Price Discipline in Declining Markets: Coffee Roasters

When industries decline, it is tempting for competitors to make a dash for regaining lost volumes by slashing prices.  But, are price wars predestined?

Nagel and Holden (2002) argue that in declining industries price volatility is usually high if contribution margins are high and the production costs are mainly fixed and sunk.  Are all three conditions necessary and sufficient for predicting adverse pricing conditions?

While a single case study cannot adequately address these issues, it can demonstrate that adverse price movements are not foreordained.  Smart industry competitors can practice price leadership and followership even in declining industries.

Folgers, Maxwell House, and Chock Full o’Nuts

In the year till April 14, 2007, 5.98 million bags of coffee were roasted for the US market, down from 6.01 million bags in the same period ending 2006.  The reported volume of roasted beans doesn’t include the number of smaller micro-roasters that are estimated to have taken 15% to 20% of the overall coffee market.  While this is a small decline in volume, it does indicate a mature to declining industry battling with a new form of competition.

So, it can be argued that the mainstream coffee roaster industry is slightly declining.

The production cost structure of branded coffee roasters includes sunk costs in the form of roasting capacity and branding, as well as marginal cost in the form of purchasing green beans, energy consumption for roasting, and packaging, shipping, and branding costs.  Larger marginal costs will decrease the contribution margin of coffee.

So, it can be argued that the mainstream coffee roasters face large sunk costs, but it will not be argued that the mainstream coffee roasters enjoy large contribution margins.

Hence, the mainstream coffee roasting industry passes two out of three criteria for predicting adverse pricing conditions.  Yes to declining market.  Yes to large fixed and sunk costs.  But not necessarily yes to high marginal costs.

Price Discipline Enjoyed

In early January, Folgers raised the price of ground coffee by about 4%.  Shortly thereafter, Maxwell House and Chock Full o’Nuts followed with similar increases.  This gives us three intelligent industry competitors and provides support that our current pricing paradigms are intact.  Price wars during market declines is not foreordained, at least not in industries with modest contribution margins going through modest contractions.

Notes

1. Susan Buchanan, “U.S. Roasts Fewer Coffee Beans”, The Wall Street Journal, June 20, 2007. P B5F.
2. At the time of this writing, Folgers is a Procter and Gamble brand, Maxwell House is a Kraft Food Inc. brand, and Chock Full o’Nuts is a Segafredo Zanetti Group’s Massimo Zanetti Beverage USA brand.
3. Thomas T. Nagle and Reed K Holden, The Strategy and Tactics of Pricing, 3rd ed. (Upper Saddle River, NJ: Pearson Education, Inc., 2002) pp 177 – 200.
4. As one who has spent sleepless nights working on difficult questions, I am delighted to have the opportunity to discuss coffee.  And, as someone who remembers the near cult-like success of Jolt Cola at the University of Chicago while solving quantitative problems in the early 90’s, it is a rare delight to apply theoretical constructs to a caffeine market case study.  Fortunately, recent news has been supportive of my habits.  Thank you for sharing with me this indulgent moment.