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The Cost of Government Economic Planning

December 11, 2009

It’s the economic question of our time, posed via Twitter by Brooke Oberwetter:

Stand-alone cupcake stores: What’s the f*cking business model? How long can $3 cupcakes demand possibly be sustained? Nonsense.

This is not a new question. I alluded to the $3 cupcake phenomenon in a post last year. The subject fascinates those across the ideological spectrum, as both the New York Times and Karen DeCoster have taken on the question. The Times described the cupcake store as “the latest entrepreneurial fantasy” and attempted to explain the business model by asking Denver cupcake seller Porche Lovely to break down her $3-per-cupcake price:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

The tendency here is to focus on the expensive ingredients. The Washington City Paper, in its own cupcake-mania report, quoted a local pastry chef who said using fancy butter and chocolates pushes the cost of food “into the 30 percent range, whereas most desserts carry a food cost of 7 or 8 percent.” So if you’re paying $3 per cupcake, you get what you pay for. And people pay for quality. As P.J. Doland tweeted in response to Brooke Oberwetter, “How long can $4 coffee demand” — aka Starbucks — “possibly be sustained?”

But is the Starbucks model applicable to cupcakes? Oberwetter noted that “coffee has addiction on its side,” and Starbucks provides a “convenient, consistent fix.” Indeed, coffee is a product that tends to be consumed on a daily basis. Even in the absence of a Starbucks, coffee drinkers will still obtain the product elsewhere or make it themselves. People pay Starbucks for the convenience and the marginally higher quality.

Cupcakes are, for most people, an occasional luxury. Patronizing a cupcake store is less about convenience than impulse. The ingredients and quality may be better than supermarket or homemade cupcakes, but it’s not clear that consumers are responding to that so much as the novelty of the cupcake store itself. As the Times article noted, these stores must rely on aggressive branding and marketing to build a customer base. That itself is an expense that drives up the cost of the cupcakes — 24 cents per $3 if you believe Porche Lovely’s calculations.

Karen DeCoster derides cupcake stores and similar “bubble businesses” that attempt to market basic products as “upscale” luxuries. In 2008 she wrote about Cold Stone Creamery, an ice cream franchise that has since fallen on hard times:

[W]hen they hand you your 5, 8, or 12 oz. cup of ice cream, with a few items like nuts or candy in it, you realize you’ve paid between $4–$7 for a gimmicky presentation, bad singing, the franchisee’s overly-high costs of operating a store, and some plain old, not-so-great-anyways ice cream. But this is presented to the customer as “the ultimate ice cream experience.”

The lesson here is never confuse demand for a product with demand for a particular business model. People want ice cream, cupcakes, and coffee. But the mistake would-be entrepreneurs make is assuming people will pay a premium for these products just because you offer them in a “gimmicky presentation,” as DeCoster put it. Sometimes they will; there’s a reason you have upscale restaurants that can charge $24 for a dish of pasta. But more often then not, these bubble businesses can’t sustain demand beyond customers’ initial curiosity.

There’s something else going on here. Lost in the discussion of expensive ingredients and branding hype, there’s the problem of the stores themselves. I mentioned to Karen recently a store that opened here in Charlottesville that offers self-serve frozen yogurt (on tap!) with a buffet of sugary toppings. As I expected, she pounced on this, noting the store’s décor “looks like a child’s bedroom or playroom” and reflected the tendency of bubble businesses “toward the juvenilization of the amusement-seeking masses who like to be treated like children and entertained by childish services that cater to that need.”

But these “childish services” are the byproduct of government planning. This goes beyond the credit boom fueling unprofitable niche businesses. I considered the yogurt store. It’s located in a storefront on Charlottesville’s “Downtown Mall,” a pedestrian commercial zone enclave created years ago by city government mandate. Like all zoning, the Mall represents the imposition of artificial scarcity on land use by the government. The city demands a certain number of commercial storefronts, even if the market requires less. If not for the yogurt store, the space would either remain vacant indefinitely or be filled by another niche business with limited profit potential. And the planners won’t just allow anything to occupy the space; it has to be consistent with the planners’ “vision” for the city.

In the name of “economic development,” state and local governments spend seemingly infinite resources on “visions,” “planning,” “offering incentives,” and the like to create the appearance of business prosperity. But it’s not real. The problem is that well-intended entrepreneurs get duped into thinking their idea is profitable in the context of the government’s plan. But as I said above, support for a product is not the same as support for a business model.

Consider the cupcakes. Sure, there is clearly a market for gourmet cupcakes with high-end ingredients. But it’s probably not a viable storefront business in most locales. Except due to zoning and government planning, there are commercial districts with “excess” capacity. Simultaneously, governments strongly discourage home-based and informal businesses that promote trade outside designated “commercial” areas. Planners also want commerce concentrated in areas where customers are more likely to pay upscale prices — and thus higher sales taxes — which contributes to the appearance of economic growth.

Gourmet cupcakes are a city planner’s dream business. It’s an impulse purchase that fits into high-foot-traffic areas (no cars!) and provides the customer with the illusion of luxury. It also tends to bring attention from fad-conscious media outlets — there’s a cable television series devoted to a Washington, DC cupcake store — which also feed the illusion.

The downside is that small startup businesses take on a lot of infrastructure to produce fairly simple products. Porche Lovely noted 57 cents of her $3 cupcakes goes to pay the mortgage — a $50,000 loan she took out to finance the $300,000 purchase of her 1,400 square-foot space in a “gentrifying” neighborhood.

Remember, commercial space comes with a ton of government intervention, which in turn keeps a lot of local bureaucrats employed. Kevin Carson forwarded this post to me about a man who thought about opening up a restaurant but thought better of it after dealing with numerous rent-seekers:

[W]hen the new owner of a local boutique hotel asked for proposals for a restaurant to replace the failing “Gifte Shoppe” in his ground floor commercial space, I jumped on it. We shook hands on a sweetheart deal lease-wise as long as he did not have to contribute to any build-out costs.

That’s when the fun began.

I sketched some plans and had them drawn up by an architect ($1000).

I submitted them for review to the County building Dept. ($300).

Everything was OK, except for the bathrooms. They were not ADA compliant. Newly built bathrooms must have a 5′ radius turning space for a wheelchair. No problem. I tried every configuration I could think of to accomodate the larger bathroom space without losing seating which would mean losing revenue. No luck. I would have to eat into my storage space and replace it with a separate exterior walk-in cooler ($5,000). I would also have to reduce the dining room space slightly so I had to plan on banquettes along the exterior wall to retain the same number of seats (banquettes vs. separate stand alone tables ($5,000) Revised plans ($150). Re-review ($100)

Next came the Utility Dept. It seems the water main was insufficient even for the current use, a 24 suite hotel, and would need to be replaced ($10,000).

Along comes the Historical Preservation Society, a purely advisory group of starched collar, pince nez wearing fuddy-duddies (well, not literally) to offer their “better take it or else” advice, or maybe lose the Historic Status tax break for the hotel.
It seems that the mushroom for the kitchen exhaust fan would be visible from the street, so could I please relocate it to the rear of the building? Pretty please? Extra ducting and more powerful fan ($5,000).

Carson added his own anecdote about a local restaurant chef complaining about “unfair” competition from street vendors who didn’t face the exorbitant rents or property taxes of his restaurant. This made me think about a storefront that recently opened — just across from the self-service yogurt place — that offers hot dogs with “gourmet toppings.” Sure, there are still (for now) street vendors who sell perfectly good hot dogs. But they’re not taking up an otherwise vacant storefront or contributing to the various local agencies that depend on commercially zoned businesses.

As long as local governments continue their monopolies over land use and planning, you’ll continue to see a rash of boom businesses come and go. Today it’s gourmet cupcakes and hot dogs. Tomorrow it will be something else. It’s really not the entrepreneurs’ fault. They’re just doing what they think customers want, when in reality it’s what the government wants.

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