Added On: Wednesday, January 09, 2008

The Strategy of Pricing at Franchise and Corporate Owned McDonald's Restaurants

Posted on August 27th, 2007 (0 Comments | Add a Comment)

Itai Ater and Oren Rigbi, two Stanford economists, have written an interesting article (“Price Control in Franchised Chains: The Case of McDonald’s Dollar Menu”) on pricing at McDonald’s restaurants using 1999 – 2006 data from outlets in Santa Clara, California.

Economists have long hypothesized that franchise owners “free ride” off of corporate owned outlets. In other words, corporate owned outlets have a higher incentive to provide better service/products than franchisees. This is because a franchisor (in this case McDonald’s) that owns corporate outlets has more to lose from offering spotty service. If this free riding exists, you’d expect prices at franchisees to be higher than those at corporate restaurants (since franchisees have less to lose by setting high prices). Sure enough, the authors found that Big Mac meal prices at franchisees were on average 12.5% higher than those at corporate outlets in 1999.

Further investigating the “free rider” issue, economists have maintained that prices will be lower at outlets characterized by repeat customers (e.g., in a neighborhood) compared to those that don’t serve repeat customers (e.g., on highways). Restaurants serving repeat customers have more to lose from high prices relative to those serving transients. The authors created proxies (distance from highway, playground on premise, offers wireless service) to designate whether an outlet has repeat customers. Outlets far away from a highway that have playgrounds and offer wireless service were considered most likely to serve repeat customers. Sure enough, franchise prices at outlets that serve repeat customers were on average 12% lower than those that tend serve “no repeat” diners.

Finally, the authors tested the substitution effects of McDonald’s dollar menu. In November 2001, McDonald’s introduced its Dollar Menu that contains 6 – 10 items. The two key entrees on the Dollar Menu are the Double Cheeseburger and McChicken. Here’s where it gets interesting: if the price differential between a Double Cheeseburger and Big Mac is too large, Big Mac aficionados will switch their allegiance to the dollar Double Cheeseburger - they are substitutes. Since the discount Double Cheeseburger is available everywhere, you’d now expect Big Mac prices to be similar at corporate and franchise restaurants (to avoid signature sandwich lovers from defecting to the dollar substitute). The authors found that the Big Mac meal franchise premium fell from 12.5% (1999, pre-Dollar Menu) to 3.63% (2006, post-Dollar Menu). Similarly, the Quarter Pounder meal premium fell from 7.1% (1999) to 1%. Interestingly, franchised restaurants maintained their “free rider” premiums over corporate owned restaurants on items like the Filet of Fish and McNuggets, which don’t have close substitutes on the Dollar Menu.

This paper is interesting for three reasons. Using pricing data, the authors empirically illustrate what strategists have long speculated: franchisees free ride on corporate owned restaurants. Second, franchisors like McDonald’s can use nationally advertised prices like Dollar Menu products or other special sandwiches, to rein in franchisee prices on signature products like the Quarter Pounder. And finally, now I know that the cheapest and best McDonalds’s are those that are corporate owned and cater to repeat customers!

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