Ann is a monopoly franchisee of ‘€œBob’€™s Best Burgers’€ and owns a single restaurant.
The franchisee can choose to make an investment I ‘ˆˆ [0, 240] to retrofit her restaurant which will increase the overall quality of the dining experience. Based on calculations from similar restaurants, if Ann chooses an investment level I, she faces an (inverse) demand curve of:
P(Q, I) = 120 + 2I ‘ˆ’ Q,
1
where P is the price that can be charged given an investment of I and an amount of food sold Q. Ann has written a contract with Bob that promises 50% of revenue in exchange for usage of the brand. Thus, Ann’€™s total revenue is given by
R(Q, I) = 1
2
(120 + 2I − Q)Q.
Given Q units of food sold and an investment of I, the franchisees costs are given by:
C(Q, I) = 1
2
Q
2 +
1
2
I
2 + 200.
The franchisee is thus trying to maximize:
πA(Q, I) = R(Q, I) − C(Q, I) = 1
2

(120 + 2I − Q)Q − Q
2 − I
2 − 400
Question 1: (8 points)
Graph the (inverse) demand function when I = 30 and I = 60. Using the graph, show
what price Ann could set if she wanted to sell 120 units with each investment level. Suppose that Ann is trying to maximize her own profits. Find the quantity Q and investment
I that maximizes her profits.1 How much profit does Ann make? How much profit does
Bob make?
Question 2: (8 points)
Suppose that as part of the contract, Bob (the franchisor) is allowed to enforce any
investment level I that he sees fit but cannot prevent Ann from shutting down if her
franchise is not profitable. For any I, Bob’s profit is equal to
πB(Q, I) = 1
2
(120 + 2I − Q(I))Q(I),
where Q(I) is the quantity Ann chooses to sell given that she is forced to invest I. What
investment level should Bob choose if he wishes to maximize his profits? What quantity
and price does Ann chose? What is Bob’s profit in this case? You should assume in this
problem that the 200 is a fixed cost that can be saved if Ann shuts down.
1This problem requires the use of a partial derivative. To solve the problem, fix the Quantity Q and
maximize profit with respect to I. Next, fix the investment I and maximize profit with respect to Q. Use the
two resulting equations to find the best Q and I.
2
Question 3: (8 points)
Suppose that Bob is able to offer a contract where he does not take a share of Ann’s
revenue but instead requires Ann to pay a fixed franchise fee of K. If the maximum
amount of investment Ann can put in is I = 240, what is the largest fixed franchise fee
that Bob could charge Ann?2 Could Bob do better if he also tried to constrain Ann’s
investment choice?
Question 4: (8 points)
Suppose Ann converts her agreement to one where she agrees to pay Bob 80, 000 to
operate her franchise over the next 10 years with no revenue sharing. In the second year
of this contract, Bob is approached by Charles who wishes to open a “dark restaurant”
which will deliver Bob’s Best Burgers to customers at home from a warehouse location
that has no shop front. Why are these dark restaurants likely to provide delivery services
at lower cost? Explain how Bob’s incentives have changed as a result of Ann’s decision
to convert her contract. Why is Ann’s restaurant likely to continue to run even if the new
delivery service cannibalizes her customers.
Part B: Concepts
Please answer each of the following two questions using concepts that you have learned
from class. We are looking for only 3-4 sentences that identify the economic issue and how
it is likely to play out in the franchise market.
Question 5: (6 points) Franchisees often argue that they are “stuck” with franchises that
they cannot exit. Franchisors argue that this cannot be true because the franchise system
is very flexible and it is always possible to resell a franchise to a new owner.
Many franchisees report that it is “dangerous” to buy a second hand franchise because
accounting standards are poor and sales and profit numbers are often misstated. Explain
how these issues are likely to influence the market for second hand franchises.
Question 6: (6 points) The government has found that many franchisers have exploited
migrant labour and have systematically underpaid them relative to legal requirements.
Why is this likely to be a particularly common issue in franchise systems where the franchisor takes a share of revenue?
2Hint: in this problem, the profit function will be convex in Q once you find the optimal investment and
thus you will not be able to just solve the problem by taking the derivatives and setting them equal to zero
(you will get a negative quantity and find a minimum.). Instead, first argue that Ann will want as large an
I as possible (i.e., I = 240) and then solve for Q.
3
Part C: Third-Degree Price Discrimination
Consider a firm who produces antiretroviral drugs to mitigate the impacts of HIV. The
firm has two potential markets: Australia and Africa. In the two markets, the demand
curves are:
QAus = 100 − P (1)
QA f rica = 296 − 10P (2)
The firm has a constant marginal cost of 20 per unit
Question 7: (8 points) Suppose that there are intermediaries in the market who are able
to buy medicine in Africa and resell it in Australia at zero marginal cost. These intermediaries prevent the firm from price discriminating.
Draw the firms aggregate demand curve being careful to recognize that for high prices
the African market will be shut down. Using this curve, calculate the price that maximizes
the firm’s profit.
Question 8: (8 points) Suppose that the Australia government passes a law that does not
allow for the re-importation of medicine that has been sent to Africa. What prices will the
firm set if it is able to price discriminate? Calculate the consumer surplus for consumers
in Africa and Australia. Is each group better off, worse off, or unaffected by allowing
price discrimination? Calculate the firms profit: is the firm better off or worse off?
Are consumers in Africa better off, worse off, or unaffected by allowing price discrimination? Are consumers in Australia better off, worse off, or unaffected by allowing price
discrimination? Is the firm better off or worse off?
End of Problem Set
4
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MCDONALD’S FRANCHISEES DUMP
ONDELIVERY
‘OUR MARGINSDO NOT ALLOWFOR THE COMMISSIONS THATUBER IS
TAKING,
‘WARNS OWNERSGROUP
February 19, 2019 12:51 PM
McDonald’s franchisees are concerned about the company’s delivery model.
McDelivery on UberEats Credit: Uber
Delivery is a high priority for McDonald’s CEO Steve Easterbrook, and a big worry for
franchisees.
Easterbrook expects a rapidly expanding delivery partnership with UberEats to drive
sales growth. Franchisees grumble that delivery costs put more pressure on their
tight profit margins.
“Our margins do not allow for the commissions that Uber is taking nor the added rent
and service fees McDonald’s is enjoying,” a newly formed organization representing
most U.S. franchisees told members last month in an email obtained by Crain’s.
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“Delivery is a growing segment of our business and it will one day cannibalize our on
premise restaurant sales. If we allow this to occur under the current arrangement,
our net cashflow will go down.”
The dispute over delivery marks another flashpoint in the increasingly tense
relationship between Easterbrook and franchisees who bear much of the cost of his
effort to remake McDonald’s as a “modern, progressive burger company.” Restaurant
owners are spending up to $315,000 per restaurant to remodel their stores to
corporate-mandated standards that include $965 chairs and the construction of a
wall separating the kitchen from customers, install self-order kiosks and buy new
refrigerators to store non-frozen beef. That comes on top of steadily rising labor and
food costs.
The tensions arise from a conflict baked into McDonald’s business model: The
company makes money off top-line sales, but franchisees make money only if their
sales exceed their costs. When headquarters issues edicts designed to boost sales,
they often create new expenses that eat into franchisees’ profits.
After McDonald’s shifted almost all stores to franchises in an effort to boost
corporate-level profitability, those owners now control 95 percent of its restaurants.
In October, many franchisees voted for the first time in McDonald’s history to form an
independent association. The National Owners’ Association drew about threequarters of the chain’s 1,700 U.S. franchisees to its second meeting in December. The
group is advocating for reduced remodeling costs and a change to the delivery deal,
among other issues.
The stakes are rising quickly. Delivery has become a $3 billion global business for the
fast-food giant over the past two years, and “we’ve been moving at a pace that is
unprecedented in the McDonald’s system” to expand delivery, Easterbrook said on an
earnings call last summer. More than 19,000 locations globally now offer delivery—up
144 percent in 18 months—including about 8,000 U.S. restaurants.
“We are confident that delivery offers additional growth potential for our business,”
Easterbrook told analysts in late January. “Even with the momentum we already have
established, we know we have an opportunity to let more customers know that
McDonald’s will bring meals to their homes, offices and college dorm rooms.”
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McDonald’s says delivery orders are about twice the size of an average in-restaurant
check. Easterbrook argues delivery also will spur customers to order more frequently.
Franchisees say they understand that delivery is critical to future growth but warn it
will cannibalize existing sales eventually. They also say the current deal unfairly
benefits UberEats and McDonald’s. Right now, UberEats takes a 20 percent cut of
every order, according to three franchisees who requested anonymity. Franchisees
pay that fee. Then McDonald’s comes in to take its cut.
McDonald’s charges franchisees a 5 percent royalty on every sale. It also requires its
franchisees to lease their locations from the company, with rent based on a
percentage of sales, usually about 10 to 12 percent. Franchisees gripe that McDonald’s
is currently charging royalties and rent on the full amount of the order, including the
20 percent they never see. This whittles an already slim profit margin to untenable
levels, they say.
In a survey by the National Owners’ Association, 785 franchisees responded “yes” to
the question, “Do you support an effort to negotiate a better commission/split with
our third-party provider and McDonald’s?” Eight said “no.” Similarly, 758 owners
said they were not satisfied with current delivery economics, while only 23 said they
were. And 565 said that delivery is not contributing positive net cash flow, compared
with 198 who said that it was.
“I believe in delivery, but the commissions everyone else gets from us is much higher
than what we get, if we get anything at all,” one franchisee wrote in the survey’s
comment section.
McDonald’s says delivery orders mostly generate new revenue that doesn’t supplant
in-restaurant purchases that are more profitable for franchisees. In January,
Easterbrook said that “incrementality still remains encouraging, in that . . . 70
percent-ish range.”
Owners, again, are skeptical. “While I may be getting a very small cash flow benefit
from my restaurant that does $4,000 (per week) in delivery sales, I do not believe the
benefit is substantial enough to sustain it,” another franchisee wrote in the NOA
survey. “It will eventually begin to replace store sales and the pass-through is not
equal.”
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Owners also point out that while they’re technically allowed to increase their prices
in the UberEats app to offset their increased expenses, McDonald’s discourages the
practice.
McDonald’s has shown it’s willing to listen to franchisees and the National Owners
Association. In November, the chain pushed back the 2020 deadline for remodeling
restaurants by two years after franchisees complained about the costs.
“As McDelivery continues to evolve, we remain committed to working with our
franchisees to evaluate the program, as well as ensuring they have the support they
need to run great restaurants and provide quality experiences and convenience for
our guests,” a spokeswoman says.
—Brigid Sweeney is a reporter for Crain’s Chicago Business
McDonald’s seems happy with UberEats handling delivery, but plenty of franchisees aren’t lovin’
it.
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