So, I went in and ordered a frappe. The cashier, in turn, asked for €1.10. Really, that cheap? This canteen is in prime location (right in the middle of the university, which is full of frappe-thirsty students!!!), packed with young students, whose willingness to pay for a frappe is unreasonably high (as any visit to the fancy cafe clusterings would attest), and, with no real competitors around.1
This canteen is practically a local monopoly and it appears to be violating one of the basic economic principles. That is, that a profit-maximizing monopolist equalizes her marginal revenue (the change in her revenue from the sale of an additional unit) to her marginal cost (the change in her cost due to the production of an additional unit), so that the profit-maximizing number of frappes is determined. Then, the demand function will give the profit-maximizing price.
However, this canteen's behavior seems to be going against this principle. Even though, the quantity of frappes may well be at the profit-maximizing level of a monopolist, the price certainly is not. To see the intuition behind this claim, suppose for simplicity that the demand side of the market can be described by a representative agent with a linear inverse demand function of the form p=a/b - d/b, where d is the quantity demanded, b>0 measures the price sensitiveness of the consumer, while a>0 is the maximum number of frappes the consumer can have.
I postulate the assumptions that a=4, and b=0.5, without maintaining that these values fully describe the market, but I do argue that they are reasonable and help to get the main point through. As claimed before, the willingness of a student to pay for cup of iced coffee is pretty high. Moreover, frappe is the "traditional" iced coffee to the point where most people order it without even checking the price first. Although, this might be because, in most places, frappe is the cheapest coffee, the crucial point is that Cypriot consumers are pretty insensitive to frappe's price. (Also, a=4 and b=0.5, suggest that at price of €8, quantity demanded is 0, and given that people were willing to pay €7.50 for frappe then I am pretty confident about the parameter values.)
We proceed by defining
Equipped with the necessary tools from the demand side, we now move to the supply side, where we will examine the cost function of the canteen.
So, how much does a frappe cost? To answer this, we need to break down its ingredients. A frappe includes a couple of tablespoons of coffee and sugar, a bit of milk and a lot of tap water. Obviously, the cost of making an extra frappe is approximately zero, and indeed the equilibrium price will be lower, the lower the marginal cost (i.e., a higher marginal cost will only magnify the problem discussed below); consequently, for simplicity let's set the marginal cost equal to zero. 2
Hence, in equilibrium "Marginal Revenue=0". A bit of algebra would reveal that, in this simple model, the quantity a representative agent consumes is "d=a/2=2" (since a=4), while the profit-maximizing price is "p=a/b - d/b=8 - 4= €4".
How do these results compare to real life? The quantity demanded of two frappes seems about right; most students drink a frappe in the morning right before (or even during) classes, and one near noon.
The price, though, differs significantly from the price of €1.10 that is actually charged. This is €2.90 difference per frappe, and although the exact price deviation is not important, what is important is that the price differs from a monopoly price, and it differs greatly. What's also important is that the particular canteen has been operating under the current management for a while now, which reveals that it's, at least, covering its average cost (note: a (near) zero marginal cost does not imply a zero average cost).
As the price of most its products are also capped, one may wonder how is the canteen covering its costs, which are labour, rent and input costs.
The labour costs are pretty standard, and are determined by the labour market for coffee-house workers, and the same goes for the input costs (of course, the canteen management could choose to use expired raw materials, but she still has to buy the products).
This leaves us with the rent, which is the one the canteen can (partially) influence. Suppose, for a moment, that the university when deciding to lease the space, it realizes that the canteen will be a local monopoly, and thus, the rent that will be charged should correspond to a local monopolist. Further, suppose that the university decides that the prices should be capped. As the rest of the (main) costs are beyond the control of the candidate canteen operator, then it's clear that no operator would be signing up the lease. Therefore, since prices are capped, it must be that the university is charging less than the monopolist rent.
In other words, the university is not getting the appropriate returns for its asset, and it is losing surplus. However, the said surplus is not a deadweight loss as it is transferred to the consumers (i.e., primarily the students) in the form of consumer surplus.This constitutes a transfer of welfare from the university towards the university community.
Since frappe is only one of the many products whose price is capped, we conclude that the transfer of welfare arising from the university's price capping policy is significantly more than argued above.
Indeed, this type of welfare transfer should struck as a problem to anyone, as it is an inefficient allocation of university funds. While the value in euros of the lost university surplus may not amount to the hundreds of thousands, it could still be a significant amount. An that could be used to aid the need-based funds, or the excellence-awards funds, or could be used in another way so that everybody is better off.
All in all, economists across the globe, more often than not, object to price caps, because the price as determined in the free-market provides vital information. In most occasions (and this one could not but be one of them), the free-market is able to aggregate economy-wide information and reflect all one needs to know in the price. Capping that creates market frictions in terms of information. However, it also creates another type of friction as the present passage argues. That is, there is an indirect transfer of welfare from the university towards (mainly) the students. This is indeed a friction as it is (weakly) dominated by a direct transfer of welfare by the university, which could be achieved by transferring either money to the students or improving its services towards the student population. Such an arrangement would benefit everybody.
Footnotes:
1. The only competitors being (i) the aforementioned fancy coffee house, and (ii) the canteen-type cafe in the senate house, which both, in fact, serve different types of markets --- i.e., provide different products, and, in the case of the senate canteen, serve mostly senate employees.
2. Another reason for assuming a zero marginal cost is apparent when we consider the time period to be a day. In this case, the materials needed to make a frappe are already bought, and thus they are a fixed cost. As a result, the marginal cost in this case is 0.
