Introduction to Franchising
Accounts for 1/3 of total retail sales in US/Canada (1985).
Types of firms that are franchised:
- Auto Dealers (All)
- Hotels: (Holiday Inn, Best Western, Days Inn, Motel 6...not Marriot,
- Restaurants (about 60%: McDonalds, Burger King, HoJo, Boston Market,
Subway, Dominos, Dairy Queen..not In N Out, Carl's Jr.)
- Auto Services (Jiffy Lube, Econo Lube n Tune, Midas, Aamco...not locals,
What is franchising?
- Somewhere between market mediation and vertical integration.
- Contractual arrangement between retailers and manufacturers or distributors.
- Long term contract
- Residual claimant is retailer.
- Retailer rents the use of brand name that is shared across outlets.
- Payment is fixed fee plus royalty.
Advantages to Franchising:
- chain/brand name is valuable because it economizes on consumers' search
- permits partial resolution of agency problem caused by managerial shirking
at the retail level by making manager of outlet residual claimant.
- can allow better use of local info; acquisition of this local info.
Franchising exploded in the 1950s/60s. Why? Increased efficiency of
- television: economies of national advertising
- highways: more transient consumers
- income increases: higher opportunity costs of search
Disadvantages: Free Rider Problems.
- Franchisor and franchisee make joint investments in chain's brand name.
- They share benefits from each others' investments in quality/brand
- Since neither appropriates full value of each others' quality, each
has the incentive to shirk.
Horizontal free riding.
- Franchisees share an asset: the reputation of the brand name.
- Quality provision maintains this asset.
- However, in cases where individual outlets do not fully benefit from
quality/reputational investments, they will tend to undersupply quality.
Particularly true when outlet serves mobile clientele (roadside motels,
McD's on the highway)
Externality affects: other franchisees (lower sales), franchisor (lower
Vertical free riding:
- Franchisor is not the residual claimant. Only earns part of increased
outlet profits (through royalty fees, and increased price for future franchises).
- May wish to undersupply advertising, quality provision.
- Less than full incentive to maintain strong brand name.
(This is exactly what happened in early years of franchising.)
If complete contract w/costless monitoring were available, these problems
would not exist. You would just rent the use of the reputation/brand name
and monitor its maintenance. Franchisees could also monitor/enforce franchisors'
No profit sharing in such a situation -- just a fixed fee, no royalty.
Incomplete contracting gives rise to alternative institutional arrangements
toward reducing agency costs.
Contractual arrangements above can be interpreted as a response to this
two sided agency problem.
Contract usually specifies retail quality standards
- use of specific inputs
- hours of operation
- training programs franchisees must undertake
- monitoring frequency, penalties
- advertising levels (local and national)
- circumstances in which franchisor can terminate agreement
- investments in relationship-specific assets
As in Jensen and Meckling, franchisor would have the incentive to find
the most efficient means of monitoring own actions (and franchisees') because
it could charge a higher price for the brand name.
This would be true even if franchisor did not have local demand information.
Price would be bid up in a competitive market.
Magnitude of agency problems: Franchising v. Company Ownership
Bearing Problem Appropriation
Company H L L L
Franchised L H H H
monitoring easy/less costly --> company owned
empirically: closer to home office, urban (economies of scale in monitoring),
worse free-rider problem--> company owned
industries w/more repeat customers (auto, shoes, sporting equip.) are more
likely to be franchised than those with fewer ones (fast food, hotels/motels,
car rental agencies)
within fast food, if near freeway, more likely to be company owned