Coffee Republic: the price mechanism at work
Many firms operate in a dynamic and competitive market. Take for example the coffee bar industry where customers are well served with rival offerings from Costa, Starbucks, Neros and Coffee Republic.
For many consumers it seems that a visit to an expensive coffee shop is a luxury item easily forgone in times of recession. Less income means less demand
For coffee bars, this means the demand curve for their products shift to the left
The extent to which the demand curve shifts the left depends upon the size of the reduction in income brought about by the recession, and the income elasticity of demand for coffee served in bars.
As a luxury product, the income elasticity demand for lattes is likely to be high. This means that as household income falls, there is an even bigger percentage fall in the demand for products sold by firms like Coffee Republic- the coffee bar and deli chain.
For example if income elasticity of demand is 2, then a 10% fall in income causes a 20% reduction in demand.
The lower price of P2 combine with fewer sales Q2 means the business is earning less revenue. Given fixed costs like rent, this means some branches move from profit into a loss. Losses offer little incentive to carry on production and businesses such as Coffee Republic opt to leave the industry.
Note that fewer coffee bars causes the supply curve in a above diagram to shift to the left exerting upward pressure on price and so allowing those firms that remain in industry to see either lower losses or higher profit.
Note also the role of price in signalling customer preferences to businesses and in influencing the allocation of resources. The fall in price caused a fall in quantity supplied – fewer resources are required to make Q2 compared with Q1.
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