Franchsing: Limited opportunism and cooperation

“Traditional” principal agent theory interprets franchising as a solution to the agency problems associated with incentives and observability. Franchising has been viewed as an institution that aligns the right to make decisions with the residual claims deriving from these decisions. One problem associated with this explanation, is that in institutions like franchise systems or firms, the relevant players or partners interact quite often. Therefore reciprocity plays an important role The success of those institutions substantially hinges on their ability to strengthen the cooperative behavior of “insiders” and to keep out opportunistic “outsiders”, that destroy cooperation While “traditional” principal agent theory has developed powerful models to explain theoretically various provisions of franchise contracts, there is a problem in explaining the non-use of opportunities for behaveing opportunistically. This paper reviews some relevant empirical findings on the “underprovision” of opportunistic behavior in franchising, that are not compatible with a principal-agent explanation of this organizational form. These findings relate to rent leaving to franchisees, the stability of contractual provisions over time, reliance on royalties from sales and the parallel use of company owned outlets and franchises in one system (the so-called plural form). To explain these discrepancies between the cooperative reality of a good franchise system and the design of franchise contracts (which is used to prevent opportunistic behavior), a “cooperative” interpretation of franchising as an organizational system is given. It is illustrated that the careful selection of franchisees enables a cooperative semiclosed entity in an opportunistic environment. Here cooperative behavior is enhanced by repeated interaction, reciprocity and the “right” incentives for investment in implicit knowledge. Ehrmann Franchising: Limited opportunism and cooperation 3 Franchsing: Limited opportunism and cooperation A. Introduction The organizational form of franchising has received much attention as a hybrid governance arrangement (see Rajan, R./Zingales, L. (2000)). “Traditional” principal agent theory interprets franchising as a solution to the agency problems associated with incentives and observability (see Posselt, T. (1999)). Franchising has been viewed as an institution that aligns the right to make decisions with the residual claims deriving from these decisions. Thus “traditional” principal agent theory maintains that hard incentives are needed to overcome agency problems in a world full of opportunists. One problem associated with this explanation, is that in institutions like franchise systems or firms, the relevant players or partners interact quite often. Therefore reciprocity plays an important role (see Fehr, E./Klein, A./Schmidt, K.M. (2001); Frey, B.S./Frost, J./Osterloh, M. (1999)). The success of those institutions substantially hinges on their ability to strengthen the cooperative behavior of “insiders” and to keep out opportunistic “outsiders”, that destroy cooperation (Frey, B.S./Frost, J./Osterloh, M. (1999) and Gächter, S./Falk, A. (2000)). While “traditional” principal agent theory has developed powerful models to explain theoretically various provisions of franchise contracts, there is a problem in explaining the non-use of opportunities for behaveing opportunistically. Firstly this paper reviews some relevant empirical findings on the “underprovision” of opportunistic behavior in franchising, that are not compatible with a principal-agent explanation of this organizational form. These findings relate to rent leaving to franchisees, the stability of contractual provisions over time, reliance on royalties from sales and the parallel use of company owned outlets and franchises in one system (the so-called plural form). Secondly, some dynamic aspects/questions of the management of both franchises and company-owned outlets, that can not be adequately treated in a static contractual analysis, are analysed in this paper. Lastly, some aspects of explaining the incongruence between contractual design and empirical findings, are discussed. By the same token, there is an explanation as to why Ehrmann Franchising: Limited opportunism and cooperation 4 theses previously mentioned empirical findings can only be fully understood when the ideal of unlimited opportunism, especially on the agent’s side, is dropped and franchising is interpreted in the light of cooperation. The paper is organized as follows. The next section briefly describes an advanced principalagent explanation of franchising using double-sided hazard. The second section describes the empirical findings that are not fully compatible with a traditional principal agent approach. The final section provides some theoretical explanations of the empirical findings and some conclusions are drawn. B. The contractual design from a principal agent perspective Producers have several options with respect to the right distribution channels. They could use a chain of company-owned outlets or a completely franchised system. The following model assumes double-sided moral hazard in the case of a single principal-agent pair. Thus both the work effort and necessary cure by outlet managers or franchisees and of the franchisor are considered. (1) ε + = ) , ( A a g U It is assumed that the “production function” contains two factors, that influence the total revenue (U), namely the efforts of the franchisor (A) and those of franchisee (a). A random term ε with mean zero and variance ... is assumed to be unobservable by the two contracting parties, also both effort levels are assumed to be unobservable. The efforts of franchisee and franchisor increase U with (2) 0 / , 0 / > ∂ ∂ > ∂ ∂ A g a g and 0 / , 0 / 2 2 2 2 < ∂ ∂ < ∂ ∂ A g a g Maximizing franchisor`s profit leads to (3) ) ( ) , ( A C F A a g f FG FG − + ⋅ = Π with f(F) representing the royalty (fixed) fee. The restriction that the franchisee`s share is high enough to guarantee his reservation profit is given by: (4) FN FN FN a C F A a g f 0 *) ( *) *, ( ) 1 ( Π Π ≥ − − ⋅ − = The optimum is characterized by marginal cost equalling marginal revenue: Ehrmann Franchising: Limited opportunism and cooperation 5 (5) *) ( ' * *) *, ( A C A A a g f FG = ∂ ∂ ⋅