Hacking Starbucks

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?

Comments

[Michael Risch]

Interesting post. It reminds me of how Burger King handled (sort of) a similar issue way, way, way back in the day when I worked there during high school.

At the time, Whopper Jr.'s were $1.60 or so, and hamburgers were $.80. Now, a Whopper, Jr. is just a hamburger with different toppings. So, the trick for poor high school students was to order a hamburger minus the mustard and ketchup, but plus the mayo, lettuce, and tomato, leaving you with the equivalent of a Whopper, Jr. Have it your way, indeed.

The reason they "partially" dealt with the arbitrage is that they charged 15 cents for the tomato and 5 cents for the lettuce. Thus, the total was a buck, and BK and the customer split the difference because BK saved some because the spruced up hamburger was served in cheaper paper rather than the cardboard box of a Whopper.

All of the above is now moot - a Whopper, Jr. is now appropriately priced at 99 cents. Perhaps Starbucks will have to reduce the price in order to encourage intended uses.

[YLlama]

I'm not sure microwaving the free milk has essentially the same effect as steaming it and dolloping the foam atop the coffee. Perhaps the ultimate taste is the same. But it might take a while for it to be perceived by the uninitiated as tasting the same.

[Randy Picker]

YLlama,

The Tribune article suggested that the taste was identical, but I can't attest to that personally.

[Spencer]

Microwaving the "latte" runs the risk that one will nuke the paper cup, thus releasing a rather toxic smell which ruins the drink entirely. This is the primary reason I buy "mistos" at starbucks, paying an extra $.45 to get hot steamed milk in my drip coffee rather than using the cold free milk.

[Rick]

A similar scenario happened at my alma mater, the university of michigan, for quiet sometime now, in which there are three coffee shops, relatively close to each other, in the same student union. One coffee shop ("shop A") has a flat "1 dollar" coffee refill policy, provided that the customer bring his or her coffee cup or mug for refill. Otherwise, a regular cup of coffee costs $1.50 tall/$1.70 grande/$2.30venti

I, as a coffee-aficionado, obviously want to pay the least amount of money for the maximum enjoyment. However, I don't want to carry a coffee cup all day, but I still want to save a dollar or so on my coffee expense per cup. Now, the other two coffee shops ("shop B" and "shop C") are willing to give out free paper coffee cup (of any size) if someone like me approach them and ask them for it. So for the past few years, my coffee expense per cup has been limited to a flat dollar per cup. (I ask for the venti cup everytime by the way) I basically saved about $1.10 per cup of coffee and not to mention that "shop A" has a promotion in which if any customer bought 9 cups of coffee at the shop, then the tenth cup order of any type of coffee is on the coffee shop (then I would order venti-skim-latte -- I actually save these "free coffee" coupons and use them during the finals time.)

However, an interesting phenomenon developed that relates to your question, "what are the limits of free milk [or free coffee cups in my situation]?" The phenomenon is actually related to customer's strategy to work his way "around" the question. Obviously, if my crave for coffee is high for a certain week [or even if my demand is normal], the coffee shop's saleperson (let's say "shop B") whom I asks for free paper coffee cups would begin noticing me and my demand for coffee cups (I don't reuse paper coffee cups). He or she would then become more and more uncomfortable to give out free cups to me. When this happens, I would switch to the other coffee shop ("shop C") in the student union and ask for free coffee cups. The strategy worked out extremely well.

Over the past about 2 years, I found out that when I asked for free coffee cups alternatively (period varies) from these two shops B and C, and also from different sales persons in each shop, the question of "what are the limits of free cups" never really took hold of their minds (or they are just too busy to care about whether or not they should give someone like me free cups) I guess the principle becomes "occassional asking is fine but frequent asking is not" so if I keep them under the mindset that I am an "occasional" asking person, then the question, "what are the limits of free cups" may never really become a serious question in the sales person or manager's mind. At the same time, I was able drink quality coffee at a guaranteed discount price (and still do occassionally). (around 50% off the regular price)