An analysis of Starbucks using Game Theory

Starbucks Corporation is an American multinational coffee company and cafe chain with over 20,000 stores across the world, the majority of which are located in the United States, making it the largest coffeehouse in the world. Starbuck’s name is inspired by the character of the first mate in the Herman Melville’s all-time classic novel Moby Dick. The mission of the company is to ‘to inspire and nurture the human spirit – one person, one cup and one neighborhood at a time’. (1) Starbuck cafes across the world sell hot and cold beverages such as coffees along with other food items such as pastries, snacks and Starbucks merchandise such as mugs and tumblers. Many of the company’s products are custom to the location of the store and the entertainment division of the company deals with marketing of books, music and movies. Ever since the company was founded in 1971, it has been growing rapidly in sale and revenues. The fact that the company has opened an average of two stores per day since 1987 is a glowing beacon of the success of the company. (2)

Starbucks first ventured into the United Kingdom when it acquired 65 coffee stores of the Seattle Coffee Company in May of 1998. (3) Today, the company serves millions of customers every day with a presence in over 50 countries around the world. Coffee is bought by the company’s coffee buyers personally travelling to the Latin America, Africa and Asia to seek out the best quality of coffee beans available and finished products are produced though Starbuck’s signature Roast enriching the flavor and balance of the coffee. The company’s first public offering was in the 26th of July 1996 and it has been listed on the NASDAQ ever since.

Here in this report, we investigate the use of games theory and simulation to evaluate and test the application of strategic leadership at Starbucks. The report also aims to critically evaluate game theory and the appropriateness of the same in the evaluation of options for strategic change/transformation.

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GAME THEORY

Game theory in simple terms is the way in which a group of intelligent individuals interact and associate with each other to achieve their own goals. A game can be described as activities that people perform for either material gain or pleasure and game theory can be defined as the study and analysis of the strategic interaction between the individuals involved in the game. A game typically contains three elements: the players of the game, the strategies applied by the players and the consequences of the decisions made by each of the players. Game theory is the study and analysis of challenging scenario and using the game situations to aid in the decision making process.

A strategy can be described as being strictly dominant, if the player ends up earning a higher payoff than any other related strategy regardless of what any of the other players do. In essence, the strategy that gives a player the highest payoff is called a strictly dominant strategy. A number of simple games can be solved by using this strategy. While using this strategy, the player analyses and compares the different strategies to decide which one of them gives the better payoff. A strategy is said to be strictly dominated, if there always exists another strategy that gives a better or same payoff compared to any other strategy for a player.

While strictly dominant strategies are powerful tools that can be used to change the flow of the game in the player’s favour, isolating the strategies and applying them to particular situations is rather difficult due to the large volumes of information that may be present. In order to identify the dominated strategies, one must be focused on the players payoff’s at the moment and mentally block out the irrelevant payoffs and strategies and isolate the relevant ones. One way to do this is to perform continuous elimination strictly dominated strategies. Once a strategy has been identified as strictly dominated, it is a rational idea not to use it since there is always a strategy better than it. By iterating this procedure, one may be able to isolate the strictly dominant strategy.

Game theory can be of great help in solving real life situations through the translation of the situations to gaming models and applying game theory on them. Some of the games that may be applicable in real life situations are as follows.

Prisoner’s Dilemma

Prisoner’s Dilemma is a classical example of a game in game theory strategy which shows why two entities, be it organizations or individuals do not cooperate with each other even through doing so will bring both of them major benefits. The formal definition of the game as defined by Albert W. Tucker is as follows:

“Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of speaking to or exchanging messages with the other. The police admit they don’t have enough evidence to convict the pair on the principal charge. They plan to sentence both to a year in prison on a lesser charge. Simultaneously, the police offer each prisoner a Faustian bargain. If he testifies against his partner, he will go free while the partner will get three years in prison on the main charge. Oh, yes, there is a catch … If both prisoners testify against each other; both will be sentenced to two years in jail. (4)”

The game is used to demonstrate how the distrust and completion of the individual parties towards each other may result in the worst possible option being forced upon each of them. This particular game can be applied to a number of commercial organizations such as ASDA and other chain supermarkets where are there are constant price wars or some other kinds of competition. Another relevant example is that of intense animosity between countries such as Indian and Pakistan, leading to an Arms Race, draining both of the countries’ resources and causing currency instabilities.

Sequential Game

A sequential game is a game in game theory where a player chooses his strategies sequentially. In this form, a player has information on the strategy that the other player has chosen before he does make his move. Thus, the sequential games have a time axis and are determined and affected by the other player’s moves. This evidently implies that the player to make the first move has the power to influence the moves of the other players in the future since each player decides on the strategies they have available at the hand and the actions of the first player therefore influence their moves.

A classic example of a real life true sequential game is that of chess, where each player takes turns in developing their strategies according to the moves made by that of his opponent. These games can be easily represented by payoff matrices and can be solved through backward induction. Another example of a common sequential game in application to real life is auctioning where each of the participants raise their auction amount based on the previous participant’s decision.

Simultaneous Game

Simultaneous games are played when each player makes his decisions without knowing the decisions or actions of the other players. In essence, simultaneous games contrast the sequential games in every sense of the word. For instance, simultaneous games do not have a time line and the actions of the players are not affected by that of each other.

An example of a true simultaneous game is rock paper scissors with each of the players taking decisions independent of each other. Normal Forms are the chosen forms of representations for simultaneous games. Bidding is another classing example of a real life simultaneous game where the participants chose their investments irrespective of what the other may have chosen.

Ultimatum Game

In game theory, ultimatum game is played between two players who have been given a specific amount of money to be divided among them. During the game, the first player makes a proposal on how to divide the cash and the second player can respond by wither accepting or rejecting the proposal. If the second player chose to accept the proposal, each of the players receives a sum of money as proposed by the first player. However, if he does not accept, neither player gets anything. This game was developed in the year 1982 by Güth, Schmittberger, and Schwarze and is often used in economic experiments.

Dictator Game

The dictator game, as the name suggested is dominated by dictator and the rest of the players are merely silent partners. It is similar to the ultimatum game in some senses; however, the role of the players other than the dictator is entirely passive. In the dictator game, the main player, i.e. the dictator proposes the division of some endowment for example, a resource such as the market share or cash prize. The rest of the players, the respondents, have no choice other than to accept the division and make do with whatever resources are left remaining by the dictator. Unlike the Ultimatum game, here the role of the respondent is entirely passive.

Hotelling Game

Hotelling game in game theory is a form of competition in which two rivalling companies choose the location of their business or the prices of their goods according to that of the competitor. The game is based on the observation that by matching the location or the price of the competitor, each player cuts into the market share of their rivals and also improves on their own shares and revenues.

GAME THEORY AT STARBUCKS

Starbucks enjoyed an unprecedented growth in its early years growing from a minor local store located in Seattle to an internationally giant of coffeehouses across the world due to a number of well organized and managed executive decisions. However, in the recent years, their growth has slowed down and the company was forced to close down around 300 stores since the year 2008. This may be due to the splitting of the market share by the emerging competitors such as McDonalds, who have introduced McCafes as their foray in to the coffee business. The two companies have been doing rather well in the past few years by using different strategies. In the following sections we try to investigate and explore how the different games and game theories are applicable with respect to the competition of these companies and examine how Starbucks rose to power.

Application of Hotelling Law/Linear City Model

The rapid expansion of Starbucks can be attributed to the application of the strategies of the Linear City Model or Hotelling Law. When Starbucks entered the local markets with a local competitor, as depicted below. Considering the market is uniquely distributed, the competitor is located in the middle, allowing them to harness maximum profits. Thus convenience is the competitor’s only advantage and with the closer the Starbucks retail shop, measured by x, is to the competitor, more market share it can gain.

With the location and convenience being the only factors of concern, if the company opens a shop just .1 miles away from the competitor, it will gain 47.5% of the customers. However, aside from the convenience the brand armed with the Starbucks experience’ and brand name, attracts more customers with its coffee being attractive to the consumer approximately around $1 a cup. Representing the Starbucks experience cost as transportation cost t, and the coffees valued at $3 and $2.5 at Starbucks and the local competitor respectively, the customer valuing a cup of coffee worth $4, he evaluates his buying decision as follows:

• Customer Utility Starbucks: WTP – (PS) = $4.0 – ($3.0) = $1.0
• Customer Utility Coffee Shop: WTP – (Pc + [1-x] t) = $4.0 – ($2.5 + [1-.1]*$1.0) = $0.6

Through this example, one can demonstrate how the ‘Starbucks experience has allowed the company to take over the local markets by capturing over 70% of the market share. With no clear competition, the company was able to effectively expand at will and take out the local coffee houses. Also the company tried to centralize itself at the local customer bases to maximize the profit. In this situation, a new competitor intending to open a new store would have to open the store to either side of store and thus would gain only less than half the market share.

Now, considering the situation where a Starbucks store located is located about half a mile away from the centre of the customer base ie x=.5. Now, considering all the factors the same as above, the customer evaluation would be:

• Customer Utility Starbucks: WTP – (P + x1t)” $4.0 – ($3 + .5*$1.0) = $.50

This implies that a new store can take over the market share as long as their location is less than that of Starbucks. This is one of the reasons why there was a phenomenon where the Starbucks stores clustered towards each other. By increasing the strategic location of their stores, the company was able to maximize their profits. In this situation, the best option available for a new store is to locate to the centre of the micro-market at x=0, splitting the market.

However with the Starbucks stores clustering towards each other with the term now known as ‘Starbucks in every corner’, the situation is a major deterrent to the entrepreneurs from opening new stores. The company in its clustering split its profits among the stores with the existing ones closing down and moving away, maintaining the Nash Equilibrium and playing their best responses.

Sequential game at Starbucks with respect to McDonalds Coffee shop proposal

While the company enjoyed a monopoly in the coffee business for a long time, the entering of McDonalds into the coffee industry affected the company’s profits significantly. The coffee market in the US was valued at around $1 billion by the company and the cost of future sales was estimated to around $100,000 per store. This situation can be described in game theory as follows.

• Game: McDonalds’ entry decision in 2007
• Actions: McDonalds’ – entry v. no entry, Starbucks – accommodate v. fight (drop prices)
• Payoffs: profits are limited by the maximum portion of Starbucks revenues vulnerable to attack i.e. price sensitive and non-loyal customers.

Look Forward Reason Back: McDonald’s enters, Starbucks responds

Adjusting the 80/20 rule to 80/25, the loyal customers of the company are approximated at around $4.85 billion. While assuming that the spending habits of the rest of the customers as the same, only around $1.2 billion of the sales would come from the non-core. With the records showing that around 37% of coffee drinkers being non-loyal customers, the company stands to lose around 10% of their revenues if the non-loyal consumers switched offer to the McCafes. Considering this over a period of 5 years, the payoff to the business for accommodation would be to lose around $1,944 million in revenues.

However, if the corporation chose to fight the fast food chain by reducing their prices to an average of 2.25 per cup of coffee from $3.50 and assuming that the average transaction costs around $3, it would a significant amount of revenues from the existing customers by around 24% per year. Projecting this to a five year period, and considering that the market share of the company is fixed, the company stands to lose around $4,801 millions.

Clearly, from these figures, the best option for the company, if McDonalds decides to enter the coffee industry, is to accommodate the newcomer, since opposing it would cost the company a lot more if it chooses to fight by cutting the prices of its products. Thus, in the case where McDonald’s enters the market, the strictly dominant strategy of the company is to work towards accommodating the new competitor.

Look Forward Reason Back: McDonald’s does not enter, Starbucks responds

However, if McDonald’s defers from entering the market, the company would maintain its status, holding on to its non-loyal customers and no loss of revenues would occur. This implies that as long as McDonald’s chooses not to enter the market, the company can keep its customer base, and the payoff would be zero. Another option is for the company to lower its process in case of a threat to the customer base, and then the payoff using the above calculations would be $4.8 billion. Thus the dominant strategy that the company can take is to do nothing and accommodate McDonald’s on its entry to the market if the company chooses to do so since the lowering of the prices is not worth the competition and loss of customers in accordance with the fall of revenues.

Look Forward Reason Back: McDonalds’ decision

Considering that the best option for Starbucks is to accommodate McDonald’s, the decision to make for McDonald’s is to decide if they could generate enough revenues in the business. In 2007, according to a statement by McDonald’s, it believes that it can generate up to $1billion in annual sales with a $100,000 investment into coffee equipment & training. Assuming that the market does not grow, extrapolating the data to five years, the payoff to McDonald’s would be a minimum of $200 million. As this data does not include the non-loyal customer base of Starbucks, this is the worst case scenario for McDonald’s.

As the situation is only profitable to the company, McDonald’s has chosen to open over 14,000 locations in the US, aiming to cut in to the Starbucks customer base.

CONCLUSION

While Starbucks and McDonalds have been able to coexist in the industry, McDonald’s has been gradually cutting into the Starbucks market share. For Starbucks to survive, they will need to combat these strategies. Simply trying to hold on to the premium market will prove to be a futile attempt to retain share, as McDonalds and others have means to access the channel. While Starbucks is attempting to diversify income by diving deeper into the grocery retail market, they will still need to invest in efforts to not only retain existing customers, but be able to attract value customers without sacrificing profitability.