In my secured transactions and bankruptcy classes, when I teach the Modigliani-Miller theorem—or, as we think of it at the University of Chicago, Miller-Modigliani—I describe it as focused on the consequences of home-brewed arbitrage. Investors outside of a firm can buy or sell debt or equity to replicate or counteract steps taken by a firm to create an optimal debt-equity ratio. Hence the theorem’s core point about the irrelevance of capital structure under certain highly-stylized conditions.
But apparently home-brewed arbitrage has taken on another meeting, as the Chicago Tribune detailed in an interesting if fluffy article yesterday about Starbucks and the bootleg latte. As the Tribune describes it, Starbucks's pricing creates a doppio-latte arbitrage opportunity. But the article raises interesting points about an item of ongoing interest for me, namely, under what circumstances can users deviate from the intended uses of producers? For regular readers of this blog, you will recognize that this once again takes us back to questions relating to digital rights management and the Digital Millennium Copyright Act (see posts here and here).
This is a language I barely speak—I don’t drink coffee and only occasionally have a hot chocolate at Starbucks—but here is the strategy as I get it. A doppio is described as a double shot of espresso that would usually be served in an 8-ounce cup. That would set you back $1.75. A latte, which goes for $3.20, is a double shot of espresso plus milk and foam in a 16-ounce cup. Our arbitraging customers order the doppio but ask for it in a 16-ounce cup and then add free milk available in canisters at Starbucks. Pop the cup in a microwave and you have the latte and have saved $1.45.
So now we have the natural question: what are the limits of free milk? That is, Starbucks provides free milk so that customers who want to add milk to their coffee can do so. (Is it fair to call this the permitted use or intended use?) Customers know their optimal coffee/milk ratio and can best achieve that by doing it on their own. Unlike the DMCA and DRM, which imposes technological limits on how content can be used, Starbucks has no simple way to control how “free” milk is used at Starbucks. But Starbucks obviously could take a number steps to limit the use of free milk, including posting signs or refusing to facilitate the arbitrage by selling drinks only in cups of the right size. The cup size limit is the most natural technical constraint; signs would be more directly contractual but would detract from ambiance.
Of course imposing a cup size limit might irritate some customers. Then the question becomes whether these are customers Starbucks would be better off without or is this exercise in arbitrage also a way that Starbucks engages in price discrimination for lattes? If we assume that the fake latte is still profitable for Starbucks even when sold for a $1.75, Starbucks may be perfectly willing to allow some of its customers to home-brew using Starbucks ingredients.
The latte price discrimination possibility makes clear the difficulties of identifying permitted/intended uses. While Starbucks probably wouldn’t announce a policy of allowing customers to create fake lattes—too many genuine latte purchasers might switch over—it might want to engage in latte price discrimination, and if so, Starbucks would think of milk use for fake lattes as an intended, if unofficial, use.
What do we think are the limits of the use of free milk? (For one set of answers, visit the Starbucks gossip blog (yes, of course there is one).) If Starbucks imposed my cup size limit rule, would we think that customers shouldn’t bring cups with them to take a sufficient amount of free milk back to the office to turn their doppios into fake lattes?