Solved Problem: Why Is Starbucks Closing Stores in New York City?

Supports:  Econ Chapter 12, Section 12.4, “Deciding Whether to Produce or Shut Down in the Short Run,” and Section 12.5, “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run”; and Essentials: Chapter 9, Section 9.4 and Section 9.5.

Photo from the Associated Press.

Solved Problem: Why Is Starbucks Closing Stores in New York City?

   In May 2021, many businesses in the United States began fully reopening as local governments eased restrictions on capacity imposed to contain the spread of Covid-19. An article on crainsnewyork.com discussed the decisions Starbucks was making with respect to its stores in New York City. Starbucks intended to keep some stores open, some stores would be permanently closed, and “about 20 others that are currently in business will shutter when their leases end in the next year.” Analyze the relationship between cost and revenue for each of these three categories of Starbucks stores: 1) the stores that will remain permanently open; 2) the stores that will not reopen; and 3) the stores that will remain open only until their leases expire. In particularly, be sure to explain why Starbucks didn’t close the stores in category 3) immediately rather than waiting until the their leases expire.

Source: Cara Eisenpress, “Starbucks Closing Some City Locations as It Moves to a Smaller, Pickup Model,” crainsnewyork.com, May 19, 2021.

Solving the Problem

Step 1:   Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4, “Deciding Whether to Produce or to Shut Down in the Short Run,” and Section 12.5, “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run.”

Step 2:   Explain why stores in category 1) will remain permanently open. We know that firms will continue to operate a store if the revenue from the store is greater than or equal to all of the store’s costs—both its fixed costs and its variable costs.  So, Starbucks must expect this relationship between revenue and cost to hold for the stores that it will keep permanently open.

Step 3: Explain why Starbucks will not reopen stores in category 2). Firms will close a store in the short run if the loss from operating the store is greater than the store’s fixed costs. Put another way, the firm won’t be willing to lose more than the store’s fixed costs. We can conclude that Starbucks believes that if it reopens stores in category 2) its loss from operating those stores will be greater than the stores’ fixed costs.

Step 4: Explain why Starbucks will operate some stores only until their leases expire and then will shut them down. If a firm’s revenue from operating a store is greater than the store’s variable costs, the firm will operate the store even though it is incurring an economic loss. If it closed the store, it would still have to pay the fixed costs of the store, the most important of which in this case is the rent it has to pay the owner of the building the store is in. By operating the store, Starbucks will incur a smaller loss than by immediately closing the store. But recall that there are no fixed costs in the long run. The stores’ leases will eventually expire, eliminating that fixed cost. So, in the long run, a firm will close a store that is incurring a loss. Because Starbucks doesn’t believe that in the long run it can cover all the costs of operating stores in category 3, it intends to operate them until their leases expire and then shut them down.

COVID-19 Update – Solved Problem: When to Re-Open Disney World during a Pandemic?

Supports:  Econ (Chapter 12 – Firms in Perfectly Competitive Markets (Section 12.4); Essentials: Chapter 9 (Section 9.4)

Solved Problem: When to Re-Open Disney World during a Pandemic

   In mid-March 2020, during the Covid-19 pandemic, the Walt Disney Company closed its Walt Disney World theme park in Orlando, Florida.  In late May, the company announced that with the approval of the Florida government it would reopen Disney World in mid-July.  An article in the Wall Street Journal noted that the company’s costs would increase because employees would need to reduce the likelihood of visitors contracting the virus while in the park by taking measures such as additional cleaning of the parks and checking the temperatures of customers.  At the same time, the company’s revenue would likely fall because fewer people were expected to buy tickets to the park or to stay in the company’s hotels.  When asked about these issues, Disney CEO Bob Chapek stated that, “We would not open up until we could cover our variable costs ….” If Disney covers its variable costs of operating Disney World, can the company be certain that it will earn an economic profit? If not, why would the company open the park?

Source: Erich Schwartzel, “Disney World to Reopen Gradually Starting July,” Wall Street Journal, May 27, 2020.

Solving the Problem

Step 1:   Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4 “Deciding Whether to Produce or to Shut Down in the Short Run.”

Step 2:   Answer the first question by explaining the circumstances under which a firm earns an economic profit. To earn an economic profit, a firm’s revenue must be greater than all of its costs—both its fixed costs and its variable costs.  So, Disney covering its variable costs is not enough for the company to earn an economic profit if it is not also covering its fixed cost.

Step 3:   Answer the second question by explaining why Disney is better off opening Disney World even if it is only covering its variable cost. With the park closed, Disney is earning no revenue but still has to pay the fixed costs of the park. These fixed costs include the opportunity cost of the funds the company’s shareholders have invested in the park, fire and other insurance premiums, and the cost of the electricity necessary to power lights and security systems. If the park remains closed, Disney will suffer an economic loss equal to its fixed cost.  If the park is opened and Disney earns enough revenue to cover the variable costs of operating the park—including the salaries of employees operating rides and working in restaurants, the higher utility costs, and the costs of increased cleaning necessitated by the virus—Disney will reduce its loss to an amount smaller than the value of its fixed costs, even though the company will not be earning an economic profit. In this circumstance, Disney will be better off opening the park than keeping it closed. In general, as we’ve seen in the chapter, firms will be willing to operate in the short run if they can earn revenue at least equal to their variable costs.  Note, though, that in the long run, Disney would need to cover all of its costs of operating the park to keep it open.

COVID-19 Update – How Will the Coronavirus Pandemic Affect the Airline Industry?

Supports:  Chapter 12 in Economics and Microeconomics – Firms in Perfectly Competitive Markets; Essentials Chapter 9.

SOLVED PROBLEM: HOW WILL THE CORONAVIRUS PANDEMIC AFFECT THE AIRLINE INDUSTRY?

During the coronavirus pandemic, many airlines experienced a sharp decline in ticket sales.  Some airlines responded by cutting ticket prices to very low levels.  For example, in early March, Frontier Airlines was offering round-trip tickets from New York City to Miami for $51 (compared to over $200 three months earlier). As one columnist in the Wall Street Journal put it, the price of many airline tickets was “cheaper than dinner or what you’ll spend on Ubers or taxis.”

  1. Briefly explain whether it was likely that the price Frontier was charging was high enough to cover the average total cost of a flying an airplane from New York City to Miami. Why was Frontier willing to accept such a low price? Would the airline be willing to accept such a low price in the long run?
  2. Some airlines believed that even after the pandemic was over, consumers might not be willing to fly on planes as crowded as they were prior to the pandemic. Accordingly, airlines were considering either flying planes with some rows kept empty or reconfiguring planes to have more space between rows—and therefore fewer seats per plane. Briefly explain what effect having fewer seats per airplane might have on the price of an airline ticket.

Sources: Jonathan Roeder, “NYC to Miami for $51: Coronavirus Slump Leads to Steep Airfare Discounts,” bloomberg.com, March 5, 2020; and Scott McCartney, “There Are Plenty of Coronavirus Flight Deals Out There, But Think Before You Buy,” Wall Street Journal, March 25, 2020.

Solving the Problem

Step 1:   Review the chapter material. This problem is about the break-even price for a firm in the short run and in the long run, so you may want to review Chapter 12, Section 12.4 “Deciding Whether to Produce or to Shut Down in the Short Run” and Section 12.5 “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run.”. In Hubbard/O’Brien, Essentials of Economics, it is Chapter 9.

Step 2:   Answer part a. by explaining why even though a ticket price of $51 was unlikely to cover the average total cost of the flight, Frontier Airlines was still willing to accept such a low ticket price—but only in the short run. As we’ve seen in Section 12.5, competition among firms drives the price of a good to equal the average total cost of the typical firm. Assuming that ticket prices prior to the pandemic equaled average total cost, then the low ticket prices in the spring of 2020 must have been below average total cost.  We have also seen, though, that firms will continue to produce in the short run provided they receive a price equal to or greater than average variable cost. For a particular flight, the fixed cost—primarily the cost of aviation fuel and the salaries of the flight crew—is much greater than the variable cost—additional meals served, somewhat more fuel used because more passengers make the plane heavier, and possibly an additional flight attendant needed to assist additional passengers.  So, the $51 ticket price may have been enough for Frontier to cover its average variable cost. The airline would not accept such a low price in the long run, though, because in the long run it would need to cover all of its costs or it would no longer fly the route. (Note: In the short run, an airline might have another reason to continue to fly planes on a route even if it is unable to cover the average total cost of a flight. The contracts that airlines have with airports sometimes require a specified number of flights each day in order for the airline to retain the right to use certain airport gates.)

Step 3:   Answer part b. by explaining the effect that having fewer seats per airplane would have on airline ticket prices. For an airline to break even on a flight, its total revenue from the flight must equal its total cost.  Flying fewer seats per plane will not greatly reduce the airline’s cost of the flight because, as noted in the answer to part b., most of the cost of a flight is fixed and so the total cost of a flight doesn’t vary much with the number of passengers on the flight.  But flying half as many passengers—if every other row is left empty—will significantly decrease the revenue the airline earns from the flight. To increase revenue on the flight, the airline would have to increase the price of a ticket. We can conclude that if airlines decide to fly planes equipped with fewer seats, ticket prices are likely to rise. Note that if on some routes the demand for tickets is price elastic, raising the price will reduce revenue and the airline will be unable to cover its cost of flying the route.