Bonding Through Investments: Evidence from Franchising
Posted: 2 Aug 2010 Last revised: 19 Nov 2013
Date Written: November 18, 2013
This paper studies whether producers’ up-front investments can help sustain relations with business partners. The initial investment combined with the business partner’s threat to terminate the contract before it expires can generate a bonding mechanism that precludes the producer from behaving opportunistically. I test this view using franchise contract data and a natural experiment. In practice, the franchisor (business partner) determines how much a franchisee (producer) needs to invest up-front. I show that franchisors affected by the passing of a law that restricts their ability to terminate misbehaving franchisees ask their franchisees for higher up-front investments. This result is particularly large for small franchise systems, as franchisees’ investments are less redeployable in case of contract termination. The data suggest that contractual up-front investments can be used to sustain business relations.
Keywords: Up-front Investments, Empirical Relational Contracts, Agency Conflicts, Franchising
JEL Classification: L22, K00
Suggested Citation: Suggested Citation