Cost pass-through mechanism in the coffee industry

Abstract

Coffee industry has offered an interesting case study for cost pass-through researchers due to relatively simple manufacturing process of coffee, and unlike in many other industries, the cost of imported intermediate goods (coffee beans) accounts for a disproportionally large share of marginal costs. Different research papers set this estimate between 50% - 70%. Furthermore, this share of marginal cost is directly observable for the researchers and the volatility of import costs arises mainly from exogeneous weather shocks. As a result of all of these factors, drawing conclusions from price reactions is clearer as opposed to price changes associated with exchange rate movements.

In many developing countries coffee trade holds significant importance both economically and socially. For some of these countries, disproportionate share of their export earnings is tied to coffee trade which in turn excessively exposes their trade balances to price volatility of raw coffee. From the inception of the International Coffee Agreement (ICA) in the early 1960s up until its abolishment in the late 1980s, relatively stable institutional environment allowed comparatively fair distribution of generated income between producing and consuming countries. From the 1990s onwards the price of raw coffee saw large increase in volatility which prompted research interest towards examining whether the abolishment of ICA had created unequal income distribution and shifted power to large multinational coffee manufacturers in the consuming countries.

Based on various industry studies, the market structure appears to be similar across different local coffee markets. Local coffee markets are characterised by a large number of consumers and a few large manufacturers of roasted coffee who hold majority of the market. Therefore, the research interest has been whether these large companies have enough market power to hold consumer prices high and thus limit demand for coffee beans at the expense of producing countries. Durevall (2007) finds evidence of some market power only in the short run but none in the long run in Swedish coffee market. Bettendorf & Verboven (2000) find that the Dutch coffee market despite oligopolistic interdependence appears to behave surprisingly competitively on an aggregate level.

Another important observation related to the industry specific cost pass-through mechanism has been that there appears to be significant incompleteness and delayed transmission of coffee bean prices to consumer prices. Bettendorf & Verboven (2000) attribute pass-through incompleteness to local costs and markup absorption. Nakamura & Zerom (2010) analyse extensively the determinants of incomplete and delayed cost pass-through in the U.S. coffee market. They find that it takes six consecutive quarters for commodity costs to fully pass-through to retail prices and 1% increase in commodity costs leads to only around 0,33% increase in retail prices. Long-run pass-through is reduced by 59% due to local costs and further 33% due to markup adjustments. Menu costs successfully explain the delayed price response in the short term. The key finding is that these pass-through dynamics in the coffee industry occur at the wholesale level. Pass-through from wholesale price to retail prices is close to immediate and complete.