PRICE CONTROL IN
FRANCHISED CHAINS: THE
CASE OF McDONALD’S DOLLAR
MENU
Itai Ater and Oren Rigbi
Discussion Paper No. 12-06
May 2012
Monaster Center for
Economic Research
Ben-Gurion University of the Negev
P.O. Box 653
Beer Sheva, Israel
Fax: 972-8-6472941
Tel: 972-8-6472286
Price Control In Franchised Chains: The Case Of McDonald’s
Dollar Menu∗
Itai Ater
Oren Rigbi
Tel Aviv University
Ben-Gurion University
[email protected]
[email protected]
December 2011
Abstract
We analyze price patterns at franchised and corporate-owned McDonald’s outlets in
1999 and 2006 and find that prices at franchised outlets were higher than those at corporate
outlets. The price difference between franchised and corporate outlets decreased between
1999 and 2006 but only for items with close substitutes in the Dollar Menu, which was
introduced in 2002. We also find that the price difference between franchised and corporate
outlets was higher among outlets located near highways than among non-highway locations.
After the Dollar Menu was introduced, this highway - non-highway difference diminished.
Our findings suggest that the Dollar Menu improved McDonald’s corporation’s control over
franchisees’ prices.
JEL classification: L14; L22; L42; K21; M37
Keywords: Franchising; Free-Riding; Reputation; Advertising; Vertical Restraints
∗
Special thanks to Liran Einav for his guidance and support. We also received helpful comments from
Ran Abramitzky, Tim Bresnahan, Peter Reiss, Assaf Eilat, David Genesove, Seema Jayachandran, Francine
Lafontaine, Philip Leslie, Raphael Thomadsen, Yaniv Yedid-Levi and participants at several universities. Ater
gratefully acknowledges financial support from the Stanford Olin Law and Economics Program and the Haley
and Shaw Fellowship.
1
1
Introduction
“Our (corporate-owned restaurants) prices are probably, on average, 3% or 4% below
our franchisees’ prices, bear in mind that we are required by law (not to).. and we
never ever try to influence their (franchisees’) pricing.” 1
Economists have long been interested in studying the impact of alternative intra-firm agency
relationships on organizational structure and firm performance (Jensen & Meckling (1976),
Holmstrom & Milgrom (1991)). An underlying theme in this literature is that agents maximize
their own payoffs, and firms adopt various mechanisms to better align their own objectives with
the incentives of their agents. The primary aim of this paper is to highlight price advertising
as one such mechanism through which principals influence agents’ decisions, thereby reducing
organizational costs and improving their control.
Business-format franchising offers a classic example for an agency relationship in which
the incentives of the chain (the principal) and the franchisee (the agent) are not completely
aligned. In typical business-format franchising contracts the chain receives an initial fixed
fee and subsequent royalties based on outlets’ sales. The franchisee, who obtains the right
to use the chain’s brand name at a specific location, maximizes her outlet’s profits net of
royalties. The royalty scheme inherently creates a conflict of interest between franchisees and
the franchisor, known as the double marginalization problem. This conflict implies that the
franchisor, who maximizes sales, prefers that the franchisees set lower prices than the prices
that would maximize the outlet’s profits. Another explanation why franchisees set higher
prices than the prices the chain would choose is known as franchisees’ free-riding or demand
externality (Lafontaine & Shaw (2005) and Lafontaine & Slade (2007)). This explanation
focuses on the residual claimancy status of the franchisees, which gives them incentives to
maximize their own profits, sometimes at the expense of the chain. For instance, the chain
considers future customers to be an important source of profits, regardless of the specific outlet
they visit. A franchisee, on the other hand, is concerned about future customers only if they
visit her outlet. Hence, the franchisee may not fully internalize the effect of her pricing decisions
1
Matthew Paull, McDonald’s Corporation CFO at McDonald’s Earnings Conference Call, 01/24/2006. For
transcript see http : //seekingalpha.com/article/6176 − mcdonalds − q4 − 2005 − earnings − conf erence −
call − transcript − mcd. Last accessed on 12/01/2011.
2
on future visits at other outlets of the chain, and might set prices higher than the prices that
the chain would choose.2
The mechanism we propose helps franchisors by inducing franchisees to adopt the franchisor’s desired prices, even if the franchisees are not contractually required to. In particular,
we claim that through price advertising, franchisors inform consumers about recommended
prices, thereby changing consumer search behavior and reservation prices. Franchisees acknowledge the effect of advertising on consumers’ tastes and adjust their prices accordingly.
Taking this mechanism into account, franchisors maximize their profits by ex-ante optimally
choosing the advertised price and the level of advertising. In our empirical application, we use
panel price data collected before and after a large national advertising campaign by McDonald’s, the largest franchising chain in the world. The campaign advertised the Dollar Menu, a
fixed set of items whose price was advertised across the U.S. as one dollar each. Importantly,
franchisees were not contractually required to adopt the advertised prices at their local restaurants. Nevertheless, outlets located in residential areas chose to adopt the advertised prices in
the Dollar Menu.
We start the analysis by investigating the effect of the Dollar Menu on prices of McDonald’s menu meals whose prices were not advertised. We use sales and survey data to determine
whether a non-advertised meal has a good substitute in the Dollar Menu, and we claim that
offering the Dollar Menu constrained franchisees’ ability to raise the prices of these substitute
meals. To substantiate this claim, we compare the prices of these meals across franchised and
corporate outlets before and after the introduction of the Dollar Menu. We define an item’s
price differential as the difference between the item’s average price in franchised outlets and
its average price in corporate outlets in a given year, conditional on the controls included in
the regression. The assumption is that prices at corporate outlets reflect the chain’s profitmaximizing prices, while prices at franchised outlets do not. Our analysis shows that price
differentials of meals that have a good substitute in the Dollar Menu decreased significantly
after the Dollar Menu was introduced. When we perform a similar analysis for meals that do
not have good substitutes in the Dollar Menu, we do not find similar reductions in their price
2
In theory, franchised restaurants may also have incentives to set lower prices than corporate-owned restaurants to “steal business” from nearby same brand restaurants. We, as other papers on the fast-food industry,
do not find evidence for such argument. Hastings (2004) explicitly studies this argument in the context of the
gasoline industry.
3
differentials. Hence, our findings suggest that the introduction of a cheaper menu alternative
could enhance price uniformity across franchised and corporate-owned outlets and improve the
chain’s control over prices set at its franchised outlets.
To look for evidence of franchisees’ free-riding, we also examine price patterns at McDonald’s outlets located near versus at a distance from highways. Outlets located near highways are less likely to draw repeat customers, and franchisees have lower incentives to internalize the demand externality they inflict on the chain. We focus on the meals that have good
substitutes in the Dollar Menu, and compare their price differentials among outlets that are
near versus far from a highway, before and after the introduction of the Dollar Menu. Consistent with the demand externality argument, our finding indicate that before the Dollar Menu
was introduced, the price differentials at outlets located near highways were higher than the
corresponding price differentials at outlets located far from a highway. After the introduction
of the Dollar Menu, the difference in the price differentials between highway and non-highway
locations decreased. These findings lend additional support to our assertion that the Dollar
Menu increased McDonald’s capacity to affect franchisees’ prices. This capacity is particularly
important in locations where franchisees have a greater incentive to free-ride on the chain’s
reputation.
Business-format franchising, common in the retail and service industries, is an important phenomenon for the economy. According to Lafontaine & Shaw (1999), business-format
franchising accounts for 3.5% of the U.S. GDP. Business-format franchising in the fast-food
franchising industry is a particularly suitable setting for studying the ability of a chain to
control downstream prices for two main reasons. First, fast-food chain outlets that offer a
standard experience have been a basic ingredient of the industry’s success and growth over
the last 50 years. Thus, it is natural to focus on fast-food chains’ efforts to achieve uniformity
across outlets as well as to maintain and enhance their reputation. Second, McDonald’s, like
many other chains, operates franchised as well as corporate-owned outlets. This dual organizational structure offers a unique opportunity for testing the ability of the chain to affect
prices at franchised outlets.
Our paper contributes to three main strands of literature. The first is the literature
on organizational economics, particularly in the context of franchising, which explores the
4
misalignment of incentives between franchisees and franchisors. This literature has shown
that product quality and prices at franchised outlets differ from the quality and prices in
corporate-owned outlets, and it examines how chains can address these differences.3 There is
little evidence, however, of how chains, for a given organizational structure, operate to reduce
these agency costs. The proposed advertising mechanism adds to this literature and offers
a novel way through which franchisors solve the double marginalization problem and other
reputational concerns.
Second, we contribute to the literature on the economics of advertising by providing
evidence on price advertising or price recommendations as a mechanism for alleviating organizational problems. This role of price advertising can complement other, more traditional
roles, of advertising. The idea that advertising changes consumer tastes is common within the
persuasive view of advertising, although this type of advertising typically enables firms to set
higher rather than lower prices (Bagwell (2007)). In addition, in contrast to previous literature (Milyo & Waldfogel (1999)), we do find evidence regarding the effect of advertising on
non-advertised items. Finally, our paper is related to the literature on vertical restraints. This
literature typically shows that upstream manufacturers try to soften competition in the downstream market to ensure that retailers earn high profits. In contrast, we provide evidence that
vertical restraints can be used to strengthen competition in the downstream market, thereby
increasing franchisees’ sales. We further discuss this distinction in Section 4.
The remainder of the paper is organized as follows. Section 2 provides information on
McDonald’s Dollar Menu and describes the data used in the paper. In Section 3, we describe
the sales patterns and estimate the changes in prices before and after the Dollar Menu’s
introduction. Section 4 contains a discussion of our results. In Section 5, we offer concluding
remarks.
3
See Kalnins (2003), Graddy (1997) and Jin & Leslie (2009) on the fast-food industry, Kalnins (2010)
on the hotel industry, and a survey by Lafontaine & Slade (1997). Papers that discuss how chains address
these differences include Brickley & Dark (1987), Brickley (1999), Klein & Leffler (1981), Kalnins (2004) and
Lafontaine & Shaw (2005).
5
2
Dollar Menu and Data
2.1
McDonald’s Dollar Menu
McDonald’s Dollar Menu is a fixed set of 8 menu items that are sold for one dollar each. These
items include two main dishes - a Double Cheeseburger and a McChicken sandwich – together
with side dishes and desserts: Small Fries, Small Soft Drink, Side Salad, Apple Pie, Sundae
and Yogurt Parfait. The Dollar Menu campaign was introduced nationwide in September 2002
following a six-quarter period of relatively poor sales performance. The composition of items
in the Dollar Menu is identical across McDonald’s restaurants, and its items were also available
before September 2002. According to industry reports, the Dollar Menu was an attempt to
boost sluggish sales and to cripple Burger King, McDonald’s main rival.4 To promote the
Dollar Menu’s introduction, McDonald’s added $20 million to its advertising budget in the
last quarter of 2002. Historically, McDonald’s franchisees are responsible for setting the actual
prices at their outlets. In particular, each franchisee determines whether to offer the items
advertised in the Dollar Menu for the price of a dollar or for any other price.5
The success of the Dollar Menu is somewhat controversial. While McDonald’s Corporation considers it successful, accounting for 14% of McDonald’s sales in the U.S. and for
10%-15% of McDonald’s total advertising expenditure,6 at least some franchisees oppose the
Dollar Menu. Business Week cited a McDonald’s franchisee saying that “we have become our
worst enemy” and complaining that the (Dollar Menu item) costs him $1.07 to make ... so he
sells it for $2.25 unless a customer asks for the $1 promotion price. The Wall Street Journal
cited a McDonald’s franchisee saying that the Dollar Menu did not increase sales at his seven
New York City restaurants but rather squeezed profit because he was selling discounted items.7
Interestingly, previous advertising campaigns that focused on offering low prices, such as the
“Campaign 55” in the mid 1990s, failed partially due to franchisees’ opposition to selling the
Big Mac for 55 cents only (Kalnins (2003)).
4
Advertising Age, 09/02/2002.
Only recently the United States Court of Appeals clarified that chains can require franchisees to adopt
Value Meals: “There is simply no question that Burger King Corporation had the power and authority under
the Franchise Agreements to impose the Value Menu on its franchisees.” Burger King Corporation v. E-Z
Eating (11th Cir. 2009). See also the 1997 U.S. Supreme Court decision in State Oil Company v. Khan, which
allowed franchisors to negotiate downstream prices with franchisees.
6
See f.n. 1 and an interview with McDonald’s CEO, Ralph Alavarez, Dow Jones Newswires, 10/19/2007.
7
Business Week (03/03/2003) and Wall Street Journal (11/02/2002), respectively.
5
6
2.2
Data
Our data come from several sources. Our main data set was collected in July 1999 (Thomadsen
(2005)) and in July 2006. It includes the location, price menu, ownership and characteristics
of all 300 fast-food outlets located in the Santa Clara County (CA) that are affiliated with
the following hamburger and sandwich chains: Burger King, Carl’s Jr., In-N-Out, Jack-in-theBox, McDonald’s, Wendy’s, Subway and Quizno’s. The process of collecting the 2006 data
was similar to that used to collect the data in 1999: We visited all the outlets in the Santa
Clara County and documented the menu prices and characteristics of each outlet. Prices were
photographed (when permitted) and were copied when taking photographs was not possible.
For each outlet, we also know whether it is franchised or corporate-owned and the
owner’s identity. Ownership data were obtained from the Assessors’ Office and the Public
Health Department in Santa Clara County. Although we analyze price patterns at McDonald’s
outlets, we use data on the other chains to determine the competitive environment of an outlet
in 1999 and 2006. We define competition variables based on a competitor’s distance from an
outlet and the competitor’s affiliation with a chain. We distinguish between three ranges of
distance: close is defined as within 0.1 miles of an outlet; medium is defined as within 0.1-0.5
miles; and far is defined as within 0.5-1 mile. For example, the variable Close BK Competitors
counts the number of Burger King outlets that are within 0.1 miles from a McDonald’s outlet.
The variable Close Other Burger Competitors counts the total number of Carl’s Jr., In-NOut, Jack In The Box, and Wendy’s outlets within 0.1 miles of an outlet. The variable Close
Sandwich Competitors counts the number of close Subway and Quizno’s outlets. In addition,
we distinguish between franchised and corporate McDonald’s restaurants: e.g., the variable
Close MD Corp. Competitors counts the number of close corporate McDonald’s outlets. We
supplement the data on outlets with various demographic data at the ZIP code level obtained
from the 2000 Census data and 2005 Community Sourcebook America.
Table 1 displays the number of corporate and franchised McDonald’s outlets in the
Santa Clara County in 1999 and in 2006, entry and exit patterns, and ownership distribution
of franchised outlets. In Table 2 we compare descriptive demographic data, outlet characteristics and the number of competitors for corporate versus franchised outlets. Some comparisons
reveal interesting distinctions between franchised and corporate locations. First, outlets are
7
geographically clustered by ownership type. Geographical proximity may help multi-unit owners save labor or other common inputs across outlets. Second, McDonald’s corporate outlets
are more likely to be located near a Burger King outlet, McDonald’s main rival. Third, the
corporate-owned outlets are, on average, located closer to a highway than the franchised outlets. Presumably, if the chain is concerned about free-riding behavior near highways, then it
may choose to locate its corporate restaurants near highways. Most of the other comparisons
between franchised and corporate outlets, however, show statistically insignificant differences.
In fact, when we jointly compare all the characteristics, we cannot reject the hypothesis that
franchised and corporate outlets are located in similar environments. This gives us additional
confidence that the price patterns we find in franchised versus corporate outlets are not driven
by their distinct local environments.
We also use sales and cost data from one McDonald’s franchised outlet that adopted
the Dollar Menu. The sales data include prices, the quantities sold of each item, and the
number of cashier transactions in that outlet for any month between June 2001 and June 2006.
Finally, in September 2007 we collected data by phone from 41 McDonald’s restaurants located
in the 35 largest U.S. airports.8 These data include information on whether each restaurant
offered the Dollar Menu, the prices of a Big Mac and a Double Cheeseburger and ownership
information.
3
3.1
Empirical Analysis
Decision to Adopt the Dollar Menu
McDonald’s franchisees are not contractually required to adopt the Dollar Menu. Yet, all but
one of McDonald’s franchised and corporate outlets in Santa Clara County offer it.9
8
We also sampled a few McDonald’s restaurants in Santa Clara County in September 2007 and verified that
prices had not significantly changed since July 2006.
9
In contrast, none of the 41 McDonald’s restaurants located in U.S. airports, including two corporateowned airport restaurants, offer the Dollar Menu. Table 3 provide descriptive statistics for McDonald’s airport
restaurants. One possible explanation for this finding is that restaurants facing highly inelastic demand, for
example, due to fewer repeat customers, are less concerned about disappointing their customers by not adopting
the advertised Dollar Menu. Indeed, when Burger King Corporation introduced its Value Meal in 2006, it
exempted franchised restaurants located in highly seasonal tourist destinations from offering it.
8
3.2
Substitution Patterns Between Items
We use the sales data to examine the substitution patterns between items offered on the Dollar
Menu and the following non-advertised meals: Big Mac, Quarter Pounder, Chicken McNuggets
6 pc., Filet-O-Fish. Each of these meals include a sandwich, small fries and a soft drink and
was offered both in 1999 and in 2006. On the basis of the substitution patterns we find, we
then study the effect of the Dollar Menu on the prices of these meals.
Figure 1 presents the time series of item percentage of total outlet transactions. Each
item measure is normalized according to its level of transactions in August 2002 – the month
before the Dollar Menu was introduced. The percentage of customers purchasing a Double
Cheeseburger skyrocketed, from 0.4% to 14.6% between August 2002 and March 2004. The
proportion of McChicken transactions also increased, from 11.17% to 21.44%.10 Over the same
period of time, the share of transactions in which the Big Mac meal was sold dropped from
8.69% to 5.8%.11 On the other hand, despite the observed seasonality in sales, the share of instore transactions of the Chicken McNuggets 6 pc. and the Filet-O-Fish meals remained fairly
stable. For example, Filet-O-Fish sales went from 3.89% to 3.84% of transactions. Overall,
Figure 1 suggests that the increase in sales of the Dollar Menu items was also driven by
customers who switched from meals, such as the Big Mac meal.
We also surveyed 104 undergraduate students to explore the substitution patterns between the Chicken McNuggets meal, the Big Mac meal, and the Dollar Menu items. The survey
and the results are presented in Appendix A. We find that 82% of the respondents who chose
the Big Mac meal before the Dollar Menu was available switched to a Dollar Menu option
after it was introduced. On the other hand, only 53% of those who chose Chicken McNuggets
switched to a Dollar Menu option when it became available. We compare the mean of switching
customers in the two groups and reject the null hypothesis of mean equality at 1% confidence
level. Based on this evidence, we conclude that the meals that experienced a reduction in sales
10
The price of the McChicken sandwich has not changed, while the price of the double cheeseburger has
dropped by 50% following the introduction of the Dollar Menu. The prices of the Big Mac, Quarter Pounder
and McNuggets 6pc. meals experienced three identical price increases between August 2002 and March 2007.
The total price change was 30 cents, or roughly 7%. The Filet-O-Fish meal price also changed 3 times over the
period, by 30 cents, for an overall increase of 8%.
11
Matthew Paull, McDonald’s CFO at the time the Dollar Menu was introduced, acknowledged in a conference
call to analysts: “(The Dollar Menu) brought in a lot of customers who might not have otherwise visited us.
(But) We have seen a small drop in sales of our signature sandwiches, things like the Big Mac and the Quarter
Pounder with Cheese. We’re not thrilled with that.” Restaurant Business, 01/28/2003.
9
after the Dollar Menu was introduced exhibit high cross price elasticities with the Dollar Menu
items. We refer to these as meals that have close substitutes in the Dollar Menu.
In the next section we use the panel data on prices at both franchised and corporate
outlets to explore whether the substitution patterns we found can explain changes in price
patterns for 1999 and 2006. In particular, we expect that the Dollar Menu – a cheap menu
alternative – will constrain franchisees’ ability to raise prices of items that have close substitutes
in the Dollar Menu. We do not expect to find such an effect on meals that do not have
close substitutes in the Dollar Menu. We start by providing descriptive statistics on the Big
Mac meal, McDonald’s signature item, and then use regression analysis to estimate the price
differentials of meals that have and do not have close substitutes in the Dollar Menu.
3.3
3.3.1
Price Patterns in 1999 and 2006
Descriptive Statistics for the Big Mac Meal
To illustrate the price changes between 1999 and 2006, Table 4 presents descriptive statistics
for the Big Mac meal. The difference between the average Big Mac meal price at franchised
outlets and the average Big Mac meal price at corporate outlets decreased from 44 cents in 1999
to 23 cents in 2006. The standard deviation of the Big Mac meal prices at corporate-owned
and franchised outlets dropped from 26 cents and 29 cents in 1999 to 13 cents and 18 cents
in 2006, respectively.12 In Figure 2 we also present the kernel densities of the Big Mac meal
price in franchised and corporate-owned outlets in both time periods. This figure illustrates
how the Big Mac meal price increased from 1999 to 2006 and how the two price distributions
approached each other over time.
The reduction in the variation of prices at both franchised and corporate outlets between 1999 and 2006 also can be explained by the introduction of the Dollar Menu. This is
because the pricing decision for a given item is affected, in part, by the prices of the item’s
substitute menu options. Before the Dollar Menu was introduced, its items were priced independently by each franchisee while after it was introduced, the price variation of the Dollar
12
Putting aside cost considerations, pricing decisions at both franchised and corporate outlets balance local
demand conditions with the chain’s overall interest in maintaining uniform prices, or targeting a certain price
level. Naturally, pricing decisions at corporate restaurants assign less weight to outlet-specific demand conditions
compared with decisions of franchisees. Consequently, there is less price variation across corporate outlets than
across franchised outlets.
10
Menu items dropped to zero. Presumably, this fall also contributed to the decrease in the price
variation of substitute menu items, which is what we find. Consistent with this claim, such
narrowing in the price distributions is not observed for items that do not have close substitutes
in the Dollar Menu. For example, the standard deviation of the Filet-O-Fish meal price at
corporate outlets was 17 cents in 1999 and 15 cents in 2006. The corresponding numbers at
franchised outlets were 20 cents in both 1999 and 2006.
3.3.2
Regression Analysis
We use the following SUR differences-in-differences specification to test the changes in prices
between 1999 and 2006:
X
ln(pijt ) = α+γ∗D2006,jt +δ∗Df ranchised,jt +η∗D2006,jt ∗Df ranchised,jt +β∗Xjt +
θk ∗Compjtk +ijt
k
(1)
This specification examines changes in prices of meals that were offered in both 1999
and 2006. pijt is the price of meal i in outlet j in year t. D2006,jt is a dummy variable equal to 1
for observations collected in 2006. Df ranchised,jt is a dummy variable equal to 1 if outlet j was a
franchised outlet in year t. Xjt is a vector containing outlet j characteristics in year t, including
the number of seats, the existence of a drive-thru, the existence of a playground, whether the
outlet is located in a mall, and demographic variables of the ZIP code in which the outlet
is located. Each competition variable, Compjtk , consists of the number of a rival’s outlets
operating in the vicinity of each McDonald’s outlet. The set of rivals includes the following
chains: Burger-King, McDonald’s (divided into corporate-owned and franchised outlets), other
hamburger chains and Subway and Quizno’s combined. The main parameter of interest is η,
which refers to change in the price differential of meal i from 1999 to 2006. The observation
that η is negative only for meals that have close substitutes in the Dollar Menu is consistent
with the view that the Dollar Menu improved McDonald’s capacity to affect franchisees’ prices.
Table 5 presents estimation results for the equation that uses the logarithm of the Big
Mac meal price as the dependent variable. We find that the Big Mac meal price differential
decreased by 9.3%, from 12.5% in 1999 to 3.2% in 2006. Other outlet and demographic
characteristics are typically insignificant, with the exception of a positive coefficient on the
11
Subway-and-Quizno’s medium competitor variable, as well as the negative coefficients on the
number of close Burger-King restaurants, the number of close McDonald’s franchised outlets,
and the proportion of blacks in the population.
Table 6 displays estimation results for the equations corresponding to the other meals
that were offered in 1999 and 2006. It demonstrates that the price differentials on meals
with close substitutes in the Dollar Menu decreased between 1999 and 2006. Specifically, the
price differentials for the Quarter Pounder and the Double Quarter Pounder meals dropped
significantly, from 7.7% to 1.4% and from 7.6% to 2.7%, respectively. On the other hand,
the price differentials for meals that do not have close substitutes in the Dollar Menu did
not change. In particular, we find the following statistically insignificant changes in the price
differentials of the Filet-O-Fish, Chicken McNuggets 6 pc., and Chicken McNuggets 20 pc.:
2.3% to 1.6%, 5.9% to 5.1%, and 2.6% to 1.8%, respectively.
In the regression, we control for each outlet’s level of competition in 1999 and 2006
by including the number of hamburger and sandwich chain-affiliated outlets located near each
McDonald’s outlet. The inclusion of Subway and Quizno’s in the set of rivals potentially
controls for health-conscious changes in the tastes of the population between 1999 and 2006.
We experimented with several criteria for the level of competition (e.g. perimeters around each
outlet).13 None of these modifications changed the main results. We also explored a spatial
econometrics approach to model competition. In this approach, competition is accounted for by
including a function of the prices set in competing outlets rather than the number of competing
outlets. Following Kalnins (2003), we focus on intra-chain competition only. Specifically, the
competition variable for meal i in outlet j is the average price of meal i among outlet j 0 s
competitors, weighted by the inverse of each competitor’s distance from outlet j. In order to
avoid cases in which the set of competing outlets is an empty set, the distance threshold for
the purpose of defining competitors is 2.4 miles. Since the price in competing outlets might
be correlated with unobserved local demand conditions, we instrument for a competitor’s
price with the prices set in other outlets managed by the same franchisee. We find that the
main parameter of interest is qualitatively unchanged when we take the spatial econometrics
13
Specifically, other distance thresholds used to test the robustness of the results are: 0.1-1-2, 0.5-1-2 and
1-2-3. For example, 0.1-1-2 implies that close competitors are within 0.1 miles of an outlet, medium competitors
are within 0.1-1 mile, and far competitors are 1-2 miles away.
12
approach. Another concern is that franchisees who faced increased competition from nearby
outlets, such as Burger King restaurants, responded by setting lower prices and by adopting
the Dollar Menu. Thus, we may misleadingly attribute the observed reductions in the price
differentials to the Dollar Menu. However, the fact that all McDonald’s restaurants adopted
the Dollar Menu and that Burger King restaurants are located closer to corporate restaurants
implies that we should have observed an increase, not a decrease, in the price differential.
Furthermore, the national introduction of the Dollar Menu across the U.S. and its uniform set
of items further alleviate these concerns. To capture potential changes in the intensity of local
competition between 1999 and 2006, we also verified that our results are qualitatively similar
when we allow the coefficients on the competition variables to vary between years. Finally, we
checked that our results are not driven by entry or exit of outlets by restricting the sample
to include only restaurants that existed in both 1999 and 2006 and that did not change their
ownership.
Importantly, using panel data with observations from the same geographic area enables
us to rule out alternative explanations that rely on time-invariant unobservables, including
unobservable factors affecting the decision as to where to locate corporate and franchised
outlets. Furthermore, because the price differentials of only a subset of the items changed, a
possible alternative explanation should be based on a change in unobservables affecting only
that subset of items. So, for example, a change in outlets’ royalties paid to McDonald’s cannot
explain the different price patterns, because an outlet’s royalties are determined according to
the outlet’s total sales, rather than on a per-item basis. Similarly, a change in the ownership
structure of franchised outlets between 1999 and 2006 is unlikely to have a different impact on
prices of different items. Furthermore, as shown in Panel B of Table 1, there were few changes
in the ownership structure. Accordingly, when we include the number of outlets owned by a
franchisee, our main results do not change.14 Nevertheless, if certain unobserved factors, which
changed between the two periods, affected the demand for meals with close substitutes in the
Dollar Menu, and had no effect on the other meals, then our estimates overstate the effect of
the Dollar Menu.
14
Ownership structure might affect pricing decisions because a single franchisee, owning several outlets, may
internalize the positive demand externality and charge lower prices. Alternatively, a multi-unit franchisee in the
same geographical area may choose higher prices because she internalizes the business stealing effect.
13
Finally, we performed the same empirical analysis for Jack-in-the-Box, the only hamburger chain in Santa Clara County, other than McDonald’s, that operates a mixture of
corporate-owned and franchised outlets. We observed 35 and 36 outlets of Jack-in-the-Box
in 1999 and in 2006, respectively, six of which were franchised in each period. We found that
the price differential for the Jumbo Jack meal, the chain’s signature item, decreased significantly, from 6% in 1999 to 1.3% in 2006. This is consistent with the introduction of the
Jack-in-the-Box Value Meal at the end of 2001.
3.4
Repeat Customers Analysis
The results presented above show that the price differential of meals that have close substitutes
in the Dollar Menu dropped between 1999 and 2006. In this section, we make a step forward in
providing evidence that demand externality is one of the factors affecting the price differential
between franchised and corporate outlets. Specifically, we distinguish between outlets according to the prevalence of repeat customers among their clientele. Our interpretation is that
franchised outlets that cater to fewer repeat customers take less into account the impact of
their current pricing decisions on future visits at the chain. Consequently, holding everything
else equal, prices at these outlets are likely to be higher than prices at other outlets.
Our main proxy for repeat customers is distance of an outlet from a highway. We define
a dummy variable, Df ar−f rom−highway,j which equals one if outlet j is located more than 1/4
of a mile from a highway exit and zero otherwise.15 We test our conjectures regarding the
role of repeat customers by estimating the following SUR heterogenous difference-in-difference
15
The 2000 Bay Area Travel Survey reports that 60% of trips on the 101 Highway, one
of the two main highways in Santa Clara County, are not home-work trips.
See Table
7.3 in RVAL2000 Validation Technical Summary 2.pdf which can be downloaded from f tp
:
//f tp.abag.ca.gov/pub/mtc/planning/f orecast/RV AL2000/P DF validation report.zip.
Last accessed
on 12/01/2011. The variable Df ar−f rom−highway,j exhibits significant variability for both franchised and
corporate outlets. In 1999 the share of franchised outlets located near a highway was 18%, whereas the share
of corporate outlets near a highway was 28%. The corresponding numbers in 2006 were 19% and 29%.
14
specification:
ln(pijt ) =α + γ1 ∗ Df ar−f rom−highway,j + γ2 ∗ Df ranchised,jt + γ3 ∗ D2006,jt +
γ4 ∗ Df ar−f rom−highway,j ∗ Df ranchised,jt + γ5 ∗ Df ar−f rom−highway,j ∗ D2006,jt +
γ6 ∗ Df ranchised,jt ∗ D2006,jt + γ7 ∗ Df ar−f rom−highway,j ∗ Df ranchised,jt ∗ D2006,jt +
X
β ∗ Xjt +
θk ∗ Compjtk + ijt
k
(2)
γ4 and γ7 are the main parameters of interest. γ4 refers to the difference in 1999 between the
price differentials at outlets located at a distance from a highway and at outlets located near a
highway. γ7 is the coefficient on the triple interaction term. It refers to the difference between
the change from 1999 to 2006 in the price differentials at outlets located far from a highway
and the corresponding change in the price differentials at outlets located near a highway. Given
the intuition offered above, we expect that the price differential in 1999 will be greater among
outlets near a highway, and that the decrease in the price differentials between 1999 and 2006
will be greater in absolute terms among outlets near a highway. Specifically, we expect γ4 to
be negative and γ7 to be positive.
The results for the meals that have close substitutes in the Dollar Menu are shown in
Table 7. They lend support to the argument that franchised outlets located near highways
cater to fewer repeat customers and hence charge higher prices than franchised outlets located
at a distance from a highway. The results also suggest that the introduction of the Dollar Menu
was particularly effective in reducing the price differentials in outlets located near highways.
For example, the Big Mac meal price differential at outlets located near a highway was 17%
(γ2 ) in 1999, and it fell to 5.4% (γ2 + γ6 ) in 2006. At outlets located at a distance from a
highway, the price differentials were only 10.9% (γ2 + γ4 ) and 2.7% (γ2 + γ4 + γ6 + γ7 ) in 1999
and 2006, respectively.
An alternative explanation for higher prices near highways is that those franchisees
incur higher costs. However, most of the costs are similar for franchisees, whether located near
or at a distance from the highway. The royalties that a franchisee pays to the chain are typically
determined according to the cohort of the contract rather than on a particular characteristics
15
of an outlet location. Furthermore, McDonald’s franchisees purchase their inputs from the
same certified suppliers, and at equal terms, and McDonald’s corporation owns the premises
of the franchised units (See Kaufmann & Lafontaine (1994) and Lafontaine & Shaw (1999)).
Other costs, such as labor, are unlikely to vary significantly across outlets located within the
same county. Therefore, higher costs near a highway probably do not explain the observed
price differentials.
In addition to using distance from a highway, we employ two other proxies for an outlet’s
level of repeat customers: the presence of a playground and whether wireless service is offered
at the restaurant. Playgrounds attract parents with children to McDonald’s restaurants, and
McDonald’s performs a survey based on demographic trends to determine the profitability
of a playground. Furthermore, Robinson, et al. (2007) report that 32% of the children in
their sample visit McDonald’s outlets more than once a week, and nearly 72% visit them
more than once a month. As a comparison, the results of the survey discussed in Appendix
A indicate that only 2% of Stanford students visit more than once a week at McDonald’s.
Wireless service serves as a proxy for high school and college students who regularly attend
McDonald’s restaurants.16 In addition, we define a combined proxy as the interaction of the
three proxies discussed above. Table 8 shows the number of outlets characterized by each of
the repeat business proxies for corporate and for franchised outlets. A feature of these proxies
is that each can be interpreted as accounting for a different segment of fast-food consumers:
travelers, families with young children, and local high school and college students. We present
the estimated coefficients of the Big Mac Meal equation using each of the other proxies in Table
9. The results reveal similar patterns to those found when using the distance from a highway
as a proxy. Furthermore, we obtain qualitatively similar results when we use these additional
proxies in the Quarter Pounder and Double Quarter Pounder meal regressions.
4
Discussion
In this paper, we claim that price advertising can be used to influence franchisees to set lower
prices in their outlets, thereby addressing organizational intra-chain conflicts. Theoretical
16
Conversations with franchisees support the usage of these proxies for repeat business. Wireless service was
not offered in 1999, and we treat outlets that offer wireless service in 2006, as catering to consumers with a
tendency to repeat both in 1999 and 2006.
16
models on vertical restraints typically emphasize that manufacturers aim to soften price competition among their distributors in order to ensure that each distributor sufficiently invests
in promotional efforts that will eventually lead to higher profits.17 In contrast, as we show,
business-format franchising chains may actually want to increase price competition among their
franchisees. This probably occurs because a chain’s profits depend on franchisees’ total sales,
which increase when prices decrease. In addition, in many instances, such as in the fast-food
industry, the franchisor values more than franchisees do the effect of low prices today on future
sales and on the chain’s overall reputation.
Chains adopt two main strategies to strengthen competition among their franchisees.
First, chains can open new outlets near existing outlets of the same brand in order to exert
competitive pressure on existing outlets. Indeed, franchisees, who typically do not have exclusive territories built into their contracts, have vocally resisted such attempts by chains, known
as encroachment (see Kalnins (2004) for evidence on encroachment). Second, as we emphasize
in this paper, chains can introduce and advertise low-price items that will generate pressure to
set lower prices. Both strategies can have important implications for firms and for consumers.
Most likely, firms may use the encroachment strategy during expansion periods (Toivanen &
Waterson (2005)), while the latter strategy is probably more suitable when the chain operates
in mature markets.
A potential concern with low prices is that franchisees’ profits may fall, even if overall
sales increase. In Appendix B we present evidence from a franchised outlet demonstrating that
its profits increased after the introduction of the Dollar Menu. Although this limited evidence
comes from only one outlet, we believe it could be representative of many outlets that benefited
from the Dollar Menu.
Finally, given that the inherent tension between franchisors and franchisees is associated with all items sold by the franchisees, it seems natural to ask why chains advertise only
a subset of items. This strategy might be more efficient for several reasons: first, the corresponding advertising expenses should be lower and may prove more effective in attracting
consumer attention compared to a campaign that advertises a larger number of prices and
17
Notably, this literature identifies a different type of free-riding behavior that focuses on the incentives of
retailers to benefit from actions performed by other retailers. See Telser (1960) and Mathewson & Winter (1984)
for early theoretical papers and Zanarone (2009) for a recent related empirical work.
17
items. Furthermore, McDonald’s might prefer franchisees to independently choose prices for
some items, either because franchisees are more familiar with the local demand environment
or because McDonald’s may find it harder to dictate the entire menu. Finally, as we show in
the paper, advertising a subset of items has an effect on other, non-advertised items.
5
Concluding Remarks
Economists, marketing experts and legal scholars have all devoted considerable effort to studying economic tensions – typically in the context of downstream prices – that arise between
upstream and downstream firms, such as franchisors and their franchisees. In this paper, we
add to this literature by addressing the question of how franchisors actually influence franchisees’ prices.
We compare the prices of several items sold at franchised and corporate McDonald’s
outlets before versus after the introduction of McDonald’s Dollar Menu. We find that prices
in franchised outlets are higher than the prices at corporate outlets. Furthermore, between
1999 and 2006 the price differentials decreased but only for items with close substitutes in
the Dollar Menu, which was introduced in 2002. In addition, the price variations of meals
with close substitutes in the Dollar Menu decreased between 1999 and 2006, while the price
variations of other meals did not decrease.
We also distinguish between franchised and corporate outlets located near versus far
from a highway. We assume that franchisees located near highways face more inelastic demand
and have higher incentives to free-ride on the chain’s reputation by charging high prices. We
show that before the Dollar Menu was introduced, the price differentials among outlets located
near highways were larger than the price differentials farther from a highway. After the Dollar
Menu was introduced the price differences between outlets located near versus far from a
highway diminished.
Together, our findings suggest that the uniform introduction of low-priced items in
general, and the Dollar Menu in particular, serves as a managerial tool to affect franchisees’
prices and thus to improve the control of the chain over its franchisees’ prices. Furthermore,
although our empirical application comes from the franchising industry, we believe that the
mechanism we highlight in which a principal influences its agents’ behavior by altering the
18
expectations of related third parties can be applied to other, more general, settings.
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19
A. Kalnins (2010). ‘Pricing Variation within Dual Distribution Chains: Evidence and Explanation’. Working paper, Cornell University .
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20
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21
Table 1: Ownership Structure and Exit/Entry Patterns for McDonald’s
Panel A: Entry and Exit Patterns
Corporate
Franchised
1999
26
36
Exit
4
4
Entry
0
6
2006
22
38
Panel B: Number of Franchisee Outlets
Franchisee ID
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
1999
11
6
3
3
0
1
1
1
1
1
0
1
1
1
1
1
1
1
1
2006
8
7
5
3
2
1
1
1
1
1
1
1
1
1
1
1
1
1
0
Panel A presents entry and exit patterns of McDonald’s outlets in Santa Clara County, divided into
franchised and corporate-owned outlets. In panel B we show the number of outlets operated by each
franchisee in 1999 and 2006.
22
Table 2: McDonald’s Outlet Characteristics
Characteristics
Income (ZIP code)
Rent (ZIP code)
Dineout Index (ZIP code)
Population Density (1,000s/Sq. Mile) (ZIP code)
Proportion of Children (Up to Age 18) (ZIP code)
% Male (ZIP code)
% Black (ZIP code)
Drive Through
# Seats
Mall
Playground
Distance from Highway (Miles)
Far from Highway
Close BK Competitors
Medium BK Competitors
Far BK Competitors
Close MD Corp. Competitors
Medium MD Corp. Competitors
Far MD Corp. Competitors
Close MD Fran. Competitors
Medium MD Fran. Competitors
Far MD Fran. Competitors
Close Other Burger Competitors
Medium Other Burger Competitors
Far Other Burger Competitors
Close Sandwich Competitors
Medium Sandwich Competitors
Far Sandwich Competitors
All Characteristics
*** p<0.01, ** p<0.05, * p<0.1
Corporate
(N=26)
78910
1204
167
8.39
0.21
0.51
0.03
0.65
87
0.04
0.43
0.57
0.65
0.14
0.14
0.36
0.09
0.05
0.09
0.00
0.00
0.00
0.14
0.50
0.64
0.09
0.36
0.14
Franchised
(N=36)
73145
1126
164
8.16
0.21
0.51
0.03
0.67
114
0.05
0.33
0.89
0.77
0.03
0.26
0.28
0.00
0.00
0.00
0.03
0.08
0.23
0.13
0.38
0.77
0.18
0.08
0.46
t-Stat.
1.43
1.55
0.3
0.76
0.13
0.95
1.43
-0.11
-0.86
-0.14
0.79
-1.79*
-0.99
1.69*
-1.09
0.57
1.94*
1.34
1.94*
-0.75
-1.33
-2.23**
0.09
0.67
-0.66
-0.93
2.95***
-2.19**
1.47
The table presents characteristics of franchised and corporate-owned outlets in 1999. The right column
shows the t-statistic obtained from testing the null hypothesis that the mean values of the corresponding
characteristic are equal in franchised and corporate outlets.
23
Table 3: Characteristics of Airport Restaurants
Mean
Std.
10th %
90th %
N
Big Mac Meal
Corp.
Fran.
5.23
5.92
0.35
0.54
5.03
5.14
5.65
6.81
4
34
Double Cheeseburger
Corp.
Fran.
2.07
1.93
0.25
0.37
1.81
1.49
2.29
2.26
4
34
The table presents descriptive statistics for the (with tax) nominal Big Mac meal and Double Cheeseburger prices that were collected in September 2007 from McDonald’s outlets in the 35 largest U.S.
airports.
Table 4: Summary Statistics of the Big Mac Meal Price
Mean
Std.
10th %
90th %
t-stat.
Corp.
3.33
0.26
3.24
3.46
1999
Fran.
3.77
0.29
3.46
4.11
6.01
2006
Corp.
Fran.
4.69
4.92
0.13
0.18
4.54
4.65
4.87
5.09
4.91
The table presents descriptive statistics for the (with tax) nominal Big Mac meal prices that were
collected in July 1999 and July 2006 from all McDonald’s outlets in Santa Clara County.
24
Table 5: Testing Changes in the Big Mac Meal Price Differential
Dependent Variable: ln(Big Mac Meal)
D_2006
0.343***
(0.016)
D_franchised
0.125***
(0.015)
D_franchised*D_2006
-0.093***
(0.017)
Close BK Competitors
-0 070***
-0.070***
(0.021)
Medium BK Competitors
0.008
(0.014)
Far BK Competitors
0.008
(0.009)
Close MD Corporate
0.020
(0.028)
M di
Medium
MD C
Corporate
t
0.013
0 013
(0.020)
Far MD Corporate
-0.001
(0.016)
Close MD Franchised
-0.072***
(0.020)
Medium MD Franchised
-0.019
(0.034)
Far MD Franchised
0.032**
(0.014)
Close Other Hamburger
-0.002
(0.011)
Medium Other Hamburger
-0.000
(0.009)
Far Other Hamburger
0.002
(0 007)
(0.007)
R2
0.94
Close Other Sandwich
Medium Other Sandwich
Far Other Sandwich
Drive Thru
# Seats
Mall
Playground
log(Median
l (M di HH IIncome))
log(Median Rent Contract)
Dineout Spending Index
Population Density
% Children
% Male
% Black
Constant
N
0.006
(0.010)
0.039***
(0.014)
-0.003
(0.007)
0 016
0.016
(0.012)
-0.000
(0.000)
-0.028
(0.052)
-0.006
(0.013)
-0.000
0 000
(0.000)
0.000
(0.000)
0.001
(0.000)
-0.006
(0.007)
0.088
(0.250)
0.479
(0.408)
-0.936*
(0.566)
5.266***
(0 245)
(0.245)
114
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
The table contains the full set of regressors from Equation 1 for which the logarithm of the Big Mac
meal price is used as the dependent variable.
Standard errors are in parentheses. Errors are clustered by outlet.
25
26
0.95
0.78
115
0.95
113
Dependent Variable
ln(Quarter Pounder
ln(Filet-O-Fish
Meal)
Meal)
0.091***
0.246***
(0.013)
(0.011)
0.077***
0.023**
(0.012)
(0.011)
-0.063***
-0.007
(0.014)
(0.013)
0.9
107
ln(McNuggets
6pc.)
0.209***
(0.017)
0.059***
(0.011)
-0.008
(0.023)
0.9
110
ln(McNuggets
20pc.)
0.126***
(0.010)
0.026***
(0.009)
-0.008
(0.011)
The table shows the coefficients that correspond to the change in prices in corporate outlets from 1999 to 2006 (D2006 ), to the price
differential in 1999 (Df ranchised ) and to the change in the price differential from 1999 to 2006 (Df ranchised ∗ D2006 ) for the meals that were
offered in 1999 and 2006. We use a SUR regression, and each column presents the results of the equation in which the logarithm of a different
meal price is used as the dependent variable. In addition to the covariates presented in the table, the set of control variables included in each
equation is the same set of variables presented in Table 5.
Standard errors are in parentheses. Errors are clustered by outlet.
N
115
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
R2
D_franchised*D_2006
D_franchised
D_2006
ln(Double Quarter
Pounder Meal)
0.255***
(0.013)
0.076***
(0.012)
-0.049***
(0.014)
Table 6: Testing Changes in the Price Differentials of All McDonald’s Meals Offered in 1999 and 2006
Table 7: Testing Changes in Price Differentials of McDonald’s Meals Near and at a Distance
From a Highway
D_far-from-highway (γ )
1
D_franchised (γ 2 )
D_2006 (γ 3 )
D_far-from-highway*D_franchised
(γ 4 )
D_far-from-highway*D_2006 (γ 5 )
D_franchised*D_2006 (γ 6 )
D_far-from-highway*D_franchised*D_2006 (γ 7 )
R2
N
Standard errors in p
parentheses
*** p<0.01, ** p<0.05, * p<0.1
ln(Big Mac
Meal)
0.040*
(0.027)
0.170***
(0.033)
0.358***
(0.018)
-0.061*
(0.041)
-0.020
(0.030)
-0.116***
(0.035)
0.034
(0.044)
0.93
Dependent Variable
ln(Double Quarter
Pounder Meal)
0.031*
(0.018)
0.119***
(0.014)
0.272***
(0.012)
-0.058**
(0.023)
-0.023
(0.023)
-0.082***
(0.017)
0.047*
(0.027)
0.92
114
ln(Quarter Pounder
Meal)
0.025*
(0.018)
0.125***
(0.015)
0.125***
(0.017)
-0.062***
(0.024)
-0.050**
(0.024)
-0.124***
(0.022)
0.086***
(0.029)
0.7
110
110
The table presents the estimation results of Equation 2 which is the SUR heterogenous difference-indifference specification that allows the change in the price differential to vary across outlets located
near and at a distance from a highway. The dependent variable in each column is the logarithm of the
price of the Big Mac, Quarter Pounder and Double Quarter Pounder meals, respectively. The dummy
variable Df ar−f rom−highway,j equals 0 if outlet j is closer than 1/4 of a mile from a highway exit and 1
otherwise. In addition to the covariates presented in the table, the set of control variables included in
each equation is the same set of variables presented in Table 5.
Standard errors are in parentheses. Errors are clustered by outlet.
Table 8: Outlet Characterization by Repeat Business Proxies (2006)
Proxy
Far from Highway
Playground
Wireless Service
All Proxies Combined
N
Corporate
15
8
21
5
21
Franchised
30
15
27
7
37
The table presents the number of outlets characterized by repeat-customer proxies in 2006. Outlets are
divided according to ownership structure.
27
Table 9: Testing Changes in Price Differentials for the Big Mac Meal using Various Proxies
for Repeat Customers
D_repeat (γ )
1
D_franchised (γ 2 )
D_2006 (γ 3 )
D_repeat*D_franchised
(γ 4 )
D_repeat*D_2006 (γ 5 )
D_franchised*D_2006 (γ 6 )
D_repeat*D_franchised*D_2006 (γ 7 )
Repeat Business Proxies
Playground
Wireless
All Proxies
Presence
Service
Combined
0.039
0.061**
0.063*
(0.036)
(0.028)
(0.047)
0.151***
0.193***
0.152***
(0.015)
(0.026)
(0.014)
0.356***
0.357***
0.353***
(0.010)
(0.019)
(0.011)
-0.059*
-0.076**
-0.104*
(0.039)
(0.037)
(0.054)
-0.031
-0.018
-0.043
(0.031)
(0.015)
(0.048)
-0.105***
-0.130***
-0.107***
(0.018)
(0.026)
(0.017)
0.026
0.046*
0.057
(0.038)
(0.028)
(0.052)
R2
0.93
114
N
Standard errors in p
parentheses
*** p<0.01, ** p<0.05, * p<0.1
0.93
107
0.93
107
The table presents the estimation results of Equation 2, which is the SUR heterogenous difference-indifference specification that allows the change in the price differential to vary across outlets distinguished
by the extent to which they have repeat customers. The dependent variable is the logarithm of the Big
Mac meal price. The repeat-customer proxies utilized are the presence of a playground, the availability
of wireless service and a variable that intersect the two proxies mentioned here and the distance from
a highway. In addition to the covariates presented in the table, the set of control variables included in
each equation is the same set of variables presented in Table 5.
Standard errors are in parentheses. Errors are clustered by outlet.
28
Figure 1: % of Outlet Transactions for Different McDonald’s Menu Items
% of Outlet
Transactions
60 80 100 120
Index August 2002 = 100
Dollar Menu Introduction
% of Outlet
Transactions
100 300
Jan−2002
Jan−2003
Jan−2004
Date
Jan−2005
6 McNuggets Meal
Fillet−O−Fish Meal
BigMac Meal
Quarter Pounder Meal
Jan−2006
Dollar Menu Introduction
Jan−2002
Jan−2003
Jan−2004
Jan−2005
Jan−2006
Date
Dollar Menu Main Items − Double Cheeseburger and McChicken
The figure plots the smoothed time series of the percentage of transactions in which each of the items was
purchased over the period of October 2001 - March 2006 in a single franchised outlet. The percentage
of transactions for each item was normalized to 100 in August 2002 - the month before the Dollar Menu
was introduced. In the lower part of the figure, we display the percentage of the outlet transactions for
the Dollar Menu items: the Double Cheeseburger and the McChicken. The percentages of the outlet
transactions for the regular menu items are shown in the upper part of the figure. The Dollar Menu
introduction date in September 2002 is marked by a thick vertical black line.
The value used as the bandwidth is 0.4.
29
Figure 2: McDonald’s Big Mac Meal Price Distributions
0 .01 .02 .03
Density
McDonald’s 1999 Big−Mac Meal Price Distributions
300
350
400
450
500
550
Price
Franchised Outlets
Corporate Outlets
0 .01 .02 .03
Density
McDonald’s 2006 Big−Mac Meal Price Distributions
300
350
400
450
500
550
Price
Franchised Outlets
Corporate Outlets
The figure plots the kernel density of the Big Mac meal price, estimated separately for franchised and
corporate-owned outlets for the time periods 1999 and 2006.
30
A
Survey Results
The survey, aiming to find substitution patterns between McDonald’s items, was conducted
among 104 undergraduate students at Stanford University in late April 2007. The survey and
a summary of the responses are presented in Figure B1 and Table B1.
Table A1: Survey Response
Big Mac Meal
Chicken McNuggets
Big Mac
Meal
0.18
0
Chicken McNuggets Dbl. CheeseBurger
McChicken
Enlarged Dbl. CheeseBurger Enalrged McChicken
Meal
Dollar Menu Meal Dollar Menu Meal
Dollar Menu Meal
Dollar Menu Meal
0
0.39
0.14
0.21
0.07
0.47
0.13
0.21
0.06
0.13
The Table contains a summary of the responses to the survey we conducted. The (i, j) entry of the table
is the proportion of respondents who chose option j from the extended menu conditional on choosing
option i from the base menu.
31
Figure A1: Survey
Hi Students,
We are running a study on individuals’ fast food preferences, and would highly appreciate your
help in filling the short questionnaire below.
Note that there are no right or wrong answers, your participation is voluntary.
You enter a McDonald’s restaurant and need to choose among the following two available
standard meals (each containing an entrée + medium fries + medium soda)
A. Big Mac Meal ($4.59)
B. Chicken McNuggets (6 piece) Meal ($4.29)
1. Which one of the four meals above would you choose? ___
The next time you enter a McDonald’s outlet you discover that McDonald’s introduced two new
Dollar Menu Meal options.
Dollar Menu Meal can be one of two options:
- Dollar Menu Meal - one small entrée + medium fries + medium soda for $3.00
- Enlarged Dollar Menu Meal - two small entrées + medium fries + medium soda for $4.00
Therefore, you now have the following six options to choose from (two regular meals and four
Dollar Menu Meals):
A. Big Mac Meal ($4.59)
B. Chicken McNuggets (6 piece) Meal ($4.29)
C. Double Cheeseburger Dollar Menu Meal – Double Cheeseburger + medium fries +
medium soda ($3.00)
D. McChicken Dollar Menu Meal - McChicken + medium fries + medium soda ($3.00)
E. Enlarged Double Cheeseburger Dollar Menu Meal – Two Double Cheeseburgers + one
medium fries + one medium soda ($4.00)
F. Enlarged McChicken Dollar Menu Meal – Two McChicken + one medium fries + one
medium soda ($4.00)
2. Which option would you choose? ____
3. In case your preferred option is not available, which other option would you choose instead?
______
4. How often do you eat at McDonald’s or other fast food chains?
1.
2.
3.
4.
Once a week or more
Once a month or more
A few times a year
Hardly ever or never
Answer: ____
Thank you for your cooperation!
The survey displayed above was filled out by the students. Note that the first question should have
been “Which one of the two meals above would you choose?”.
32
B
The Effect on Profits and Revenues
To illustrate the effect of the Dollar Menu on revenues and profits, we use cost data obtained
from one franchised outlet. In Figure B1 we present a plot of the revenues and profits of the
twenty top selling items, normalized to their August 2002 level.18 As can be seen in the Figure,
following the introduction of the Dollar Menu the increase in outlet revenues was higher than
the respective change in outlet profit. For example, the revenues increased by 18% between
August 2002 and June 2003, whereas the profits increased by only 11%. Note, though, that to
calculate the profit, we only use price and direct input cost. Thus, we ignore other non-fixed
cost factors that would reduce franchisees’ profits, such as rent payments and royalties.
18
We observe monthly cost data for 2007 only. Thus, the cost data used to calculate profits are taken from a
randomly selected month. For example, the unit costs of Big Mac, Double CheeseBurger, 6 McNuggets, small
Coke and large fries are: 58, 50, 49, 9 and 28 cents, respectively.
33
Figure B1: Revenues and Profits Before and After the Dollar Menu
120
Index August 2002 = 100
100
110
Dollar Menu Introduction
Jan−2001
Jan−2002
Jan−2003
Jan−2004
Jan−2005
Jan−2006
Date
Revenue
Profit
The figure plots the smoothed time series of revenues and profits based on the 20 top-selling items
between June 2001 and June 2006 in a single franchised outlet. These measures were normalized to 100
in August 2002. Profit is defined as the sum of price minus cost of inputs for any item sold.
The value used as the bandwidth is 0.4.
34