Features of Franchising Contracts

1. Firm specific assets.

Capital assets: Franchisees may be required to purchase certain types of equipment, buildings, etc., that can only be used with an individual firm. For example, giant gaudy Holiday Inn signs. Or Howard Johnson's makes its buildings be painted turquoise and green. (Not McDonalds -- franchisees do not own the building.)

Human capital: Franchisees must go into training programs in which they learn skills, some of which may be firm-specific. Specific business practices that would have to be learned over if the individual were to maintain other franchises for other companies.

Firm-specific assets serve to bond the franchisee's committment to produce quality or invest in brand name. It makes termination more costly to franchisee because costs are sunk. For example, suppose Holiday Inn were to terminate relationship with a motel that did not have specific assets. No problem -- franchisee would just hook on with another chain at fairly low cost. "Switching costs" make termination more costlyh and induce better behavior.

Analogous story for firm-specific human capital.

However, this investment can be held up by franchisor. Value of the franchise is reduced if franchisor grants nearby franchise. Investment in firm-specific asset/value of franchise is reduced.

Incentives against this:

-- Franchisor's reputation. Might impact value of subsequent franchises they sell.

-- Ex ante agreements specifying exclusive territories, circumstances where expansion is allowed, compensation when territory is encroached...

2. Exclusive Dealing/Tie In Agreements

Contract requires franchisee to purchase inputs from the franchisor or from a specific set of third party supplier.

One interpretation: exercise of market power by the franchisor, earns monopoly rents from sales of inputs to franchisees.

Alternative interpretation: response (efficient) to vertical/horizontal free rider problem.

Our arrangement above: franchisee will not cheat as long as quasi-rents earned by franchisee as member of chain exceeds the short run profits they earn from chiseling/low quality.

This can be costly, with all of the monitoring costs involved, particularly when input quality is hard to judge (hamburgers, for example).

It may be less costly/more efficient for the franchisor and franchisee to simply agree that franchisor will supply inputs at a given price. If this is value increasing, then you can make both parties better off with such an agreement.

Monitoring may take place when delivery of input is made, or during inspection of facility.

Alternatively, it may be efficient for franchisor to designate preferred suppliers, and monitor these suppliers. This may require the suppliers to earn rents from this in order to bond them to produce high quality goods.

Aside: why are tie-in arrangements suspect?

Trace back to Chicken Delight case.

CD sued by franchisees, for requiring them to purchase "buckets" and "kits" from them. What the chicken come in. CD claimed that this was to prevent quality shirking. But does bucket really matter?

Particularly suspect when they didn't require specific suppliers of the Chicken itself.

More likely explanation: dinners are more profitable to retailer than buckets of chicken. This was a way to extract rents via price discrimination.

Bottom line: Tie in arrangements may have efficiency explanation in economizing on monitoring costs.

3. Commitments of advertising.

Response to franchisors' incentive to free ride.

Problem: incomplete contract...hard to commit to quality of advertising, etc.

Why do we see McD's and others have ads that are of relatively high quality?

-- company owned stores, royalties: they benefit directly

-- reputations affect franchise prices

4. Other Rights/Arrangements

Sometimes franchisors impose requirements to force certain business practives because of network efficiencies -- having everyone adopt similar business practice standards.

Accounting standards, computer networking connections, reporting/ordering standards.

If efficient, then prices (fees/royalites) will adjust so that both parties are willing to accept terms.

Important: When evaluating these features, must look at situation before contract is signed and franchise fee is paid.

Once that happens, many of the features can look like unfair business practices by the franchisor (tie-ins, terminations). But these may be part of a broader economic arrangement that is efficiency-enhancing.

More difficult termination would make initial franchise fee higher because it would make enforcing the agreement more costly for franchisor.