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ECON 460
November 19, 2011
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A REVIEW OF FRANCHISE THEORY
INTRODUCTION
In service based industries one of the fastest growing forms of market structure is that of franchise agreements. Certain aspects of franchise contracts tend to be idiosyncratic in nature thereby attracting a great deal of interest by academics and business analysts in recent years. Various explanations have been proposed for the widespread use of franchise contracts in certain industries. While a great deal of the franchise contract has been explained in the literature, there remains certain aspects of this form of arrangement that has yet to be addressed. This paper intends to address two of these issues as well as proposing an alternative modelling approach to franchise contracts. The second section of this paper describes the basic structure of franchise con- tracts. The third section discusses the various explanations that have been proposed to explain franchising. The fourth section sets two aspects of the franchise contract that has not been addressed in the literature. The Örst of these is existence of both corporate owned outlets and franchised outlets within the same organization. Some authors have predicted that one form or the other would come to dominate the or- ganization. Others have tried to explain under which conditions one form would be preferred by the parent company (or Franchisor). Yet many organizations exist as a mixture of both types of contracts and have chosen both forms of contract when expanding the number of outlets. The second unexplained observation is apparent rigidity in various organizationsífranchise fee structure; both over time and between individual franchisees. This section introduces spatial or geographical considerations to the problem of franchising. When placed in a spatial context a testable hypothesis is proposed in which both of the issues identiÖed can be explained.
Franchise contracts have certain common characteristics^3. The franchisor sells or leases the right to produce or sell some product to a franchisee. Written into the contract are various obligations and commitments required by both parties. First, with the right to use the franchisorís brand name, the franchisor also agrees to supply various types of assistance. This includes orientation with the production process, managerial and accounting assistance, site selection and development, and any ongoing assistance or advice, as required. The franchisor also takes responsibility for national marketing and advertising also any research and development of the prod- uct. Second, the franchisee agrees to operate the business in the manner stipulated by the franchisor. This includes hours of operation, pricing scheme, inventory levels, and adherence to the operating manual ñ if one is supplied. Third, the franchisee agrees to pay royalties to the franchisor. This is usually in the form of a non-linear outlay schedule, comprised of a Öxed fee plus a share of the revenues. Fourth, there will be a monitoring and auditing clause in the contract. This may be spelled out explicitly, but will usually give the franchisor arbitrary and discretionary power. Fifth, the contract will have a termination clause. The termination clause will heavily favour the franchisor who can practically end at will. The franchisee, on the other hand, also can terminate, but at unfavourable terms, usually incurring a heavy penalty. Finally, the contract will contain miscellaneous clauses dealing with sale of the franchise, rights of heirs, territorial restrictions and any other conditions that may be speciÖc to the particular product. (^3) See, for example, Rubin, P. "The Theory of the Firm and the Structure of the Franchise Con- tract," Journal of Law and Economics, 21 (1978) 223-233; or Caves, R.E. and Murphy, W.F. "Fran- chising: Firms, Markets and Intangible Assets," Southern Economic Journal, 42 (1976)
EXPLANATIONS OF FRANCHISING
Franchising As a Method of Capital accumulation
It was believed that franchising Örst arose as a form of capital accumulation and rapid expansion^4. This line of reasoning can be discredited on two accounts. First, if an individual is to buy a franchise, he bears all the risk (uncertainty of the residual claim) of that one outlet, whereas the franchisor has his risk spread across all outlets. To bear this higher risk, a risk averse franchisee will demand a higher risk premium (share of the proÖts). The franchisor could therefore put together a package of shares from all the outlets, and sell them to the individual store managers. The franchisor thus lowers the risk premium he must pay while maintaining full control of the outlets. Being the less costly arrangement, this form of organization will dominate. Second, franchisees tend to have little or zero wealth. Therefore, the funds they invest in a franchise must be acquired. With imperfect capital markets, it is unlikely that an individual would be more successful at raising the needed capital than an already established Örm. Therefore, capital accumulation is not an adequate expla- nation of franchising^5.
Franchising to Ensure Agent Compliance
A brand name is a mechanism by which certain measures (but not usually all) may be foregone^6. The brand name provides an implicit guarantee of a certain level (^4) See, for example: Hunt, S.D. "The Trend Toward Company-owned Units in Franchise Chains," Journal of Retailing, vol. 49, 2 Summer (1973), "Firms often choose the route of franchised units because they simply do not have access to the capital required.. ."; Caves and Murphy, Supra note 3 , "For Önancing outlets the capital supplied by franchisees has no ready substitute 5 : : :".
6 Rubin, P.^ Supra note 3. The need to establish a brand name is based on what Barzel calls "excess measurement", where the free attributes of a transaction are dissipated through excess measurement. fSee Barzel, Y.
constraints as disincentives to shirk. Shirking can be deÖned in two ways; quality or quantity shortfalls. There is an incentive to produce output other than the one preferred by the franchisor, since the franchiseeís marginal cost curve is usually di§erent from that of the franchisorís. The proÖt maximizing level of output is determined at the point marginal revenue equals marginal cost. Having incurred sunk costs establishing the brand name, the franchisorís marginal cost (of brand name production per unit of output) is zero. In this respect the franchisor is a sales maximizer. The franchisee produces those attributes of the product that experience limited economies of scale, and therefore his marginal cost is positive and often rises as output is increased. Quality shirking is a form of the free-rider problem. When brand names allocated to many local outlets, this free-riding problem takes two forms. The Örst is vertical free-riding on the national brand name, and results from the franchisee having better knowledge of the state of the local market than the franchisor. This form of free-riding always exists in franchise arrangements. The second form, horizontal free-riding, arises when a percentage of customers from any one of the outlets are transient in nature. This portion of customers base their demand on the average quality of all outlets visited, and not just on the quality level supplied by the outlet they happen to be patronizing. This allows an individual to free-ride on the quality level of other franchises. In both cases the beneÖts to quality reduction (reduced production costs) accrue only to the free-rider while costs of quality reduction (devaluing the brand name) are shared by the franchisor and other franchisees. 7 The devaluation could be (^7) Though the end result is the same from both forms of free-riding, the distinction is important to the nature of the contractual constraints used to remedy the problem. Horizontal free-riding can be handled through assigning territorial rights to individual franchisees. Vertical free-riding requires monitoring plus a reward or penalty system. The importance of this distinction in explaining franchise contracts is explored in greater detail in Mathewson, F. and Winter, R. "The Economics of Franchise Contracts," The Journal of Law and Economics, Oct. (1985) 503-526.
Level of Sales (Demand)
Level of Service or Effort
Q*good day
Q*bad day
S cheating S *
Low Demand (bad days)
High Demand (good days)
Reduction in service to “believing it is a bad dayfool”Franchisor into
A
B
N
compounded if transient customers base their demand solely on a visit to a free-riding outlet, by which the brand name becomes irretrievably associated with a sub-standard product. An example of franchisee shirking on quality is illustrated in Ögure one. Suppose the local demand for the product is an increasing function of the franchiseeís service (or e§ort). Further suppose that the local demand is stochastic (volitile) such that there are both high demand (good days) and Low demand (bad days) states. This volitility is exogenous and independent of any e§orts by the franchisee. It is assumed that the local franchisee has better knowledge of local demand condi- tions and, in most cases, the franchisor relies on the franchisee to convey information
restrict the franchiseeís ability to make such trade-o§s. Contract provisions that set hours of operation, prices and outlet design serve to deter this form of franchisee behavior. The franchisor is particularly concerned with quality chiselling, because it devalues the brand name he has expended much investment in attaining. With the existence of free-rider problems the franchisor will be forced to engage in monitoring. If the costs of monitoring are positive, this prohibits perfect monitoring, and this is assumed to be the case (otherwise the franchisor would have chosen an alterna- tive contractual arrangement). The franchisor will, therefore, require some incentive structure to ensure quality compliance, to supplement the necessarily inadequate level of monitoring. The franchisor could require that the franchisee put up a forfeitable bond that would be lost with non-compliance^8. However, this creates a reverse moral hazard problem: if the bond is su¢ ciently large the franchisor may renege on his promise to maintain the brand name and abscond with the bond. Also, if the franchisee was su¢ ciently wealthy to a§ord an adequately sized bond, then he would invest in a more diversiÖed, less risky asset than a franchise, with fewer constraints on his managerial sovereignty. This implies a wealth constraint on the franchisee; which is a necessary condition for a franchise contract^9. Faced with wealth constrained franchisees, the franchisor will require a reward structure to ensure quality compliance. The reward (^8) For further dicussion on this form of constraint see: Klein, B. "Borderlines in Law and Eco- nomics: Transaction Cost Determinants of íUnfairíContractual Arrangements," American Economic Review 9 , 70, 2 May (1980) 356-362. It is a lack of collateral that makes a franchise contract superior to any privately negotiated loan agreement a bank could o§er the individual. A limited wealth condition is equivalent to a default option on loans to franchisees so that banks incapable of writing performance contracts superior to franchisors will rationally limit their loans to franchisees that ease the purchase of the local right to the brand name, knowing incentives in a franchise contract. The limited wealth constraint as a necessary condition for franchising is a well established result in the literature. See, for example Mathewson, F. and Winter, R. Supra note 7 ; or Rubin, P. Supra note 3.
will be such that the return to the franchisee from quality compliance exceeds the expected savings from quality reduction. The actual level of monitoring thus will be decided by the relationship between its cost, and the levels of beneÖts and penalties described above. It also will depend on the attitudes to risk of the parties. For the purposes of this paper it is assumed parties are risk-neutral, other attitudes can be included as simple extensions. Therefore if greater than normal returns exist in an industry one would predict an ináow of franchisees^10. Besides the sunk investment in the brand name the Örm also incurs non-salvageable investment in individual franchisees. The Örm must invest both time and resources in training the franchisee and developing the new outlet in a way that allows the franchisee to operate the business. This form of investment is necessary to attract potential franchisees who lack experience or knowledge in the particular industry. 11 Only those with such inadequate human capital will o§er themselves as franchisees, since for individuals possessing the necessary expertise, the beneÖts of using the brand name do not outweigh the costs (proÖt sharing and behavior constraints). It is natural then, for franchise arrangements to have great appeal to individuals who lack su¢ cient wealth and human capital to establish an independent operation. Though franchisees must pay a large portion of their revenues to the franchisor, their expected value of the franchise exceeds that of a totally independent operation because (^10) This turns out to be the case. Established franchise Örms have queues of up to two or three years for the granting of a franchise licence. McDonaldís accepts less than one percent of all applicants, and territorial rights are sold several years before actual construction of the outlet takes place, as prospective operators wait for natural population growth to reach a level that can supporting an outlet. (Kroc, R. Grinding It Out: The Making of McDonaldís, Henry Regnery Co., Chicago, Illinois (1977).) 11 Seltz, D.D. The Complete Handbook of Franchising Addison-Wesley Publishing Company Inc. (1982)
the breakdown between corporate owned and franchised outlets found within a given organization. It is frequently observed that an organization that engages in franchising will frequently buy back certain franchised outlets and operate them as corporate stores while at the same time issue franchises in new areas. Furthermore, there appears to be little correlation between the size of the quasi-rent that individual outlets are earning and the decision to buy them back. The second unexplained observation is the fact that franchise fees remain relatively Öxed, both across outlets and over time, while across outlets there is a wide variability in rents being earned. This fact appears to be inconsistent with the proposition that franchise fees allow the parent company to capture some of the economic rents being earned by the agent. 16 Incentive compatibility constraints determine the extent that a parent company can capture the economic rents being earned by the individual outlets. If one assumed that individual franchisees have similar opportunity costs then one would expect that the quasi-rent required to ensure compliance would be the same across franchises. Therefore, if economic rents vary across outlets, the residual (minus the quasi-rent) would be captured by a variable franchise fee. One would expect the parent company to set each outletís franchise fee based on local market conditions. One characteristic common to franchise industries is that aspects production and distribution are carried out by many small, geographically displaced outlets. There- fore, when the parent company wishes to monitor its outlets, the monitor engage in considerable travel. In a large chain this will require the monitor to cover great distances in the execution of his duties. Therefore one would expect the remoteness of an outlet to have a bearing on the choice of contractual arrangement between the parent company and the local operator. If the location of outlets and the distance between outlets is a function of market (^16) See Tirole, J.The Theory of Industrial Organization, chapter 4 (1988).
density, one would expect to see a clustering of outlets in more densely populated areas. This gives rise to an asymmetric distribution of stores which will have a signiÖcant e§ect on the costs of monitoring. If the monitor has to travel a signiÖcant distance to inspect a particular outlet, then frequent monitoring will be quite costly. However, if there is a second outlet in close proximity to the Örst outlet, then the marginal travel cost of monitoring the second store will be quite low. This implies a non-convexity in the monitorís cost function that will e§ect the choice of contract between the parent company and the individual outlets. In the case of one outlet geographically displaced from the monitor it may be more proÖtable to give the local agent a quasi-rent rather than frequent monitoring to ensure compliance. However, if a second store is established in close proximity to the Örst it may be more proÖtable for the parent company to switch to extensive monitoring and reclaim the quasi-rents. While this point may seem straightforward with respect to the parent companyís decision to franchise a new outlet, it implies something more. The decision to expand the number of outlets and the decision to change the form of the contract between the parent company and the local operator may be two aspects of one decision. This may explain why one form of contract has not come to dominate the other over time; something that has been predicted by analysts of these industries. 17 With respect to the issue of Öxed franchise fees, this too may be best explained in a spatial context. When a local market grows, so does the rents earned by the local franchisee. So why doesnít the parent company increase the franchise fee accordingly? One would expect that this would be a fairly straightforward clause to include at the outset of the franchise agreement. It is assumed that the franchisee has better knowledge of local market conditions (^17) The list includes: Caves and Murphy Supra note 3; Hunt, S.D. "the Trend Toward Company- owned Units in Franchising in Franchise Chains", The Journal of Retailing vol. 49 (1973).
and the decision to convert a franchise outlet to a corporate owned-store. Third, the results from the model questions the e§ectiveness of franchise fees at extracting economic rents being earned in the local market. Finally, the franchisor will design the contract such that it anticipates the chang- ing opportunity costs of the franchisee. The franchise contract serves to govern the ongoing relationship between principal and agent, anticipating systematic changes between the two that occur during the life of the agreement. The franchisor will attempt to lower the franchiseeís opportunity costs through a combination of con- tractual constraints and monetary incentives. Moreover, the franchisor will set the initial franchise fee in a manner that will result in self-selection of those potential franchisees with stronger commitment to the franchise. The model in this paper is limited to the set of franchise contracts where some input on the part of the franchisee is a major component of the Önal product. The model does not apply to all forms of franchising observed in the economy, in partic- ular franchise arrangements that are classiÖed as manufacturer-retailer relationships. Such industries that experience large economies of scale in centralized production of the Önal product may Önd franchising simply an e¢ cient method of delegating the responsibility of distribution.
BIBLIOGRAPHY
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