Tuesday, March 15, 2005

Shipping the Premium Coffee Out

In the latest issue of Mental Floss (to which my brother gave me a subscription as a Christmas gift), an article on Guatemala includes the following travel tip:
True, Guatemalan coffee is some of the best joe in the world. Just don’t drink it in Guatemala. Because the beans are one of the country’s major exports, growers are under enormous pressure to stay competitive in the international market. That’s why Guatemala’s highest-quality beans are reserved for those (twelve) Starbucks near you. Sometimes, you can still find the good stuff in major java-producing towns like Cob├ín and Antigua, but there’s certainly no guarantee. When not selling leftovers to unsuspecting tourists, growers have begun transforming sub-par coffee into everything from compost to fuel. Whether or not Mocha Java Premium will be available at your local Shell station has yet to be determined.
So, Guatemala exports mostly high-quality coffee beans, while keeping the low-grade stuff at home. Why? The article points to the competitive pressure of the international market, but that explanation doesn’t quite work. Guatemalan growers could simply sell the low-quality beans at a lower price – possibly under different brand names, if they’re worried about tainting the reputation of the good beans.

A better explanation, I suspect, is the Alchian-Allen theorem, sometimes called the “third law of demand.” This theorem states that when the prices of two substitute goods, such as high and low grades of the same product, are both increased by a fixed per-unit amount such as a transportation cost or tax, consumption will shift toward the higher-grade product. This is true because the added per-unit amount decreases the relative price of the higher-grade product.

Suppose, for example, that high-grade beans are $3/pound and low-grade beans $1.50/pound. Then high-grade beans cost twice as much as low-grade. But now add on a per-pound international shipping cost of $1. Now the effective prices are $4 and $2.50, so that high-grade beans cost only 1.6 times as much as low-grade. This difference will induce distant coffee-buyers (like Americans) to choose a higher ratio of high-to-low grade beans than local coffee-buyers. (My dollar figures are purely illustrative; I have no idea what the actual prices are.)

One of my colleagues, a University of Washington alum, tells me that he learned the Alchian-Allen theorem as the “ship the good apples out” theorem. Just substitute coffee beans for apples and the story is complete.

I assume there’s also an income effect at work: Americans are generally richer than Guatemalans, and higher incomes induce people to decrease their consumption of inferior goods (like lousy coffee) and increase their consumption of superior goods (like premium coffee). That, too, would explain Guatemala’s shipping the good beans out.

(I couldn’t find a good basic treatment of Alchian-Allen online, but here are some articles on the subject.)


Anomaly UK said...

There are many examples of this. When I visit the USA (from Britain), I'm struck by the flimisiness of much of the housing. By the time you've paid the British price for land that you can build a house on, there's really no point skimping on the construction

Anonymous said...

I'm assuming if the lower-grade bean sold at a higher price than the higher-quality bean in the international market, then we would all be drinking lower quality coffee when going to Starbucks. Maybe then Starbucks would make an effort not to burn their coffee!