Introduction to Franchising

Accounts for 1/3 of total retail sales in US/Canada (1985).

Types of firms that are franchised:

What is franchising?

Advantages to Franchising:

Franchising exploded in the 1950s/60s. Why? Increased efficiency of brand names.

Disadvantages: Free Rider Problems.

General problem:

Horizontal free riding.

Particularly true when outlet serves mobile clientele (roadside motels, McD's on the highway)

Externality affects: other franchisees (lower sales), franchisor (lower franchise fee).

Vertical free riding:

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' efforts.

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

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), company owned

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

empirically, no!