Q4.

On Jan 3, 2012, Starbucks in New York City raises the price of a "tall" cup of coffee from $1.70 to $1.85. It actually costs a customer $2.01, including tax. At first, many customers are annoyed by this move, because they usually do not carry pennies. But surprisingly, after a few months, Starbucks find that their monthly quantity sold (#no. of cups sold) for "tall" coffees actually increases! Interestingly, Starbucks observes that the shares of payment methods have changed. They see that the share of "tall" coffee transactions that are paid by cash significantly drops, and the share of "tall" coffee transactions that are paid by credit cards and pre-paid cards significantly increases.

a. (2 points) Explain why customers switch to use credit cards and pre-paid cards to pay for "tall" coffees.

b. (6 points) Explain why Starbucks sees an increase in sales despite raising the price for a "tall" coffee. [Your answer should involve Prospect Theory. Draw a picture to describe the use of Prospect Theory, and then show how its implications can answer this question.]