Understanding a Market Equilibrium: Challenges for Restaurants

Something seems to be happening in the US restaurant market. Lots of well-known chains are closing “under-performing” locations while others are asking for bankruptcy protection. [1] [2] [3] Even in Canada, some news items talk about restaurants offering discounts to “bring customers back” because “eating out is expensive”.

This post notes that change is common in the restaurant business and, in a market equilibrium, companies must think carefully about the prices they charge [1]. In more extreme situations, they must think about the shutdown decision. It is also true that turnover should be expected. It might even be welcomed.

An important feature of the restaurant market is low barriers to entry. Almost anybody who thinks that they are a good cook, who thinks that the market is not serving a certain type of cuisine and who has enough money can open a restaurant. Existing restaurants worry that their head chef or their skilled staff may be hired away by competitors. Even a good reputation may have little effect in the long term, because of online reviews on Yelp or Google.

If you apply a bit of imagination, you will also notice the growth of things that act like restaurants. Food trucks imply that the “restaurant” can move from place to place during the day, to take advantage of opportunities. Grocery stores offer a growing selection of ready-to-eat foods. The growth of delivery services means that pizza is no longer the only food which can be delivered at 3:00am. Ghost kitchens prepare a wide variety of cuisines.

So, even if the restaurant market does not fit the textbook definition of a “perfectly competitive market”, there is no reason to expect independent restaurants to earn “excess profits”. 

There is also some debate about whether the failure rate of restaurants is high or very high and whether survival for the first five years makes it easier to survive for the next five years.

Some evidence shows that, in March 2023, 51% of restaurants were losing money or “breaking even”. It is easy to blame individual restaurants for their failings. The brands which are closing locations are shutting them selectively. Other explanations include

• Covid: It had a drastic effect immediately. Restaurants which survived incurred a lot of debt, which became much more expensive when interest rates rose.
• Poor menu pricing and selection: who knew that “swicy” food (sweet and spicy) is a thing.
• Staffing problems

One website advises “By making the appropriate financial cuts for your equipment, utilities, labor, ingredients, and other expenses, you will be able to maintain your budget.” I am not sure what this statement contributes since, for reasons discussed in Economics classes, operational efficiency is important at all times.

Some websites advise using technology to overcome the problem of poor financial performance. This advice a disguised application of some jargon: i.e., the distinction between short-run and long-run decision making with an emphasis on capital-labour substitution. Maybe the next step is to replace some staff with robots [1] [2].

This jargon is important because economics classes also teach that technology is not a long-run solution to low profits, especially when everybody in the industry can buy the same technology. Low barriers to entry imply that profits are never going to be great: if the industry were fantastically profitable then more restaurants would open until it was not so profitable. Operational efficiency is important to continued survival, not just a “nice idea”, and profit is an incentive.

In a market economy, turnover reallocates resources. The people who work at the restaurants which are closing will find jobs elsewhere: there are labour markets. Kitchens which prepare Chinese food can be converted to prepare gourmet swicy burgers (until that fad fades): there are real estate markets. Investors worry about the allocation of financial capital and, if you want, you can listen to reports with advice on which of the companies which own the big restaurant brands are likely to generate a high financial rate of return.

Now, it’s your turn to write

• In your opinion, is there an overlooked opportunity in the restaurant market? How would you know if there is enough market demand, or if this “opportunity” is an example of a market failure?
• This post has focused on independent restaurants mostly, even if there are many restaurant chains. Do you know what they think about when they update their menus? Who earns the profit: local franchisee, head office, or investors?
• In a market equilibrium, how do restaurant find the balance the pressure to lower prices (to attract customers) with the pressure to raise prices (to cover the increased costs of foods and wages)?
• If you worked at a restaurant, and were worried that it was going out of business, what could you do?