that fair trade coffee wholesalers could pay two, three or sometimes four times the market price for coffee in the developing world without adding anything noticeable to the production cost of a cappuccino, because coffee beans make up such a small proportion of that cost.
Charging an extra 10p gave the impression that that was the cost of the fair trade coffee, but a customer who reached that conclusion would have been wrong. A certain Undercover Economist made some inquiries and Costa abandoned the premium of fair trade coffee, but because it was bad public relations, not because it was unprofitable.
Fair trade coffee allowed Costa to find customers who were willing to pay a bit more if given a reason to do so. By ordering a fair trade cappuccino, you sent two messages to Costa. One message may or may not have interested them: "I think that fair trade coffee is a product that should be supported."
The second message is the one that they were straining to hear: "I don't really mind paying a bit extra."
They know that socially concerned citizens tend to be less careful with their cash in coffee bars, while unconcerned citizens tend to keep their eyes on the price.
* Cappuccino for the concerned £1.85.
* Cappuccino for the unconcerned £1.75.
Costa's strategy was designed to get maximum value out of the scarcity power they rented from the London Eye. They are torn between raising prices and losing customers, or lowering prices and losing margins. If they have to charge the same price to every customer, they will simply have to guess the best trade-off between the two options. But if they can charge a high price to the lavish (or concerned) and a low price to the thrifty (or unconcerned), then they can enjoy the best of both worlds.
And there is no need to worry on Costa's behalf that this strategy has now been denied to them. Costa has plenty of alternative ways to identify customers for a price increase. Any well-run business would seek to charge each customer the maximum price he'd be willing to pay - and they do.
Take the Starbucks on the Strand in London. The price list looks like this:
* Cappuccino£1.85.
* Hot chocolate £1.89.
* Caffe mocha £2.05.
* White chocolate mocha £2.49.
* Venti white chocolate mocha £3.09.
Or, to translate:
* Cappuccino (no frills) £1.85.
* Hot chocolate (no frills) £1.89.
* Mix them together - I feel special £2.05.
* Use different powder - I feel very special £2.49.
* Make it huge - I feel greedy £3.09.
Starbucks isn't merely seeking to offer a variety of alternatives. It's also trying to give the customer every opportunity to signal that they've not been looking at the price. It doesn't cost much more to make a larger cup, to use a flavoured syrup or to add chocolate powder or a squirt of whipped cream.
Every single product costs Starbucks almost the same to produce, down to the odd few pence or so.
By charging wildly different prices for products that have largely the same cost, Starbucks is able to smoke out customers who are less sensitive about the price. Starbucks doesn't have a way to identify lavish customers, so it invites them to hang themselves with a choice of luxurious ropes.
