Tao, Zhigang: Franchising as a Nexus of Incentive Devices for Production Involving Brand Name
World Conference Econometric Society, 2000, Seattle

Chongen Bai, University of Hong Kong
Zhigang Tao, University of Hong Kong
Franchising as a Nexus of Incentive Devices for Production Involving Brand Name
Session: C-13-18  Wednesday 16 August 2000  by Tao, Zhigang
Franchising involves a variety of contractual and ownership arrangements within a single company. In recent years, a great deal of effort has been made to understand this increasingly popular organization (Lafontaine, 1992, 1993, and Lafontaine and Slade, 1997). There are at least two stylized facts that have posed challenges to the existing theories of the firm. One is the co-existence of company-owned and franchised units, and the other is that franchisees make substantial amount of investment highly specific to their franchise companies.
We set out to explain both puzzles based on the importance of the brand name in franchising (Kaufmann and Lafontaine, 1994). The effort to develop and maintain the brand name changes over time and is difficult to verify (Hadfield, 1990), which has two implications. One is that agents who run franchise units need to be given appropriate incentives for the brand-name-maintenance effort. The other is that franchising contracts are incomplete. For incentive purposes, it is optimal to divide the agents into two groups. Those in the first group (managers of company owned units) receive a salary and focus on brand maintenance. Those in the second group (franchisees) receive a share of the revenue in their own unit and focus mainly on unit specific sales effort (Bai and Tao, 2000). However, the franchisees should also be subject to a minimum service standard that is crucial for brand name maintenance. The high-powered incentive for the franchisees to increase sales revenue implies that they have a strong tendency to divert effort from meeting the minimum standard. To discourage the franchisees from doing so, they should be subject to severe penalty when found violating the standard. We show that, to serve this purpose, it is optimal to have the franchisees make investment highly specific to their franchise companies.
Specifically, the investment by the franchisee to buy physical assets (buildings, equipment, etc.) can be viewed as a performance bond for the minimum standard. If the franchisor controls the assets when the franchisee leaves the company, then the franchisor has an incentive to opportunistically accuse the franchisee of violating the standard and fire the franchisee, getting all the profits arising from the assets. If the franchisee controls the assets, such opportunistic behavior of the franchisor will not occur. Furthermore, if the assets are relationship specific so that their value is very low when detached from the brand name, then the franchisee will have strong incentive not to violate the minimum standard, fearing of being deprived the right to use the brand name in the event of violation.
Overall, the plural forms of contractual and control right arrangements in franchising serve as a nexus of incentive devices for production involving brand-name-maintenance effort in an incomplete contract framework.
Submitted paper full-text in .pdf

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