Cupcakes and Hotelling’s law

This link might provide a clue to to the beach question Professor Smitka posed on Monday. One of my best friends from high school works at Georgetown Cupcake while studying at Georgetown University. The same thing happened there, but to a larger degree: within four years of Georgetown Cupcake opening, there are now five stores that specialize just in cupcakes within a quarter mile radius.

The principle of minimum differentiation and the Bertrand paradox both apply in the cupcake cases. With the exception of brand name (which, granted, brand loyalty has huge influence), I’m not sure if anything short of a cupcake connoisseur could distinguish quality differences between a Baked&Wired cupcake and one from Crumbs. And yet, the price of one cupcake from any one of these stores is between $2.75 and $3.00, so there is minimum undercutting between firms and all of the owners go home making sizable profits.

5 thoughts on “Cupcakes and Hotelling’s law

  1. This is a very interesting real-life example of the oligopoly problem.

    The oligopoly problem as I understand it is this: When only a few firms exist in a market, that market will resemble a kind of market that would result if the few (or in our case 2) firms colluded to maximize profit. Does anyone else find it odd that both owners encourage people to try treats from both shops? Call me a pessimist, but I would not be surprised if the cupcake eaters in this small town in Idaho see increases in the prices of goods from both stores to further maximize their profits, especially given the success and rising popularity of both shops (given that both shops likely get their supplies from a similar supply chain, a rise in their costs of production would be displayed in rising prices at both stores, so at least they got that going for them in terms of potential excuses to the SEC).

    In line with the Bertrand paradox, Frosted cannot raise its prices without Sweet B, because that would leave them vulnerable to losing market share. Rather than one shop boldly attempting to differentiate from the other or undercutting prices, they both happily keep their prices comparable and enjoy the profits of their luxury good. The nature of competitive firms, as well as human nature, suggests this pattern will continue.

  2. My hunch would be that the “special” products of each are slightly different. We might also see something similar to Lexington Coffee on Washington Street and Lexington Coffee Roasters on Main Street. How do those shops differ? — and keep in mind that Lexington Coffee serves LCR coffee (plus now others) and that the owners of LCR founded the Lexington Coffee Shop but sold it when their roasting business expanded to where they couldn’t handle both.
    Then there’s another on Jefferson Street. I’ve only been there so don’t know whether they offer a different mix.
    So … from a customer’s perspective, are they perfect substitutes?

  3. I cannot speak to the coffee example as I always brew my own, but to the cupcake example, no they are not perfect substitutes. My Los Angeles home gives me a unique perspective on the “Cupcake Wars” and the “Cupcake Bubble” so to speak. There is a tremendous and fierce competition for the big brand name in cupcakes. My guess is Sprinkles, which operates in the same market as Georgetown Cupcakes, offers its cupcakes for $3.50 upwards to $4 per cupcake. Although they offer similar products, Sprinkles has taken the Apple route in marketing and captures the “luxury” cupcake market.

    As anecdotal evidence, the Crumbs shop, located a block away from the Sprinkles, offers a larger cupcake at a lower price. Even so, the Crumbs shop does not see nearly as much business. Interestingly, Sprinkles position as the market leader and inarguably the starter of the cupcake craze is able to charge a premium without fear of competition within its particular price bracket.

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