Franchise Theory

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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. 2

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 Örms
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 companyís product have limited scale economies that require production at the local market level.

A principle characteristic of franchise contracts is the agentís right to use a national brand name in exchange for a share of the proÖts. 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
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