Will price discounting help restaurants survive the crunch?

If eating in is the new going out, life is going to get really tough for hundreds of mid-market restaurants in the months ahead.

Hard-pressed consumers hit by a potent combination of falling property and share prices, declining real incomes, a slump in confidence and fears of huge job losses, are cutting back on non-essential items in their monthly budgets. They are eating out less or perhaps switching to lower-priced chains that – on the plate at least – seem to offer better value for money.

How can restaurants respond to the threat posed by a fall in discretionary spending?

The simple solution is to offer deep discounts to keep the diners coming in. Without generous price discounts, footfall will decline and leave restaurants with a large amount of spare capacity.

Given that some of the costs of operating a restaurant are fixed and do not depend on the number of paying customers, running well below full capacity can lead to a rise in average costs and put great pressure on cash flow and profit-projections.

Great offers on lunches and early-evening meals have been around in the industry for years – regardless of where the country is in the economic cycle.

Using elasticity of demand

The case for heavy price discounting can be a powerful one – and the effects draw on three separate types of elasticity of demand.

Lower prices ought in theory to stimulate higher demand although the extent that this happens depends on the price elasticity of demand for a meal out. Owners of restaurants will be hoping that prospective customers will be price-sensitive and respond to the cut-price deals.

Related to this is cross-price elasticity, the responsiveness of demand for X following a change in the price of a related product.

Many restaurant owners will have recognised implicitly that cutting the price of eating out is needed to reduce the relative price differential between that and a take-away meal or ready meal from the supermarket. Marks and Spencer has been just one of the food retailers looking to compete directly with restaurant chains with its £10 meal deal for a “restaurant quality” main meal, starter and dessert for two plus a bottle of wine

The third elasticity links spending to changes in the real incomes of consumers – namely income elasticity of demand.

In a recession when incomes are heading lower, the demand for normal goods falls in tandem, but much depends on how strong this effect is. I suspect that for many people, that extra night out at a decent restaurant has a strongly positive income elasticity of demand – it is a luxury that can be safely discarded when economic conditions are poor.

So although deep discounts such as two for one offers or Go Sushi’s ‘Buy 5 get 5 free offer’ can make eating out look affordable, the price effect might be drowned out by the impact of cuts in real living standards.

But there are other benefits from enticing more people into restaurants even if the menu is heavily reduced. The profit margin on food will be lower but the restaurant can recover much of this from sales of drinks where mark-ups are substantially higher. Fuller diners are also better for staff morale and productivity.

Many of the mid-market restaurants will consider moving away from a-la-carte menus to offer fixed-price deals as a matter of routine – such as a 3-course meal for two people for £25 or £6.95 for two dishes or whatever demand-sensitive price point they discover through trial and error.

Dangers of anchoring to a lower price

But there is a danger that lowering prices on a huge scale might actually cause more harm that good in the medium term once the recession is over. This argument is based around behavioural economics and the concept of anchoring for if consumers start to expect really low prices from the mid-market segment of the restaurant industry, they may be reluctant to accept a return to ‘normalised’ menu prices if and when the economy recovers.

Restaurateurs have a tricky balancing act to perform – keeping their heads above water but avoiding putting into the mixer ingredients for lower profits in the medium term.