The History of Performance: How Franchisor and Franchisees Signal Their Future Actions in Targets and Performance

Abstract

This paper explores relational contracting in a target setting context, where the franchisor distributes sales quotas to individual franchisees. We find evidence consistent with forces described in relational contract theory. This theory proposes that relations between parties evolve via the signals they send to each other. To the extent that these signals are clearer and more credible, the parties can better gauge each other’s intentions to meet the expectations. We show that the signals of both the franchisor and franchisees create a mutual understanding of both parties’ intentions. That is, over time, the franchisor starts to interpret repeated outstanding performance of a franchisee against peers as a signal of a commitment to meet expectations. The franchisor reciprocates with less target ratcheting. Likewise, franchisees interpret less ratcheting as evidence the franchisor is committed to meeting their expectations. The franchisees reciprocate with greater effort, which then, in turn, makes it less likely for franchisors to further ratchet the target in the future. Additionally, we show that the franchisor commits to restrain from ratchting targets, even when it is tempting to renege.

Keywords: Target setting, Target ratcheting, Ratchet effect, Target achievement, Relational-contracts theory

JEL Classification: L10, L20, L24, L25