# ECON10004: INTRODUCTORY MICROECONOMICS ASSIGNMENT 2: SEMESTER 1, 2019 Due: Monday, May 13, 2pm

• Assignments must be submitted via the LMS subject webpage.
• Remember to keep a copy of your assignment.
• Limit: 1250 words (diagrams and equations do not count toward the word limit.)
• Points are awarded according to the quality of the answers.

Over the last two years, there has been increasing attention paid to Australia’s franchise system. Many franchisees appear to be under significant financial distress and the industry is so fraught with disagreements that the ACCC has setup its own website page to try to educate potential franchisees about the risks in entering into a franchise agreement.
Many of the issues that we have studied in this semester can help us to understand the perils that exist in the franchise world. This problem set will ask you to apply your knowledge to one of the issues and then will ask you to discuss other issues using concepts that you have learned from the class.

# Part A: Misaligned Incentives

In the attached article from Ad Age, McDonald’s and its franchisees are engaged in an ongoing dispute over remodeling requirements for existing restaurants and fees associated with delivery. The following problem is designed to think about these issues in more detail.
Ann is a monopoly franchisee of “Bob’s Best Burgers” and owns a single restaurant. The franchisee can choose to make an investment I 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 Q,
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.
Given Q units of food sold and an investment of I, the franchisees costs are given by:
C
The franchisee is thus trying to maximize:

# 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
,
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.

# 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. What is the largest fixed franchise fee that Bob could charge Ann? 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?
Problem Set Continues on The Next Page

# 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) QAfrica = 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

MCDONALD’S FRANCHISEES DUMP
ON DELIVERY
‘OUR MARGINS DO NOT ALLOW FOR THE COMMISSIONS THAT UBER IS TAKING,’ WARNS OWNERS GROUP
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. “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.” 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.”
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.