Franchise Theory Essay

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 Orst of these is existence of both corporate owned outlets and franchised outlets within the same organization.

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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 organizationsifranchise 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 identiOed can be explained. STRUCTURE OF THE FRANCHISE CONTRACT A basic result derived in modern property rights literature is that when any given set of rights is exchanged, the principals involved will select the institutional frame- work that minimizes the sum of production and transaction costs 1 . The most com- monly observed of these arrangements (or governance structures) are price mediated markets and centralized employment within Orms 2 . These are not the only forms of arrangement within which transactions are carried out, and the distinction between the two mentioned above is not as clear as it is suggested.An example of an alterna- tive institutional framework is a franchise arrangement, and the purpose of this paper is to analyze the nature and purpose of franchise contracts. In a franchise contract, a parent company contracts out the right to produce or market its product to an agent. Contractual stipulations involve rules governing the behavior of the agent including pricing, mode of production, and territorial or market restrictions.

A frequently observed feature of a franchised industry is that certain aspects of the parent companyis product have limited scale economies that require production at the local market level.A principle characteristic of franchise contracts is the agentis right to use a national brand name in exchange for a share of the proOts. The brand name is a signal to consumers in a local market that the agent supplies a product of a certain quality.

The e§ectiveness of the brand name as a quality signal will decide its value to consumers. Given the nature of brand names and the characteristics of certain industries that rely on them, franchise contracts as a form of governance structure may be the most e? cient for enhancing and protecting the value of the brand name. 1 Williamson, O. E.

“Transaction Cost Economics: the Governance of Contractual Arrange- ments”, The Journal of Law and Economics , 22, Oct. (1979) 223-261 2 Cheung, S. N. S. “The Contractual Nature of the Firm,” The Journal of Law and Economics , 26 April (1983) 1-21. 3 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 franchisoris 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 nif 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 Oxed 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 speciOc 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) 4 EXPLANATIONS OF FRANCHISING Franchising As a Method of Capital accumulationIt was believed that franchising Orst 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 proOts). 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 Orm.

Therefore, capital accumulation is not an adequate expla- nation of franchising 5 . Franchising to Ensure Agent ComplianceA 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 Onancing outlets the capital supplied by franchisees has no ready substitute ::: “. 5 Rubin, P.Supra note 3 . 6 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.

f See Barzel, Y. 5 of quality, and as such removes the necessity of prospective consumers assessing the level of desirable attributes about the product. Since it is these attributes that are compared to relative prices in the consumption decision, and the need for measure- ment consumes resources, removing this need lowers the e§ective per unit price of the desired attributes.

This characteristic of the brand name is analogous to the removal of an ad valorem tax, and can be represented by a rightward shift in the demand curve, the shift being the size of the measurement cost. Having established a brand name, the beneOts that are described above can be ac- crued at zero marginal cost, the establishment being e§ectively a sunk cost (although there may still be per period Oxed costs in maintaining brand name status to some ex- tent). It is natural, then, for a company to want to expand output, taking advantage of these large economies in the sale of brand name reputation.Such expansion will be subject to certain limitations. Technologically there may be diseconomies of scale, and in a spatial context the market will eventually become saturated. To overcome these constraints it becomes necessary to develop subsidiaries, each of optimal plant size, and each unlimited by the extent of its market.

If the brand name is successful in reducing excess measurement, then competitive forces will be mitigated, allowing the possibility of shirking by subsidiariesiemployees. This may not be a problem if the output is clearly deOned and straightforward to monitor.But, if the product has (intangible) attributes that are di? cult to assess upon inspection, then monitoring may become prohibitively costly, the Orm having great di? culty in fully monitoring the performance of subsidiaries.

This rules out the possibility of one large, vertically integrated Orm, making necessary the choice of an alternative governance structure of which the franchise is an example. This contractual arrangement allows the required expansion, whilst also providing behavior “Measurement Costs and the Organization of Markets,”


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