As the pace of life becomes faster and faster, the growing restaurant industry has fulfilled people’s need for a fast and filling meal. Of course, restaurants also serve an important role for special occasions or for a simple social gathering. No one can deny the importance of the restaurant industry in their life. Not only are restaurants important to people’s everyday lives, they also contribute a lot to the economy. In fact, according to the data by the National Restaurant Association (NRA), the restaurant industry is the nation’s second-largest private-sector employer, providing jobs for about 10% of America’s work force. Looking at the Restaurant Industry Outlook for 2017 published by the NRA, the industry sales will reach $799 billion, which translates to 4% of U.S. gross domestic products. Compared to last year, the industry has showed a real increase of 1.7% in sales. The number is even larger when compared to 2010, which had sales of $587 billion. That is a 36% increase. This projection shows an optimistic picture of the industry in general, but why do we always hear the phrase: “restaurant fails”?
It is not uncommon for us to hear some restaurants in town go bankrupt shortly after their openings. As a matter of fact, this news pops up quite often. Based on a post by CNBC, around 60% of new restaurants fail within the first year and about 80% fail within 5 years. Such a high failure rate raises scholars’ attention, who are attempting to find out a persuasive reason for the high failure rate. In addition, it is important to find out whether these failures are caused by basic supply or demand shifts, or if they are largely due to externalities. If the market behavior is the reason here (i.e., unqualified owners were “crowded out” over time), then there is nothing to worry about since that is how the market works, However, if externalities play a big role and could potentially impose a negative effect on the growth of the industry, then the issue becomes more serious since the industry can affect the United States labor market.
Scholars have done much research over the years to analyze the reasons. A study done by Zheng Gu concludes that the restaurants “with low earnings before interests and taxes and high total liabilities are more likely to be bankruptcy candidates.” In the article “Why Restaurants Fail,” authors summarize reasons: low profits, lack of effective marketing strategies, managerial limitations and incompetence, and barrier to entry is low while market competition is high. While these articles are adequate in explaining some of the failure cases, they fail to identify the possible effect of externalities.
One possible externality is the health inspection score. A post by the NRA points out that the current letter-grading system for food safety needs to be reformed, since the letter assigned is not so much based on the quality of the ingredients, but more on the proficiency at dealing with the inspection process. Usually, consumers lack the understanding of the significance of the scores, yet refuse to dine at the low score restaurants because they are concerned about food safety. The subjective scores could bring false pictures of restaurants’ food safety status, and the restaurants that are being unfairly criticized can receive a result as harsh as bankruptcy.
Another externality is online consumer reviews. With the improvement of technology and the widespread usage of online review systems, opinions become easier to spread and the effects are bigger. How many times did you check the reviews on Yelp during your trip to try to find a “five star” restaurant? Have you ever turned any restaurants down just based on their poor reviews? It is very likely for you to experience these things at some point of your life, and that shows the power of “the word of mouth.” Restaurants with good reviews typically get more visitors, and those with poorer reviews experience declines. This becomes especially clear as an externality when reviews are artificially manipulated by competitors, which is not directly related to the restaurant performance.
One drawback for both externalities is that the effect is hard to quantify, since it is nearly impossible to record the change in consumer perceptions. However, the health inspection scores and restaurants’ evaluations by consumers certainly have some effect on the success of restaurants, and the adverse effect might lead to failure.
Overall, there are few externalities that we can find to explain the high failure rate within the restaurant industry. The failures are more likely due to factors such as poor location, poor management, and the non-systemic financing system. Surely, another convincing explanation would be faulty estimation of the risk when entering the industry and overconfidence in success in the future. When someone is picturing a bright future after opening a restaurant, he or she often ignores or underestimates the high risk behind the optimistic numbers. This phenomenon is discussed in Capone and Capone’s article, as they suggest that there is a high probability for people to enter unprofitable markets because of the misestimation of the profit potential. This misconception coupled with the nature of the market directly leads to the high failure rate. Therefore, the high failure rate is not something that we need to be concerned with, especially when the restaurant industry is experiencing a steady growth despite this high failure rate.