Chapter 57 Question 050

Why do many restaurants offer free refills for drinks? (Mike Hedrick) The late George.George Burns once told an anecdote of a business owner who said that he lost a lot of money on every item he sold and made it back by selling volume.Of course, relying on this approach, no business can last long.So the common practice of free drink refills becomes a mystery.How can a restaurant provide this kind of service without losing money? Most businesses sell a lot of goods.To stay in business, businesses don't have to charge more than they cost for each item.Instead, it only needs to make total revenue equal or exceed the total cost of goods sold.So, if entrees, desserts, and other items already include enough profit margins, restaurants can certainly offer free refills without losing money.

But why would a restaurant want to offer free refills?From a restaurant's perspective, the existence of this practice contradicts the logic of perfect competition.The logic holds that customers will pay the full cost of any additional goods or services they purchase.But the competition is not enough.In restaurants, as in many other industries, the average cost of serving customers decreases as the number of customers dining increases.This means that the average cost of a restaurant serving a meal is higher than the marginal cost of a meal.Since restaurants must charge more for each meal than the marginal cost of that meal, the restaurant's profit increases whenever it attracts additional customers.

Now, let's imagine the original situation: all restaurants do not offer free refills.What if a restaurant started doing this at this point?Diners who enjoyed free refills at the restaurant felt they had gotten a good deal.As word of mouth spreads, the restaurant will soon find itself with far more customers than before.Although the refill service will add some cost, this part of the cost is quite low. For this to succeed, restaurants must make more money on the oversold meals than the cost of free refills.And because the restaurant's profit margin on the oversold meals is likely to exceed the cost it incurs for free refills, the restaurant's overall profit will increase.

Seeing the restaurant's success with free refills, competing restaurants are sure to follow suit.As more restaurants do this, the increase in diners at the first restaurant will gradually become smaller.If all restaurants started offering this service, each restaurant would have about the same business volume as before when none of them offered free refills.And because profit margins in the restaurant industry are typically thin, for many restaurants, free refills seem to portend losses. If the price of each meal remains constant during the above process, it will indeed cause losses.But thanks to the free refills, diners gain more net profit during the meal than before, because they now get refills that used to cost a few dollars for nothing.The fact that diners are getting more out of their meals drives restaurants to raise the price of their meals.When all is said and done, the price of meals should roughly rise enough to cover the cost of free refills.

Another factor to consider is that restaurants generally charge two dollars for a cup of iced tea, soft drink and soda that costs only a few cents.To drink enough, a person has to refill countless cups.If 10 percent of customers order drinks because of free refills, the restaurant is almost guaranteed to be in the money.This reasoning implies that restaurants that serve canned soft drinks and iced tea are less likely to offer free refills, and they are.The exception once again confirms the rule from the negative side.