Tag: Shifts in the demand curve

Solved Problem: Difficulties in Determining the Price Elasticity of Demand for Frappuccinos

Supports: Microeconomics and Economics, Chapter 6, and Essentials of Economics, Chapter 7.

Photo from the New York Times.

An article in the Wall Street Journal reported that Starbucks during certain periods is cutting by 50 percent the prices of many of its coffees, including its Frappuccino. The article also noted that: “Many restaurant chains are pumping out new deals this year in a bid to reverse weak traffic.” The article also quoted a Starbucks spokesman as saying that Starbucks is cutting prices “to ensure that consumers who are facing a challenging economic environment continue to visit its cafes.”

  1. What is Starbucks likely assuming about the price elasticity of demand for Frappuccinos?
  2. Suppose that after cutting its price of Frappuccinos by 50 percent, the quantity of Frappuccinos sold increases by 20 percent. Ignoring any information other than the values of the price cut and the quantity increase, calculate the price elasticity of demand for Frappuccinos. Considering only the value of the price elasticity of demand you calculated, will Starbucks earn more revenue or less revenue from selling Frappuccions as a result of the price cut? Briefly explain.
  3. Suppose that during the time that Starbucks cuts the price of Frappuccinos, competing coffee houses also cut the prices of their coffees. How will this fact affect your answer to part b.? Briefly explain.
  4. Does the fact that, because of inflation, some consumers are facing a “challenging economic environment” affect your answer to part b.? Briefly explain. 

Solving the Problem

Step 1: Review the chapter material. This problem is about the determinants of the price elasticity of demand and the effect of the value of the price elasticity of demand on a firm’s revenue following a price change, so you may want to review Chapter 6, Section 6.2 and Section 6.3.

Step 2: Answer part a. by explaining what Starbucks is likely assuming about the price elasticity of demand for Frappuccinos. Starbucks appears to be assuming that the demand for Frappuccions is price elastic, in which case a cut in the price will result in a more than proportional increase in the quantity of Frappuccions demanded. 

Step 3: Answer part b. by using the values given to calculate the price elasticity of demand for Frappuccions and explain whether as a result of the price cut Starbucks will earn more or less revenue from selling Frappuccinos. If all other factors affecting the demand for a product are held constant, the price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price. Therefore, in this case the price elasticity of demand for Frappuccinos equals 20%/–50% = –0.4. Therefore, relying just on the information on the changes in the price and quantity demanded, the demand for Frappuccinos is price inelastic. As explained in Section 6.5, when demand is price inelastic, a cut in price will result in a decrease in revenue.

Step 4: Answer part c. by explaining whether other coffee houses cutting the prices of their coffees will affect your calculation from part b. of the price elasticity of demand for Frappuccinos. The calculation in part b. assumes that during the time that Starbucks cuts the price of Frappuccinos, nothing else that affects demand will have changed. We know that the coffees sold by other coffee houses are substitutes for Frappuccinos. So we would expect that if other coffeehouses cut the prices of their coffees, the demand curve for Frappuccinos will shift to the left. The 20 percent increase in the quantity of Frappuccions sold reflects the effects of both the price cut and the shift in the demand curve for Frappuccinos. Therefore our calculation of the price elasticity of demand for Frappuccinos is inaccurate. It’s likely that the price elasticity is larger (in absolute value) than the value we caculated in part b.


Step 5: Answer part d. by explaining whether the fact that some consumers are facing a “challenging economic environment” affects your answer to part b.  The answer to part d. is similar to the answer to part c. If the fact that some consumers are facing a “challenging economic environment” means that these consumers are less likely to be buying coffee and other products away from home, then the demand curve for Frappuccinos will have shifted to the left during the period that Starbucks cut the price of these coffees. As a result, the value we computed for the price elasticity of demand in part b. will be inaccurate. Taken together, the factors mentioned in parts c. and d. indicate the difficulties that firms have in calculating the price elasticity of demand for their products during a time period when several factors that affect the demand for the products may be changing.