The Economics of Franchise Contracts
29 Pages Posted: 10 Jul 2011 Last revised: 26 Sep 2014
Date Written: October 1, 1995
An incentive problem exists in franchise relationships because of the failure of franchisees to take account of franchisor profit. Franchise contracts ameliorate this malincentive not by specifying a proxy for desired franchisee performance, but by creating a premium stream that facilitates a self-enforcing agreement. The structure of credible commitments within this self-enforcing arrangement is elucidated, with initial franchisee investments shown to serve no performance guaranteeing purpose. Franchisors do not demand large initial lump sum payments from franchisees because doing so makes it more difficult to terminate franchisees for nonperformance. Franchisors use vertical integration when the premium necessary to assure franchisee performance is large.
JEL Classification: D23
Suggested Citation: Suggested Citation
Register to save articles to
By Chifeng Dai