Cracking the Coffee-Wine Paradox

My last post, Starbucks and and Coffee-Wine Paradox, raised questions about the relative price of wine. We think of coffee as being expensive, especially coffee drinks at Starbucks and other gourmet espresso bars. But compared to wine they seem like a bargain.

You can get an excellent coffee drink for less than the cheapest glass of on-premises wine. And the price difference between generic coffee and the best (a factor of 16 according to a Decanter article) looks great compared to wine, where the cheapest bottle costs a couple of bucks and there’s almost no upside limit.

Coffee and wine are both simple quotidian pleasures (or should be). Why are their relative prices so different? Several readers and colleagues offered answers to this question.

Cost Plus Wine

Suggestions (click on the article link above and scroll down to the comments section) focused on cost differences . Coffee is cheaper to ship and store, for example, and as Rob Boyd pointed out coffee isn’t typically aged for years like red wine, which increases cost.

Wine is typically bottled at the source, so to speak, which also contributes to the cost difference. Weight gets added relatively early in the wine supply chain whereas coffee gains weight at the point where it is combined with water, brewed and served — a real advantage. “If coffee was brewed in Colombia and then shipped to Starbucks around the world,” Steve DeLong wrote, “the price would be astronomical.” (See note below.)

Steve also had the insight that, while Starbucks-style coffee products are pretty labor intensive to make, this cost also comes at the final stage of production, whereas wine’s high labor costs come much earlier and are magnified by multiple mark-ups in the distribution system. An additional  dollar of labor in the cellar translates to maybe $2 higher retail price for wine here in the US with our three-tier distribution system. An extra dollar of barista wage cost at the end of the coffee product chain has less of an impact on price.

Cost and Price

The comments I’ve received go a long way toward unraveling the paradox. As I expected, however, most people try to solve the puzzle on the cost side — focusing on why wine costs are relatively higher than coffee costs. These are good answers, but it is important to consider the demand side, too. Everyone knows that some prices are determined by production cost, but others are dictated by what people are willing to pay.

Cost rules in highly competitive markets, where products are undifferentiated and good information is readily available. Willingness to pay is more important in imperfectly competitive markets with highly differentiated products and asymmetric information.  The markets for generic coffee and wine fall into the first category, fine wines and specialty coffees into the other.

What Will You Pay?

Why do highly-rated wines cost so much to buy? Production cost is a factor, particularly for generic coffee and wine, but it alone doesn’t explain the big price gap between the bottom shelf and the top. Fine wine and gourmet coffee cost so much because people are willing to pay these prices — and they lack the confidence to pay less in some cases because they associate lower price with lower quality (or maybe lower status).

So I think Steve Kirchner is on to something when he points to differences in marketing between coffee and wine. Gourmet coffee, Steve argues, is a relatively new phenomenon and it is certainly true that the range of choices is still limited compared to wine.

Closing the Coffee-Wine Gap

How many different coffees does your grocery store sell? Probably a few dozen at two or three price points. How many wines? Probably one or two thousand at many more price points!

Fine wine is more complicated than fine coffee and there is more uncertainty surrounding it. This makes the market more “imperfect” in the jargon of economics, and price and cost are more likely to deviate.

Will coffee producers ever catch up to their wine-making cousins? Not soon, I suspect, but I think they will close the gap!

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Note: Steve’s comment about brewing coffee and then shipping it reminds me of a story I picked up back when I did tax policy economics.

When coffee was first introduced in Great Britain, it was subject to high excise taxes intended for luxury goods. Coffee shops reacted by adding non-coffee ingredients to the brew to stretch their precious grounds. Adulterated coffee. Ugh.

The tax authorities, seeing a revenue shortfall,  responded by ordering all coffee to be brewed in designated central canteens, then transported full-strength to the shops and reheated there. Twice cooked coffee. Ugh again! More expensive, of course, and adulteration was still possible, but at least the tax was paid.

Thus did high taxation ruin Britain’s taste for coffee, which has only recently recovered thanks in part to market entry by quality sellers like Starbucks.

Starbucks and the Coffee-Wine Paradox

The Water-Diamond paradox is a classic problem in economics. Water is essential to life, but it is relatively cheap in most situations. Diamonds, on the other hand, are non-essential luxuries in most uses, yet they cost the earth compared to water. How is this possible? How can market price deviate so clearly from practical value? A tough problem. John Law, John  Locke, Copernicus and Adam Smith all tried to provide sensible answers.

In Vino Paradox

Starbucks (the Seattle-based company that sells coffee with a side of lifestyle) presents us with a similar puzzle today. I call it the coffee-wine paradox in honor of the original problem.

Starbucks has started selling wine. Not at branded Starbucks stores, but at three experimental “15th Avenue Coffee and Tea” shops in Seattle.  As near as I can tell they have not yet begun to market a Starbucks wine (the image here, courtesy of Google Image Search, is apparently bogus), but who knows what will happen in the future?

I know a number of coffee bars here in the Pacific Northwest that double as wine bars and authentic espresso bars in Italy nearly always serve alcoholic beverages including wine. Starbucks knows how to sell branded goods. Connect the dots. Maybe there is Starbucks Pinot Grigio in your future?

So what is the paradox? Well, the joke is that Starbucks coffee products are very expensive. You know what I mean — the mythical four dollar caffè latte? But when you compare Starbucks coffee to wine, it looks like coffee is unbelievable cheap. Thinking in terms of absolute price both wine and coffee cost a lot but, as in the water-diamond problem, their relative prices seem totally out of line. Why is wine so expensive compared to coffee and why is coffee so darn cheap?

Pulling the Supply Chain

Coffee cheap? Well, consider what a diagram of the global supply chain for a Starbucks latte would look like. The high tech espresso machine is usually Italian-made. The milk is probably a local product and the labor likewise, but the coffee and flavorings such as chocolate and vanilla come from all over the world and pass through many processes and middleman hands on their way to you.

Wine, by contrast, is the simplest of products. It practically makes itself. Even with the notorious three-tier distribution system here in the US, it is a whole lot easier to get wine into your glass than coffee into your 20-ounce cardboard takeaway cup.

And think about the wine bar versus espresso bar experience. Servers at the wine bar retrieve the bottle and pour some in your glass.  Pretty simple. At the espresso bar, by contrast, your coffee made to order with sometimes extravagant special requests (a tall half-caff soy vanilla latte with caramel?). No doubt about it, in terms of both global sourcing and labor-intensive local production,  Starbucks coffee seems like it would be a lot more expensive to produce and serve than my mythical Starbucks wine.

So here’s the paradox. $4 for a cup of coffee (or espresso-favored coffee drink) seems impossibly expensive. Ridiculous. A joke. But $4 is impossibly cheap for a glass of decent wine these days when you are dining out. What do you think Starbucks would charge for a glass of wine? If they conform to the industry rule of thumb (and I don’t know if the 15th Avenue shops do) the price for each glass would equal the wholesale cost for the bottle. So you’d expect to pay $6 and up for fine wine (wine poured from a bottle in this context) or less if it is drawn from a bag-in-box hidden somewhere in the back room.

Generic industrial wine sells for more than a premium custom-brewed coffee product. No question about it. Wine costs too much and coffee is too cheap. Why? That’s the first part of the coffee-wine paradox.

A Factor of Sixteen

A second aspect of the coffee-wine paradox is revealed in the November 2009 issue of Decanter magazine in a short but very interesting article on coffee. It seems that coffee, like wine, comes in all sorts of variations from cheap bulk product to the equivalent of vineyard-designated grand cru coffee cuvées (if that isn’t stacking the adjectives a bit too high).

Coffee connoisseurs will pay enormous sums to get the finest, rarest coffees. Decanter quotes the price of the winning coffee from a recent international competition at £13 per 250 grams of roasted beans or roughly 40 U.S. dollars per pound. On a per-cup basis, according to the article, the top coffee sells for about sixteen times the most humble Cup of Joe. That’s a pretty high premium to have the best instead of the simply pretty good.

Consider the corresponding wine ratio. If we take Two Buck Chuck as our Nescafé equivalent, the most expensive wine on the market would cost $32 in California (where Two Buck Chuck really costs $1.99) and $48 dollars per bottle nearly everywhere else in America. But this is ridiculous. The most expensive wines cost much more than this. If you read the wine magazines you frequently encounter prices of hundreds and even thousands of dollars for the finest, rarest wines. The coffee factor is sixteen from bottom to top. The wine factor, by comparison, is fifty, sixty, a hundred, even more.

What is the solution to the coffee-wine paradox? Why does wine seem to cost so much more than coffee despite the factors that would seem to raise coffee’s cost? And why do the best wines cost so much more, in relative terms, than the best coffees? What’s your answer? Watch this space for mine!

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