Fast Food and Downward-Sloping Demand Curves

A pair of recent news articles concerning popular fast-food restaurants noted differences for different brands. First, McDonald’s restaurants are changing tactics because consumers (in the US especially) are feeling stressed by the economy. Second, even if the Canadian economy is also performing poorly, Restaurant Brands International Inc. (RBI, which oversees Tim Hortons, Burger King and many other brands in Canada) posted good news for its shareholders. These two bits of news create an opportunity to do some back-of-the-envelope calculations and to demonstrate the power of economic reasoning.

The short version of the news stories is that McDonald’s is emphasizing lower priced items on its menu in response to underwhelming financial performance while RBI is happy with its financial results and plans no big changes. Media reports often repeat what is said in a news release written by the company. If you have access to independent sources of information, it is possible to ask deeper questions concerning market conditions and business strategy.

Statistics Canada publishes monthly data on sales revenue by different types of restaurants (a.k.a. “Food Services and Drinking Places” which includes “Limited-service eating places” (i.e., fast food restaurants)) [1] [2] [3]. So, what does that data reveal?

Compared to sales one year ago, sales in May 2024 (i.e., revenue, not the number of hamburgers or donuts sold) in Canada were up by 6.4 percent; by more than the combined effect of general rate of inflation and population growth. (Please see this Excel worksheet with information from Statistics Canada.)

This result surprises me since neither economy is growing particularly fast. The shift of the demand curve should be near zero since (I assert) the quantity demanded for restaurant meals displays a positive but not large income elasticity: say, between 0.5 and 1.0.

(In other words, I offer this assertion as a “planning assumption” which may be confirmed or refuted by somebody with access to better data. The number seems reasonable to me since lower-priced restaurants are not an expression of luxury (which might imply an income elasticity greater than 1.0) and since buying food from a grocery store or buying less food is always an option.)

The greatest percentage increase is found in New Brunswick and the smallest increase is in Manitoba. Why? I do not know enough about the changes in taste or income by province. Or, it could be random variation.

The more interesting questions are related to competition. McDonald’s and Tim Hortons may not be competing directly, but consumers have a choice. Since some consumers are loyal to one brand and not the other, the competitive fight is over the middle. For this reason, it is reasonable to assume that the demand curve for each firm is elastic. For purposes of a back-of-the-envelope calculation, suppose that the price elasticity of each is -1.5.

If so then a 5 percent decrease in the price charged would increase quantity demanded by 7.5 percent: total revenue would rise. The effect on profits depends on whether the increase in the volume of sales offsets the decrease in profit margin. This consideration may explain why McDonald’s chooses to emphasize the lower price items on its menu, which presumable also cost less.

In reality, the elasticity may be higher for two reasons. First, since both brands claim to offer convenience, both are aware that customers can switch easily. Second, and again without any direct evidence, the mark-up over marginal cost is unexpectedly high. There is a rule which derives the optimal mark-up and, if the elasticity is -1.5 then the implied mark-up would be 40 percent (over marginal cost). Without having any special evidence, that seems a bit high to me.

You should wonder why McDonald’s emphasizes a pricing solution rather than directing customers with their already-considerable advertising budget. An obvious answer is: diminishing marginal returns. The resources already being spent are having an effect and spending more is not necessarily justified.

Finally, if the news were about a different company then you might wonder why they don’t close their least profitable locations. Regardless of what you may think about a company like McDonald’s being powerful enough to resist market forces, searching online reveals many examples where they close a restaurant.

Now, it is your turn.

1. The information from Statistics Canada is useful and very broad. Do you know of any (easy-to-access or free) information sources with data which offers more precise insights into the differences between different brands. Which differences justify different business strategies?
2. The discussion above offered a way to estimate the optimal mark-up over marginal cost, if you knew price elasticity. Does any public information source provide such information?
3. A more radical change in strategy would be to change the menu. Both McDonald’s and Tim Hortons have experience with removing items from their menus (e.g., for McDonald’s, salads; for Tim Hortons, favoured types of donuts which are offered temporarily as nostalgia). Both have experience adding items to their menus (e.g., for McDonald’s, coffee and pizza; for Tim Hortons, sandwiches and soups).
4. The Statistics Canada data shows that the revenue for fast-food restaurants is growing at a different rate than the revenue for traditional restaurants. Why might that be true? Can you find evidence to verify your conjecture? Since RBI owns a portfolio of brands, what implications can you foresee?