PRICE CONTROL IN FRANCHISED CHAINS: THE CASE OF McDONALD’S DOLLAR MENU

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 Tel Aviv University ater@post.tau.ac.il

Oren Rigbi Ben-Gurion University

origbi@bgu.ac.il

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.

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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

1Matthew Paull, McDonald's Corporation CFO at McDonald's Earnings Conference Call, 01/24/2006. For transcript see http : //article/6176 - mcdonalds - q4 - 2005 - earnings - conf erence - call - transcript - mcd. Last accessed on 12/01/2011.

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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

2In 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.

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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

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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.

3See 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).

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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)).

4Advertising Age, 09/02/2002. 5Only 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. 6See f.n. 1 and an interview with McDonald's CEO, Ralph Alavarez, Dow Jones Newswires, 10/19/2007. 7Business Week (03/03/2003) and Wall Street Journal (11/02/2002), respectively.

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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

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