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. Fortranscript see http : //seekingalpha.com/article/6176 − mcdonalds − q4 − 2005 − earnings − conference −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 fran-

chisor’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 ac-

knowledge 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 McDon-

ald’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 restau-

rants. 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 McDon-

ald’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 profit-

maximizing 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 restau-rants 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 thegasoline 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 Mc-

Donald’s outlets located near versus at a distance from highways. Outlets located near high-

ways are less likely to draw repeat customers, and franchisees have lower incentives to inter-

nalize 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. Consis-

tent 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 impor-

tant 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 orga-

nizational 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 orga-

nizational 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 litera-

ture (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 down-

stream 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 addressthese differences include Brickley & Dark (1987), Brickley (1999), Klein & Leffler (1981), Kalnins (2004) andLafontaine & 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 Cor-

poration 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 underthe Franchise Agreements to impose the Value Menu on its franchisees.” Burger King Corporation v. E-ZEating (11th Cir. 2009). See also the 1997 U.S. Supreme Court decision in State Oil Company v. Khan, whichallowed 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.

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-the-

Box, 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-N-

Out, 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 characteris-

tics 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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geographically clustered by ownership type. Geographical proximity may help multi-unit own-

ers 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 out-

lets. 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 Empirical Analysis

3.1 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

8We also sampled a few McDonald’s restaurants in Santa Clara County in September 2007 and verified thatprices had not significantly changed since July 2006.

9In contrast, none of the 41 McDonald’s restaurants located in U.S. airports, including two corporate-owned airport restaurants, offer the Dollar Menu. Table 3 provide descriptive statistics for McDonald’s airportrestaurants. One possible explanation for this finding is that restaurants facing highly inelastic demand, forexample, due to fewer repeat customers, are less concerned about disappointing their customers by not adoptingthe advertised Dollar Menu. Indeed, when Burger King Corporation introduced its Value Meal in 2006, itexempted franchised restaurants located in highly seasonal tourist destinations from offering it.

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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 in-

store 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 be-

tween 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

10The price of the McChicken sandwich has not changed, while the price of the double cheeseburger hasdropped by 50% following the introduction of the Dollar Menu. The prices of the Big Mac, Quarter Pounderand 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 theperiod, by 30 cents, for an overall increase of 8%.

11Matthew Paull, McDonald’s CFO at the time the Dollar Menu was introduced, acknowledged in a conferencecall 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 QuarterPounder with Cheese. We’re not thrilled with that.” Restaurant Business, 01/28/2003.

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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 Price Patterns in 1999 and 2006

3.3.1 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 be-

tween 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 inde-

pendently by each franchisee while after it was introduced, the price variation of the Dollar

12Putting aside cost considerations, pricing decisions at both franchised and corporate outlets balance localdemand conditions with the chain’s overall interest in maintaining uniform prices, or targeting a certain pricelevel. Naturally, pricing decisions at corporate restaurants assign less weight to outlet-specific demand conditionscompared with decisions of franchisees. Consequently, there is less price variation across corporate outlets thanacross franchised outlets.

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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:

ln(pijt) = α+γ∗D2006,jt+δ∗Dfranchised,jt+η∗D2006,jt∗Dfranchised,jt+β∗Xjt+∑k

θk∗Compjtk+εijt

(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. Dfranchised,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

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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′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

13Specifically, other distance thresholds used to test the robustness of the results are: 0.1-1-2, 0.5-1-2 and1-2-3. For example, 0.1-1-2 implies that close competitors are within 0.1 miles of an outlet, medium competitorsare within 0.1-1 mile, and far competitors are 1-2 miles away.

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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.

14Ownership structure might affect pricing decisions because a single franchisee, owning several outlets, mayinternalize the positive demand externality and charge lower prices. Alternatively, a multi-unit franchisee in thesame 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 ham-

burger 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 signif-

icantly, 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 accord-

ing 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, Dfar−from−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

15The 2000 Bay Area Travel Survey reports that 60% of trips on the 101 Highway, oneof the two main highways in Santa Clara County, are not home-work trips. See Table7.3 in RVAL2000 Validation Technical Summary 2.pdf which can be downloaded from ftp ://ftp.abag.ca.gov/pub/mtc/planning/forecast/RV AL2000/PDF validation report.zip. Last accessedon 12/01/2011. The variable Dfar−from−highway,j exhibits significant variability for both franchised andcorporate outlets. In 1999 the share of franchised outlets located near a highway was 18%, whereas the shareof corporate outlets near a highway was 28%. The corresponding numbers in 2006 were 19% and 29%.

14

specification:

ln(pijt) =α+ γ1 ∗Dfar−from−highway,j + γ2 ∗Dfranchised,jt + γ3 ∗D2006,jt+

γ4 ∗Dfar−from−highway,j ∗Dfranchised,jt + γ5 ∗Dfar−from−highway,j ∗D2006,jt+

γ6 ∗Dfranchised,jt ∗D2006,jt + γ7 ∗Dfar−from−highway,j ∗Dfranchised,jt ∗D2006,jt+

β ∗Xjt +∑k

θk ∗ Compjtk + εijt

(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

16Conversations with franchisees support the usage of these proxies for repeat business. Wireless service wasnot offered in 1999, and we treat outlets that offer wireless service in 2006, as catering to consumers with atendency to repeat both in 1999 and 2006.

16

models on vertical restraints typically emphasize that manufacturers aim to soften price com-

petition 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 exclu-

sive 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 associ-

ated 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 cor-

responding 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

17Notably, this literature identifies a different type of free-riding behavior that focuses on the incentives ofretailers 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 study-

ing 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 fran-

chisees’ 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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A. Kalnins (2010). ‘Pricing Variation within Dual Distribution Chains: Evidence and Expla-

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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

1999 Exit Entry 2006Corporate 26 4 0 22Franchised 36 4 6 38

Panel B: Number of Franchisee Outlets

Franchisee ID 1999 20061 11 82 6 73 3 54 3 35 0 26 1 17 1 18 1 19 1 110 1 111 0 112 1 113 1 114 1 115 1 116 1 117 1 118 1 119 1 0

Panel A presents entry and exit patterns of McDonald’s outlets in Santa Clara County, divided intofranchised and corporate-owned outlets. In panel B we show the number of outlets operated by eachfranchisee in 1999 and 2006.

22

Table 2: McDonald’s Outlet Characteristics

Characteristics Corporate Franchised t-Stat.(N=26) (N=36)

Income (ZIP code) 78910 73145 1.43 Rent (ZIP code) 1204 1126 1.55 Dineout Index (ZIP code) 167 164 0.3 Population Density (1,000s/Sq. Mile) (ZIP code) 8.39 8.16 0.76 Proportion of Children (Up to Age 18) (ZIP code) 0.21 0.21 0.13 % Male (ZIP code) 0.51 0.51 0.95 % Black (ZIP code) 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 (Miles) 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**All Characteristics 1.47*** p<0.01, ** p<0.05, * p<0.1

The table presents characteristics of franchised and corporate-owned outlets in 1999. The right columnshows the t-statistic obtained from testing the null hypothesis that the mean values of the correspondingcharacteristic are equal in franchised and corporate outlets.

23

Table 3: Characteristics of Airport Restaurants

Corp. Fran. Corp. Fran.Mean 5.23 5.92 2.07 1.93Std. 0.35 0.54 0.25 0.3710th % 5.03 5.14 1.81 1.4990th % 5.65 6.81 2.29 2.26N 4 34 4 34

Big Mac Meal Double Cheeseburger

The table presents descriptive statistics for the (with tax) nominal Big Mac meal and Double Cheese-burger 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

Corp. Fran. Corp. Fran.Mean 3.33 3.77 4.69 4.92Std. 0.26 0.29 0.13 0.1810th % 3.24 3.46 4.54 4.6590th % 3.46 4.11 4.87 5.09t-stat.

1999 2006

6.01 4.91

The table presents descriptive statistics for the (with tax) nominal Big Mac meal prices that werecollected 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

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

Dependent Variable: ln(Big Mac Meal)

2R

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)

M di MD C t 0 013 l (M di HH I ) 0 000

2R

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)

2R

(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 Constant 5.266***

(0 007) (0 245)2R

(0.007) (0.245)

0.94 N 114

*** p<0.01, ** p<0.05, * p<0.1Standard errors in parentheses

2R

The table contains the full set of regressors from Equation 1 for which the logarithm of the Big Macmeal price is used as the dependent variable.Standard errors are in parentheses. Errors are clustered by outlet.

25

Tab

le6:

Tes

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r Mea

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c.)

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.)D

_200

60.

255*

**0.

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246*

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209*

**0.

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**(0

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.013

)(0

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)(0

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)(0

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)D

_fra

nchi

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0.07

6***

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7***

0.02

3**

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9***

0.02

6***

(0.0

12)

(0.0

12)

(0.0

11)

(0.0

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D_f

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_200

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***

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26

Table 7: Testing Changes in Price Differentials of McDonald’s Meals Near and at a DistanceFrom a Highway

Dependent Variable ln(Big Mac ln(Double Quarter ln(Quarter Pounder

Meal) Pounder Meal) Meal)D_far-from-highway 0.040* 0.031* 0.025*

(0.027) (0.018) (0.018)D_franchised 0.170*** 0.119*** 0.125***

(0.033) (0.014) (0.015)D_2006 0.358*** 0.272*** 0.125***

(0.018) (0.012) (0.017)D_far-from-highway*D_franchised -0.061* -0.058** -0.062***

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

(0.041) (0.023) (0.024)D_far-from-highway*D_2006 -0.020 -0.023 -0.050**

(0.030) (0.023) (0.024)D_franchised*D_2006 -0.116*** -0.082*** -0.124***

(0.035) (0.017) (0.022)D_far-from-highway*D_franchised*D_2006 0.034 0.047* 0.086***

(0.044) (0.027) (0.029)0.93 0.92 0.7

N 114 110 110Standard errors in parentheses

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

*** p<0.01, ** p<0.05, * p<0.1p

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

The table presents the estimation results of Equation 2 which is the SUR heterogenous difference-in-difference specification that allows the change in the price differential to vary across outlets locatednear and at a distance from a highway. The dependent variable in each column is the logarithm of theprice of the Big Mac, Quarter Pounder and Double Quarter Pounder meals, respectively. The dummyvariable Dfar−from−highway,j equals 0 if outlet j is closer than 1/4 of a mile from a highway exit and 1otherwise. In addition to the covariates presented in the table, the set of control variables included ineach 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 Corporate FranchisedFar from Highway 15 30Playground 8 15Wireless Service 21 27All Proxies Combined 5 7N 21 37

The table presents the number of outlets characterized by repeat-customer proxies in 2006. Outlets aredivided according to ownership structure.

27

Table 9: Testing Changes in Price Differentials for the Big Mac Meal using Various Proxiesfor Repeat Customers

Playground Wireless All Proxies Presence Service Combined

D_repeat 0.039 0.061** 0.063*(0.036) (0.028) (0.047)

D_franchised 0.151*** 0.193*** 0.152***(0.015) (0.026) (0.014)

D_2006 0.356*** 0.357*** 0.353***(0.010) (0.019) (0.011)

D_repeat*D_franchised -0.059* -0.076** -0.104*

Repeat Business Proxies

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

(0.039) (0.037) (0.054)D_repeat*D_2006 -0.031 -0.018 -0.043

(0.031) (0.015) (0.048)D_franchised*D_2006 -0.105*** -0.130*** -0.107***

(0.018) (0.026) (0.017)D_repeat*D_franchised*D_2006 0.026 0.046* 0.057

(0.038) (0.028) (0.052)

0.93 0.93 0.93N 114 107 107Standard errors in parentheses

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

*** p<0.01, ** p<0.05, * p<0.1p

)( 1γ

)( 2γ

)( 3γ

)( 4γ

)( 5γ

)( 6γ

)( 7γ

2R

The table presents the estimation results of Equation 2, which is the SUR heterogenous difference-in-difference specification that allows the change in the price differential to vary across outlets distinguishedby the extent to which they have repeat customers. The dependent variable is the logarithm of the BigMac meal price. The repeat-customer proxies utilized are the presence of a playground, the availabilityof wireless service and a variable that intersect the two proxies mentioned here and the distance froma highway. In addition to the covariates presented in the table, the set of control variables included ineach 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

Dollar Menu Introduction

6080

100

120

% o

f Out

let

Tra

nsac

tions

Jan−2002 Jan−2003 Jan−2004 Jan−2005 Jan−2006

Date

6 McNuggets Meal Fillet−O−Fish Meal

BigMac Meal Quarter Pounder Meal

Index August 2002 = 100

Dollar Menu Introduction100

300

% o

f Out

let

Tra

nsac

tions

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 waspurchased over the period of October 2001 - March 2006 in a single franchised outlet. The percentageof transactions for each item was normalized to 100 in August 2002 - the month before the Dollar Menuwas introduced. In the lower part of the figure, we display the percentage of the outlet transactions forthe Dollar Menu items: the Double Cheeseburger and the McChicken. The percentages of the outlettransactions for the regular menu items are shown in the upper part of the figure. The Dollar Menuintroduction date in September 2002 is marked by a thick vertical black line.The value used as the bandwidth is 0.4.

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Figure 2: McDonald’s Big Mac Meal Price Distributions

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sity

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Price

Franchised Outlets Corporate Outlets

McDonald’s 1999 Big−Mac Meal Price Distributions

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sity

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Franchised Outlets Corporate Outlets

McDonald’s 2006 Big−Mac Meal Price Distributions

The figure plots the kernel density of the Big Mac meal price, estimated separately for franchised andcorporate-owned outlets for the time periods 1999 and 2006.

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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 Chicken McNuggets Dbl. CheeseBurger McChicken Enlarged Dbl. CheeseBurger Enalrged McChickenMeal 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 0.07Chicken 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 tableis the proportion of respondents who chose option j from the extended menu conditional on choosingoption i from the base menu.

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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. 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!

The survey displayed above was filled out by the students. Note that the first question should havebeen “Which one of the two meals above would you choose?”.

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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.

18We observe monthly cost data for 2007 only. Thus, the cost data used to calculate profits are taken from arandomly selected month. For example, the unit costs of Big Mac, Double CheeseBurger, 6 McNuggets, smallCoke and large fries are: 58, 50, 49, 9 and 28 cents, respectively.

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Figure B1: Revenues and Profits Before and After the Dollar Menu

Dollar Menu Introduction

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Jan−2001 Jan−2002 Jan−2003 Jan−2004 Jan−2005 Jan−2006

Date

Revenue Profit

Index August 2002 = 100

The figure plots the smoothed time series of revenues and profits based on the 20 top-selling itemsbetween June 2001 and June 2006 in a single franchised outlet. These measures were normalized to 100in 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.

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