PRICE CONTROL IN FRANCHISED CHAINS: THE CASE OF MCDONALD'S DOLLAR MENU
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Price Control In Franchised Chains: The Case Of McDonald’s
Dollar Menu∗
Itai Ater Oren Rigbi
Tel Aviv University Ben-Gurion University
ater@post.tau.ac.il origbi@bgu.ac.il
February 9, 2010
Abstract
We analyze price patterns at franchised and corporate-owned McDonald’s outlets in
1999 and 2006. We find that prices charged at franchised outlets were higher than those
at corporate outlets and that the price differentials decreased substantially between 1999
and 2006 only for items with good substitutes in the Dollar Menu, which was introduced in
2002. In addition, price differentials were higher and the reduction was generally larger in
outlets located near highways, where the incentive of franchisees to free-ride on McDonald’s
reputation is greater. We offer two possible reasons why McDonald’s was able to induce
franchisees to adopt the Dollar Menu. First, the 1997 U.S. Supreme Court Khan decision,
which allowed chains to negotiate maximum prices with franchisees, improved McDonald’s
bargaining power vis-à-vis franchisees. Second, the large advertising campaign that accom-
panied the introduction of the Dollar Menu made it costly for franchisees not to adopt the
Dollar Menu.
JEL classification: L14; L22; L42; K21; M37;
Keywords: Franchising; Free-Riding; Reputation; Advertising; Vertical Restraints
∗
We are thankful to Raphael Thomadsen for his comments and for kindly providing us with the 1999 data.
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 La-
fontaine, Philip Leslie, 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.
11 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
This paper examines price patterns in franchised and corporate-owned outlets and
asks the question of how franchising chains affect prices set by franchisees. This question is
particularly interesting in light of the 1997 U.S. Supreme Court State Oil Company v. Khan
decision which practically allowed chains to dictate downstream prices.
We use panel data to document changes in prices of several items at franchised and
corporate-owned McDonald’s outlets between 1999 and 2006. We find that the price differen-
tial, defined as the difference between the average price in franchised outlets and the average
price in corporate-owned outlets, fell significantly only for some items. We argue that the
changes in the price differentials occurred only in items that have good substitutes in the
Dollar Menu which was introduced by McDonald’s in 2002. McDonald’s Dollar Menu is a
collection of items that are being sold at both franchised and corporate-owned restaurants for
one dollar each. Our findings suggest that the introduction of a cheap menu alternative could
enhanced price uniformity across franchised and corporate-owned outlets and improved the
chain’s control over downstream prices.
The changes in the price differentials raise the question of why McDonald’s franchisees,
who are not contractually required to, chose to adopt the Dollar Menu in 2002 and contin-
ued to offer it thereafter. We offer two complementary explanations: first, we claim that
the 1997 U.S. Supreme Court Khan decision improved McDonald’s bargaining power vis-à-vis
franchisees thereby facilitating the introduction of the Dollar Menu. Thus, the conjecture is
that franchisees, concerned that McDonald’s would dictate maximum prices, have agreed to
adopt the Dollar Menu.2 Second, the large national advertising campaign that accompanied
the introduction of the Dollar Menu also induced franchisees to adopt it. In particular, the
suggested mechanism is that through advertising the chain informs consumers about the price
1
Matthew Paull, McDonald’s Corporation CFO at McDonald’s Earnings Conference Call, 01/24/06. See
http : //seekingalpha.com for full transcript.
2
Note that franchising contracts typically last 20 years. This fact, nonetheless, could hinder immediate
contractual changes.
2they should expect. Franchisees trying to meeting consumers’ expectations consequently opt
to adopt the chain’s desired price. More generally, franchisees’ profits may have increased fol-
lowing the introduction of the Dollar Menu because it served as a coordinating instrument that
improved price uniformity across McDonald’s outlets as well as the reputation of McDonald’s.
We present evidence from one franchised outlet that supports this claim.3
The literature on franchising has postulated that outlets owned by a franchisee are more
likely to face inelastic demand compared to outlets owned by the chain because franchisees
may not entirely internalize the effect of their pricing decisions on the overall reputation of the
chain.4 To explore this argument, we distinguish between outlets located near a highway with
those located at a distance from a highway, assuming that outlets located near a highway face
more inelastic demand (or serve fewer repeating customers). Consistent with this assertion, we
find that in 1999 the price differentials at outlets located near highways were higher than the
price differentials away from the highway. In 2006, after the introduction of the Dollar Menu,
the distinct price differentials between highway and non-highway locations fell.
Two basic features of the fast-food franchising industry make it suitable for exploring
the ability of a chain to control downstream prices. First, a standard experience across fast-
food chain outlets has been a basic ingredient of the fast-food industry’s success and growth
over the last 50 years. Thus, it is natural to focus on chains’ efforts to achieve uniformity
across outlets as well as to maintain and enhance their reputation. Second, McDonald’s, as
many other chains, operate franchised as well as corporate-owned outlets. McDonald’s controls
the prices in corporate-owned outlets, whereas franchisees set the prices at their independently
owned outlets. This dual organizational structure offers a unique opportunity to test the ability
of the chain to affect prices at franchised outlets by comparing the two types of outlets.
Our paper contributes to three strands of the literature. The first is the literature
on franchising which has explored how franchisees’ product quality and prices differ from the
quality and prices in corporate-owned outlets.5 Other papers discussed the concerns of chains
3
In general, however, the effect of the introduction of low-priced items on a particular outlet profits is
ambiguous. It could result in higher profits but could also be detrimental to outlets who face inelastic demand
and tend to charge relatively high prices.
4
See, for example, Barron and Umbeck (1984) and Lafontaine (1995).
5
In general, the existing evidence, particularly in the fast food industry, shows that franchisees charge higher
prices than corporate stores. See Lafontaine and Slade (1997) for a survey and also Kalnins (2003) and Graddy
(1997). Evidence from the hotel industry in Texas (Vroom and Gimeno (2007), Conlin (2004)), however, suggests
that franchised hotels charge lower prices than corporate-owned hotels.
3over franchisees’ free-riding behavior and how chains try to mitigate this problem.6 Our panel
data enables us to compare prices at franchised and corporate outlets before and after the
introduction of the Dollar Menu and helps us to rule out alternative explanations for the
empirical patterns found in the data.7 Furthermore, to the best of our knowledge, we are the
first to provide evidence on franchisees’ free-riding behavior by comparing pricing decisions at
highway and non-highway locations.8 Second, this paper contributes to the empirical literature
on antitrust and vertical restraints. Imposing maximum resale price maintenance (RPM) was
considered per-se illegal under the U.S. antitrust law before the 1997 U.S. Supreme Court
decision in State Oil Company v. Khan which determined that maximum RPM should be
examined under the rule of reason standard.9 Our findings indirectly shed light on a potential
effect of this decision on the marketplace. Finally, we provide evidence on a new role for
price advertising as a mechanism for alleviating organizational problems. Price advertising in
franchised chains is unique because the advertising and the pricing decisions are determined
by different decision makers. The chain is typically responsible for the content and scope of
advertising, while the franchisees set prices.10
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. The estimation results of
the Dollar Menu’s effect on prices, the sales data analysis and the analysis exploring prices near
a highway are presented in Section 3. In Section 4, we discuss our results and offer concluding
remarks.
6
See, for example, Brickley and Dark (1987), Rubin (1978), Brickley (1999), Klein and Leffler (1981), La-
fontaine and Shaw (2005) as well as the survey by Lafontaine and Slade (2005).
7
A closely related paper is Jin and Leslie (2009), who study the effect of an exogenous change in consumers’
information on restaurants’ incentives to maintain good hygienic quality.
8
We also find, unlike Brickley and Dark (1987), that McDonald’s corporate-owned restaurants are more likely
to be located near highways, presumably to address potential free-riding behavior by franchisees.
9
For a detailed review of the legal history of maximum resale price restraints see Blair and Lafontaine (1999).
10
See Steiner (1973), Farris and Albion (1980) as well as Levy and Young (2004) for related arguments.
42 Dollar Menu and Data
2.1 McDonald’s Dollar Menu
McDonald’s Dollar Menu is a collection of 6 to 8 menu items that are sold for one dollar each.
The Dollar Menu accounts for 14% of McDonald’s sales in the U.S.11 and it represents 10%-15%
of McDonald’s total advertising expenditure.12 The Dollar Menu was introduced nationwide in
September 2002 following a six quarter-period of relatively poor sales performance. According
to industry news reports, the Dollar Menu was an attempt to boost sluggish sales and cripple
Burger King, McDonald’s main rival.13 The Dollar Menu usually includes two main dishes
- a Double Cheeseburger and a McChicken sandwich, together with side dishes and desserts,
such as Small Fries, Small Soft Drink, Side Salad, Apple Pie and Sundae.14 To promote
the Dollar Menu introduction, McDonald’s added $20 million to its advertising budget in the
last quarter of 2002. McDonald’s 2002 annual financial report explained the 2002 increase
in expenses as follows: “The increase in 2002 was primarily due to ... higher advertising
expenses in the U.S. primarily related to the introduction of the Dollar Menu.” Launching a
large advertising campaign, such as the Dollar Menu campaign, requires the support of the
majority of franchisees. The setting of actual prices, however, remains at the discretion of each
franchisee. McDonald’s corporate officer was willing to say that franchisees are encouraged to
adopt the Dollar Menu.15
11
According to McDonald’s CEO, Ralph Alavarez, Dow Jones Newswires, 10/19/07.
12
McDonald’s Earnings Conference Call, 01/24/06. See http : //seekingalpha.com for full transcript.
13
James Cantalupo, McDonald’s CEO at the time the Dollar Menu was introduced was cited saying: “We like
to wear out our competitors with our price”, Business Week, 03/03/03. In addition, Mike Roberts, McDonald’s
U.S. president, called the Dollar Menu introduction campaign the most important endeavor he has led, “I
believe we can no longer afford to wait on incremental gains. We need radical movement now.”, Advertising
Age, 9/2/2002.
14
According to the New-York Times, the Double Cheeseburger has become McDonald’s most ordered item
since the Dollar Menu was introduced. New York Times, 04/19/2006.
15
Unlike McDonald’s, Burger King Corporation forced its franchisees to adopt the Value Meal when it was
introduced in 2006. The United States Court of Appeals for the eleventh circuit (Burger King Corporation
v. E-Z Eating (11th Cir. 2009)) confirmed recently Burger King’s right to impose maximum prices on its
franchisees: “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.”
52.2 Data
We constructed our data from several sources. Our main data set is an original panel data set
collected in July 1999 (Thomadsen (2005)) and July 2006 regarding the location, price menu,
and outlet characteristics16 of all the hamburger outlets which are chain-affiliated in Santa
Clara County, California.17 In addition, we also use data on the number of outlets operated in
the Santa Clara County by the sandwich chains Subway and Quizno’s. All the outlets in Santa
Clara County except one offer the Dollar Menu.18 In the empirical analysis, we examine price
patterns at McDonald’s outlets while the data on the other chains are used to determine the
competitive environment of an outlet. We collected the 2006 data by visiting all the outlets in
the Santa Clara County and documenting the menu prices and characteristics of the outlet.19
Ownership data were obtained by cross-referencing several public records.20
Data on outlets are supplemented by zip code demographic data, including median
household income, median rent contracts, population density, share of the population below
the age of 18, fraction of males and blacks as well as a dine out spending potential index.21 In
addition, we use sales and costs data from one McDonald’s franchised outlet which adopted the
Dollar Menu. The sales data include prices, the quantities sold for each item and the number
of cashier transactions in that outlet for all the months between June 2001 and June 2006. The
number of cashier transactions is used as a measure of the number of customers patronizing the
outlet in a particular month. The cost data correspond to the food and paper cost of each item
for each month in 2007. Table 3 displays the number of corporate and franchised McDonald’s
outlets in 1999 and in 2006 in the Santa Clara County, entry and exit patterns and ownership
distribution of franchised outlets. The table illustrates that there were no major changes in the
number of operating outlets as well as in the number of outlets operated by each franchisee. In
16
The observed outlet characteristics are: number of seats, the presence of a playground, the presence of a
drive-thru, the availability of wireless service at the outlet and whether the outlet is located in a mall.
17
There are about 300 outlets and the chains are: Burger-King, Carl’s Jr., In-N-Out, Jack-in-the-Box, Mc-
Donald’s and Wendy’s.
18
The only outlet that has not offered the Dollar Menu is a franchised outlet located in the Stanford Shopping
Center.
19
Outlet locations were obtained from chains’ websites as well as from business locator services, such as Google
Maps and Yahoo Local Maps. Prices were photographed (when permitted) and a subset of prices were copied
when taking photographs was not possible.
20
For each outlet we observe whether it is franchised or corporate-owned and the owner’s identity. Ownership
data were assembled from the Assessor Office and the Public Health Department in Santa Clara County.
21
Zip code demographics were obtained from the 2000 Census data and 2005 Community Sourcebook America.
6Table 4 we compare descriptive demographic data and outlet characteristics between corporate
and franchised outlets. Overall, the comparison suggests that franchised and corporate outlets
are located in similar environments. One notable exception is that a corporate-owned outlet is
more likely to be located near a highway. Presumably if the chain is concerned about free-riding
behavior near highways, it may choose to locate corporate restaurants near highways.
3 Empirical Analysis
We focus on changes in franchisee’s price differentials which we define as the difference between
the average price at a franchised outlet and the average price at a corporate-owned outlet. We
first examine the price differentials for all the meals that were offered in both 1999 and 2006
and then use the sales data to explain the price patterns we find. We then explore how the
price differentials varied and changed across outlets located near a highway and at a distance
from a highway. Finally, we examine how profits and revenues changed before and after the
Dollar Menu was introduced.
3.1 Price Patterns Across Adopting Outlets
3.1.1 Descriptive Statistics
Table 5 displays descriptive statistics of the Big-Mac meal price. As the table shows, the price
differential for the Big-Mac meal decreased from 44 cents in 1999 to 23 cents in 2006. Also
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.22 We
also present the kernel densities of the Big-Mac meal price in franchised and corporate-owned
outlets in both time periods in Figure 2. The Figure illustrates how the Big-Mac meal price
had increased from 1999 to 2006 and how the two price distributions approached each other
over time.
22
The price differential for the Double Cheeseburger – a Dollar Menu item – was 8 cents in 1999 and in 2006
it dropped to zero in the outlets that adopted the Dollar Menu.
73.1.2 Regression Analysis
We utilize the following SUR differences-in-differences specification to test the changes in prices
between 1999 and 2006:
ln(pjit ) = α+γ ∗D2006,it +δ ∗Df ranchised,it +η ∗D2006,it ∗Df ranchised,it +β ∗Xit +θ ∗Compit +jit
(1)
This specification examines changes in prices of meals that were offered in both 1999
and 2006. pjit is the price of meal j in outlet i in year t. D2006,it is a dummy variable equal to 1
for observations collected in 2006. Df ranchised,it is a dummy variable equal to 1 if outlet i was a
franchised outlet in year t. Xit is a vector containing outlet i 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. The competition vector Compit 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 as well as jointly Subway and Quizno’s.23 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. Table 6 presents the estimation results when the logarithm of the
Big-Mac meal price is used as the dependent variable. We find that conditional on outlet
characteristics and demographics, the price differential for the Big-Mac meal 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 the positive coefficient on the 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 outlets24 and the fraction of
blacks in the population. Table 7 displays the results for the other meals and demonstrates
two interesting patterns: for the Quarter Pounder and the Double Quarter Pounder meals,
we find that the price differentials dropped significantly from 7.7% to 1.4% and 7.6% to 2.7%,
23
We present estimation results including three competition variables; close competitors, medium competitors
and far competitors defined as the number of competitors an outlet has within 0.1 mile, 0.1-0.5 mile and 0.5-1
mile, respectively. We experimented with several other criteria for the level of competition (e.g. perimeters
around each outlet) as well as with alternative ways to define the set of rivals. None of these modifications
changed the main results.
24
Thomadsen (2007) also examined numerically how fast food prices change with the proximity of rivals.
8respectively. However, for the regressions of the Fillet-O-Fish, Chicken McNuggets 6 pc. and
Chicken McNuggets 20 pc. we find the following statistically insignificant changes: 2.3% to
1.6%, 5.9% to 5.1% and 2.6% to 1.8%, respectively. Thus, the empirical evidence on the
changes in the price differential for menu items is mixed: for some items the price differential
fell, while for others it remained stable.25
3.2 Explaining the Variation in Price Changes across Items
To explain the observed distinct patterns in different items, we now turn to analyzing the sales
data. In Figure 3 we present a time series of the proportion of cashier transactions, interpreted
as the percentage of customers who bought a particular item for the following meals: Big-Mac,
Quarter Pounder, Chicken McNuggets 6 pc., Fillet-O-Fish as well as a combined measure of
the Dollar Menu items; namely, Double Cheeseburger and the McChicken sandwich. Each
item measure is normalized based on its own August 2002 sales – the month prior to the in-
troduction of the Dollar Menu. The percentage of customers purchasing Double Cheeseburger
skyrocketed from from 0.4% to 14.6% between August 2002 to March 2004. Also, the propor-
tion of McChicken transactions increased from 11.17% to 21.44%.26 Over the same period of
time the proportion of transactions in which the Big-Mac meal was sold dropped from 8.69%
to 5.8%. On the other hand, meals with fairly stable share in the store transactions have not
experienced a change in their price differential.27 For example, the proportion of transactions
for the Fillet-O-Fish changed slightly from 3.89% to 3.84%. Overall, the Figure strongly sug-
gests that the increase in sales of the Dollar Menu items is largely driven by customers who
had substituted from the Big-Mac and the Quarter Pounder meals.28
25
The observed changes in prices between 1999 and 2006 may be driven by changes only in a subset of
the outlets in our sample. To check whether price outliers drive our results, we perform the regression analysis
excluding observations with the highest and lowest prices. We find that the results are unchanged. Furthermore,
the results are almost identical if we only use data from outlets that operated in both time periods.
26
One explanation for this difference is the fact that the price of the McChicken sandwich has not changed,
whereas the price of the double cheeseburger dropped by 50% following the introduction of the Dollar Menu.
The prices of the Big Mac, Quarter Pounder and McNuggets 6pc. meals were the same with identical 3 price
increments occurring between August 2002 and March 2007. The total price change was 30 cents, roughly 7%.
The Fillet-O-Fish meal price also changed 3 times over the period by 30 cents, an overall increase of 8%.
27
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”, 01/28/03.
28
We also conducted a survey among 104 undergraduate students to explore the substitution patterns between
the Chicken McNuggets meal, the Big-Mac meal and the Dollar Menu items. The survey itself and the results
9Importantly, using panel data with observations from the same geographic area en-
ables us to rule out alternative explanations which rely on time-invariant unobservable price
determinants including unobservable factors affecting the decision where to locate corporate
and franchised outlets. Furthermore, since the price differentials of only a subset of the items
changed, a possible alternative explanation should be based on a change in unobservables af-
fecting only this subset of items.29 A potential concern is that the ownership structure of
franchised outlets changed between 1999 and 2006.30 As can be seen in Panel B of Table 3
there were no significant changes in the ownership structure. Accordingly, when we include
the number of outlets owned by a franchisee our main results do not change.
We also performed the same basic empirical analysis for Jack-in-the-Box, the only ham-
burger chain in the Santa Clara County, apart from McDonald’s, which operates a mixture
of corporate-owned and franchised outlets. We found that the price differential between fran-
chised and corporate outlets for the Jumbo Jack meal, the signature dish of Jack-in-the-Box,
has fallen significantly from 6% in 1999 to 1.3% in 2006. This finding is consistent with the
introduction of Jack-in-the-Box Value Meal at the end of 2001.
3.3 Repeat Customers Analysis
To shed light on a potential reason why franchisees set higher prices than corporate-owned
restaurants, we analyze prices at franchised and corporate outlets located near and at a distance
from a highway. Our interpretation is that franchised outlets located near highways cater to
fewer repeat customers and face relatively inelastic demand. As such, these franchisees have an
incentive to free-ride on the chain’s reputation by charging higher prices.31 Df ar−f rom−highway,i
are presented in Appendix A: 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 to them. On the other hand, only 53% of the
Chicken McNuggets choosers switched to a Dollar Menu option when it was available. We compare the mean
of the two groups and reject the null hypothesis of mean equality at 1% confidence level.
29
Hence, for example, a change in outlets’ royalties paid to McDonald’s cannot explain the different pat-
terns because an outlet’s royalties are determined based on a total outlet sales rather than on per item basis.
Furthermore, conversations with franchisees confirm that in recent years there were no relevant changes in the
contractual arrangement between franchisees and the chain or in the cost structure of franchisees.
30
A single franchisee owning several franchised outlets may internalize the positive demand externality and
charge lower prices. Alternatively, a franchisee owning several outlets in the same geographical area may choose
higher prices because of internalizing the business stealing effect.
31
The 2000 Bay Area Travel Survey, available at www.mtc.ca.gov, reports that 60% of trips on the 101
Highway, one of the two main highways in Santa Clara County, are not home-work trips. Brickley and Dark
(1987), among others, previously used the distance from a highway as a proxy for repeat business.
10equals one if an outlet is located more than 0.25 miles from a highway exit and zero otherwise.
Specifically, we employ the following SUR heterogenous difference-in-difference specification:
ln(pjit ) =α + γ1 ∗ Df ar−f rom−highway,i + γ2 ∗ Df ranchised,it + γ3 ∗ D2006,it +
γ4 ∗ Df ar−f rom−highway,i ∗ Df ranchised,it + γ5 ∗ Df ar−f rom−highway,i ∗ D2006,it +
γ6 ∗ Df ranchised,it ∗ D2006,it + γ7 ∗ Df ar−f rom−highway,i ∗ Df ranchised,it ∗ D2006,it +
β ∗ Xit + θ ∗ Compit + jit
(2)
The results for the three meals whose price differential were affected by the Dollar
Menu are shown in Table 8. They are consistent with 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 may also suggest that the
introduction of the Dollar Menu was particularly effective in reducing the price differentials of
outlets that initially charged relatively high prices such as those located near a highway. For
example, in 1999 the Big-Mac price differential near a highway was 15.2% (γ2 ) and in 2006 it
fell to 4.5% (γ2 + γ6 ). At outlets located at a distance from a highway, the price differential in
1999 was only 11% (γ2 + γ4 ) and 2.8% (γ2 + γ4 + γ6 + γ7 ) in 2006.32
Finally, to examine pricing decisions when consumers can be characterized as having
highly inelastic demand, we present in Appendix B price data from restaurants located at
airports.33 We find that franchised and corporate-owned restaurants at airports set higher
prices than the restaurants in the Santa Clara county, and that none of them adopted the
Dollar Menu. Given that payments to the chain are determined as percentage of sales, the
chain is probably better off charging very high prices at outlets facing highly inelastic demand.
In particular, this would happen if the additional revenues generated at these locations offsets
32
One might suspect that the effect attributed to repeat business is driven by the higher costs that franchisees
incur near a highway. McDonald’s corporation owns the premises of both franchised and corporate units. The
royalties franchisees pay to the chain are typically determined based on the cohort of the contract rather than on
a particular characteristics of an outlet location. Furthermore, McDonald’s franchisees and the chain purchase
their inputs from the same certified suppliers and at equal terms. Therefore, higher costs near a highway are
unlikely to explain the observed price differentials.
33
The airport data, however, include only post Dollar Menu prices.
11the negative effect on its reputation due to these high prices.34
3.4 The Impact of the Dollar Menu on Revenues and Profits
Though the paper focuses on prices at franchised and corporate-owned outlets, a related ques-
tion is whether all or only a subset of franchisees benefited from the introduction of the Dollar
Menu. If the Dollar Menu was instrumental in coordinating prices among McDonald’s outlets
and in enhancing price uniformity then all franchisees may have increased their profits. Al-
ternatively, the Dollar Menu may have been used to discipline astray franchisees, who would
otherwise gain from their ability to free-ride on the reputation of the chain. In this case, some
franchisees gain and others lose from the introduction of the Dollar Menu. The chain, unlike
franchisees, attempts to maximize franchisees’ revenues because royalties are determined based
on an outlet’s sales.
To shed light on the effect of the Dollar Menu on revenues and profits, we utilize cost
data from the a single franchised outlet. In Figure 4 we present a plot of the revenues and
profits of 20 top selling items normalized to their August 2002 level.35 As can be seen in
the Figure, the increase in outlet revenues were consistently higher than the respective profit
change following the introduction of the Dollar Menu. For example, the revenues increased by
18% between August 2002 and June 2003, whereas profits have increased by only 11%.
4 Discussion and Concluding Remarks
Economists and legal scholars devoted considerable effort to studying the relationship between
vertically related firms, like franchisors and franchisees, and to highlighting potential conflicts
regarding downstream prices. Historically, franchisees have set prices at their own outlets and
the chain could determine prices only at corporate-owned outlets. When choosing prices at its
corporate-owned units, the chain faces a tradeoff between maintaining the chain’s reputation for
low prices and enhancing price uniformity and between the additional profits the chain could
34
Consistent with this view, when Burger King corporation introduced its Value Meal in 2006, it exempted
franchised restaurants located in highly seasonal tourist destinations from offering the Dollar Menu, see Burger
King Corporation v. E-Z Eating (11th Cir. 2009).
35
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 cost of Big-Mac, Double CheeseBurger, 6 McNuggets, small
coke and large fries are: 58, 50, 49, 9 and 28 cents, respectively.
12generate from setting prices that would maximize local profits. Franchisees, who maximize
their outlet profits net of royalties, probably assign a lower weight to the chain’s reputation
than the chain does. Consequently, franchisees may set prices which are sub-optimal from the
point of view of the chain thereby encouraging the chain to affect franchisees’ prices.36 The
tension between upstream and downstream firms was brought in front of the U.S. Supreme
Court in the matter of State Oil v. Khan. In its decision the Supreme Court37 allowed firms,
which were previously prohibited, to set maximum prices at the downstream market.
We exploit the introduction of McDonald’s Dollar Menu in 2002 to test changes in
prices of several items sold at franchised and corporate-owned outlets. We find that the price
differential, defined as the difference between the average price in franchised outlets and the
average price in corporate-owned outlets, fell between 1999 and 2006 only for items that have
good substitutes in the Dollar Menu. For example, the price differential of the Big-Mac meal
decreased from 12.5% in 1999 to 3.2% in 2006, whereas the price differential of the Fillet-O-
Fish remained stable over the same time period. We also show that the price differentials
were larger at outlets located near highways and that the distinct price differentials between
highway and non-highway locations fell in 2006. Thus, our paper offers a potential avenue
through which the U.S. Supreme Court decision in State Oil Company v. Khan affected the
marketplace, suggesting that the Supreme Court decision may have led franchisees (who are
not contractually required) to adopt the Dollar Menu.
Importantly, the improved control of the chain over prices set at its franchised outlets
is not necessarily at the expense of franchisees and may actually result in higher profits for
both the chain and its franchisees. We present evidence from one outlet that supports this
view.
36
There are additional reasons why chains may be interested in influencing franchisees’ prices. First, to
eliminate double marginalization. Second, to increase franchisees’ sales because chains extract their revenues
as a percentage of the sales revenue rather than the profits of franchisees. See, however, Schmidt (1994) who
argues that the chain can determine the combination of competition level and royalty that maximizes the vertical
relationship profits.
37
Overruling Albercht v. Herald Company (1968), 390 U.S. 145.
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15A 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 2007.38 The survey
and a summary of the responses are presented in Figure 1 and Table 1.
Table 1: Survey Response
Big Mac Chicken McNuggets Dbl. CheeseBurger McChicken Enlarged Dbl. CheeseBurger Enalrged McChicken
Meal Meal Dollar Menu Meal Dollar Menu Meal Dollar Menu Meal Dollar Menu Meal
Big Mac Meal 0.18 0 0.39 0.14 0.21 0.07
Chicken McNuggets 0 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 that chose option j from the extended menu conditional on choosing
option i from the base menu. Among the 56 respondents who chose Big-Mac meal as their first choice,
46 (82%) switched to a Dollar Menu option once it was offered to them. On the other hand, only 25
(53%) out of the 47 respondents who chose Chicken McNuggets switched to a Dollar Menu option. We
perform group mean comparison tests and reject in 1% significance level the null hypothesis that the
percentage of respondents who switch to Dollar Menu option is the same for respondents that choose
Big-Mac meal and for those who choose Chicken McNuggets. We reject the null hypothesis even when
we test for mean difference over respondents that visit McDonald’s at least few times a year.
38
We use prices from the only outlet in Santa Clara county that did not introduce the Dollar Menu to control
for price changes in the Big-Mac meal and the Chicken McNuggets meal that occurred following the introduction
of the Dollar Menu.
16Figure 1: 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. Once a week or more
2. Once a month or more
3. A few times a year
4. Hardly ever or never
Answer: ____
Thank you for your cooperation!
17B Airport Data
We collected data from McDonald’s restaurants located in the 35 largest U.S. airports in
September-October 2007. The data indicate whether each restaurant offers the Dollar Menu,
prices of a Big-Mac meal and a Double CheeseBurger, ownership information as well as whether
an airport employee discount is offered. We assume that restaurants located at airports serve
highly inelastic demand.39 Two interrelated implications of facing highly inelastic demand
are higher prices and lower incentive to offer the Dollar Menu. Note also that the chain may
be better off charging high prices if the additional revenues generated more than offset the
potential harm to its reputation.
While 59 out of the 60 McDonald’s restaurants located in Santa Clara County offer the
Dollar Menu, none of the 41 McDonald’s restaurants located at airports chooses to offer it. The
average price (including tax) of a Double Cheeseburger at an airport restaurant is 1.95 dollar
compared to an average price of 1.12 dollar at non-airport restaurants. Another suggestive
evidence that airport restaurants have little incentive to induce repeat business is their usage
of an airport employee discount. Nearly 90% of airport restaurants offer an airport employee
discount. These discounts vary across outlets within an airport and typically depends on the
price of the item.40 By screening airport employees as potential repeating customers that have
more elastic demand, airport restaurants can charge passengers higher prices and not offer
the Dollar Menu. Table 2 displays descriptive statistics of the prices charged at McDonald’s
airport restaurants.41
39
The inelastic demand can be driven by fewer repeat customers, less competition and higher customer
average income. For example, a survey of 1,900 departing passengers at Denver International Airport reports
that, on average, passengers travel through the airport less than four times a year. The report is available at
http : www.f lydenver.com/diabiz/bizops/documents/concesSurvey.pdf
40
The typical discount is calculated as a percentage share of the price, 5% - 10%, although some offer an
absolute price discount. Some restaurants offer different discounts depending on the item price.
41
We also sampled few McDonald’s restaurants in Santa Clara County in September 2007 and verified that
prices have not significantly changed since July 2006.
18Table 2: Summary Statistics - Airport Restaurants
Big‐Mac Meal Double Cheeseburger
Corp. Fran. Corp. Fran.
Mean 5.23 5.92 2.07 1.93
Std. 0.35 0.54 0.25 0.37
10th % 5.03 5.14 1.81 1.49
90th % 5.65 6.81 2.29 2.26
N 4 34 4 34
The Table presents descriptive statistics for the (with tax) nominal Big-Mac meal and the Double
Cheeseburger prices in McDonald’s restaurants located in U.S. airports during September 2007. None of
these restaurants offers the Dollar Menu. Prices are significantly higher at airport restaurants compared
to non-airport restaurants as presented in Table 5
19Table 3: Ownership Structure and Exit/Entry Patterns
Panel A: Entry and Exit Patterns
1999 Exit Entry 2006
Corporate 26 4 0 22
Franchised 36 3 5 38
Panel B: Size of Franchisees
1999 2006
# Outlets/Franchisee # Franchisees # Outlets/Franchisee # Franchisees
11 1 8 1
6 1 7 1
3 2 5 1
1 13 3 1
2 1
1 13
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 distributions of outlets owned by
franchisees in 1999 and 2006. While changes in the number of outlets owned by each franchisee may
lead to changes in their pricing decisions, the data suggest that there were no major changes in the
ownership structure between 1999 and 2006.
20Table 4: Ownership Structure and Outlet Characteristics
Charactersitics Corporate Franchised t-Stat.
Income (zipcode) 78910 73145 1.43
Rent (zipcode) 1204 1126 1.55
Dineout Index (zipode) 167 164 0.30
Population Density (1,000s/Sq. Mile) (zipode) 8.39 8.16 0.76
Proportion of Children (Up to Age 18) (zipode) 0.21 0.21 0.13
% Male (zipode) 0.51 0.51 0.95
% Black (zipode) 0.03 0.03 1.43
Drive Through 0.65 0.67 -0.11
# Seats 87 114 -0.86
Mall 0.04 0.05 -0.14
Playground 0.43 0.33 0.79
Distance from Highway (Mile) 0.57 0.89 -1.79
Far from Highway 0.65 0.77 -0.99
Close BK Competitors 0.14 0.03 1.69
Medium BK Competitors 0.14 0.26 -1.09
Far BK Competitors 0.36 0.28 0.57
Close MD Corp. Competitors 0.09 0.00 1.94
Medium MD Corp. Competitors 0.05 0.00 1.34
Far MD Corp. Competitors 0.09 0.00 1.94
Close MD Fran. Competitors 0.00 0.03 -0.75
Medium MD Fran. Competitors 0.00 0.08 -1.33
Far MD Fran. Competitors 0.00 0.23 -2.23
Close Other Burger Competitors 0.14 0.13 0.09
Medium Other Burger Competitors 0.50 0.38 0.67
Far Other Burger Competitors 0.64 0.77 -0.66
Close Sandwich Competitors 0.09 0.18 -0.93
Medium Sandwich Competitors 0.36 0.08 2.95
Far Sandwich Competitors 0.14 0.46 -2.19
The Table presents characteristics of franchised and corporate-owned outlets in 1999. For example,
the average zipcode income where corporate outlets are located is $ 78,910, whereas it is $ 73,145 for
franchised outlets. The average number of far – within 0.5-1 mile – Burger King competitors is 0.36
for corporate outlets and 0.28 for franchised outlets. We cannot reject the null hypothesis that the two
types of ownership are located in the same environment (p-value=0.14). The right column shows the
t-statistic obtained from testing the null hypothesis that franchised and corporate outlets face the same
corresponding characteristic. Interestingly, the likelihood that a corporate outlet will be located closer
to the highway is significantly higher. Presumably, the chain chooses to locate corporate outlets near
highways to mitigate free-riding concerns by franchisees at these locations.
21Table 5: Summary Statistics - Big-Mac Meal Price in Santa Clara County
1999 2006
Corp. Fran. Corp. Fran.
Mean 3.33 3.77 4.69 4.92
Std. 0.26 0.29 0.13 0.18
10th % 3.24 3.46 4.54 4.65
90th % 3.46 4.11 4.87 5.09
t-stat. 6.01 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. Franchisee’s
price differential, defined as the difference between the average price in franchised outlets and the average
price in corporate outlets, decreased from 44 cents in 1999 to 23 cents in 2006. The standard deviation
of the Big-Mac meal price dropped from 26 cents in 1999 to 13 cents in 2006 for corporate-owned outlets,
and from 29 cents to 18 cents in franchised outlets.
22Table 6: Franchisees’ Price Differential for the Big-Mac Meal - Full Estimation Results
Dependent Variable: ln(Big Mac Meal) Dependent Variable: ln(Big Mac Meal)
D_2006 0.343*** Close Other Sandwich 0.006
(0.016) (0.010)
D_franchised 0.125*** Medium Other Sandwich 0.039***
(0.015) (0.014)
D_franchised*D_2006 -0.093*** Far Other Sandwich -0.003
(0.017) (0.007)
Close BK Competitors -0.070*** Drive Thru 0.016
(0.021) (0.012)
Medium BK Competitors 0.008 # Seats -0.000
(0.014) (0.000)
Far BK Competitors 0.008 Mall -0.028
(0.009) (0.052)
Close MD Corporate 0.020 Playground -0.006
(0.028) (0.013)
Medium MD Corporate 0.013 log(Median HH Income) -0.000
(0.020) (0.000)
Far MD Corporate -0.001 log(Median Rent Contract) 0.000
(0.016) (0.000)
Close MD Franchised -0.072*** Dineout Spending Index 0.001
(0.020) (0.000)
Medium MD Franchised -0.019 Population Density -0.006
(0.034) (0.007)
Far MD Franchised 0.032** % Children 0.088
(0.014) (0.250)
Close Other Hamburger -0.002 % Male 0.479
(0.011) (0.408)
Medium Other Hamburger -0.000 % Black -0.936*
(0.009) (0.566)
Far Other Hamburger 0.002
(0.007)
R2 0.94 N 114
Standard errors in parentheses
*** pTable 7: Franchisees’ Price Differentials
Dependent Variable
ln(Double Quarter ln(Quarter Pounder ln(Fillet‐O‐Fish ln(McNuggets ln(McNuggets
Pounder Meal) Meal) Meal) 6pc.) 20pc.)
D_2006 0.255*** 0.091*** 0.246*** 0.209*** 0.126***
(0.013) (0.013) (0.011) (0.017) (0.010)
D_franchised 0.076*** 0.077*** 0.023** 0.059*** 0.026***
(0.012) (0.012) (0.011) (0.011) (0.009)
D_franchised*D_2006 ‐0.049*** ‐0.063*** ‐0.007 ‐0.008 ‐0.008
(
(0.014)) ((0.014)) ((0.013)) ((0.023)) ((0.011))
24
R2 0.95 0.78 0.95 0.9 0.9
N 115 115 113 107 110
Standard errors in parentheses
*** pTable 8: Price Patterns Near and at a Distance from the Highway
Dependent Variable
ln(Big Mac ln(Double Quarter ln(Quarter Pounder
Meal) Pounder Meal) Meal)
D_far_from_highway (γ ) 0.049 0.041* 0.036*
1
(0.032) (0.021) (0.021)
D_franchised (γ 2 ) 0.152*** 0.120*** 0.126***
(0.028) (0.014) (0.016)
D_2006 (γ 3 ) 0.360*** 0.276*** 0.130***
(0.017) (0.013) (0.018)
D_far_from_highway*D_franchised (γ 4 ) -0.042 -0.065*** -0.070***
(0.039) (0.024) (0.024)
D_far_from_highway*D_2006 (γ 5 ) -0.028 -0.033 -0.060**
(0.034) (0.026) (0.026)
D_franchised*D_2006 (γ 6 ) -0.107*** -0.077*** -0.120***
(0.032) (0.018) (0.023)
D_far_from_highway*D_franchised*D_2006 (γ 7 ) 0.025 0.048 0.087***
(0.044) (0.030) (0.031)
R2 0.93 0.92 0.71
N 114 110 110
Standard errors in parentheses
*** pFigure 2: McDonald’s Big-Mac Meal Price Distributions
McDonald’s 1999 Big−Mac Meal Price Distributions
0 .01 .02 .03
Density
300 350 400 450 500 550
Price
Franchised Outlets Corporate Outlets
McDonald’s 2006 Big−Mac Meal Price Distributions
0 .01 .02 .03
Density
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. It is easily observable how the two price
distributions approached each other from 1999 to 2006.
26Figure 3: % of Transactions for Different Menu Items
Sales Data − % of Transactions
Index August 2002 = 100
% of Transactions
60 80 100 120
Jan−2002 Jan−2003 Jan−2004 Jan−2005 Jan−2006
Date
6 McNuggets Meal Fillet−O−Fish Meal
BigMac Meal Quarter Pounder Meal
% of Transactions
300
100
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. In the lower part of the figure,
we display the percentage of transactions of the Dollar Menu items: the Double Cheeseburger and the
McChicken. The percentages of 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 figure demonstrates two interesting patterns. First, the sales of the Dollar Menu as a percentage of
the transactions tripled in the observed period. Second, the sales of the Big-Mac meal and the Quarter
Pounder meal as percentage of the transactions dropped abruptly after the Dollar Menu introduction,
whereas the percentage revenue figures of the Fillet-O-Fish meal and the McNuggets meal remained
relatively stable.
The value used as the bandwidth is 0.3.
27Figure 4: Revenues and Profits Before and After the Dollar Menu
Revenue and Profit
Index August 2002 = 100
120
110
100
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 most selling items
between June 2001 and June 2006 in a single franchised outlet. These measures were normalized to 100
in August 2002. The Figure shows that the Dollar Menu had a positive impact on both revenues and
profits, though the effect on revenues is larger.
The value used as the bandwidth is 0.3.
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