Francine Lafontaine

Double-Sided Moral Hazard and the Nature of Share Contracts

Contractual arrangements involving revenue/profit sharing are often based on fairly simple, often linear, rules. In addition, in many contexts these contracts are not finely adjusted to the particular circumstances of individual agents or markets, nor do they vary over time to the extent current theories based on optimal contracting suggest they should. We develop a simple model of such revenue- or profit-sharing arrangements based on double-sided moral hazard and show that this model can account for many of these stylized facts. More specifically, the model shows that linear contracts can be optimal and that benefits from customizing terms can, in some cases, be quite limited, if not zero.

The Evolution of Ownersip Patterns in Franchise Systems

Two sets of competing theories have been proposed to explain the existence offranchising; one set based on resource constraints and another on incentives issues. As individual franchise systems mature, these theories predict dryerent patterns in the evolution of the mix offranchisedand company-owned outlets. In this paper, we report the results of an empirical study of franchise system evolution. The jindings generally support the incentives-based rationale for franchising, but they also support a modified resource constraint theory, one which recognizes the synergistic efSects of dual distribution. franchise systems, like other organizations, have life cycles that predict various aspects of their structure and processes. More specifically, they reasoned that the resource scarcity that drove expanding chain retailers to embrace franchising early in their system’s life cycle would lessen as the system became more established. The costs associated with managing franchisees gradually would outweigh the benefits associated with the resources that the franchisees provided, and the systems would move toward chains of company-owned, rather than franchised, outlets. Although the specifics of Oxenfeldt and Kelly’s hypothesis have been questioned (see Dant, Kaufmann, and Paswan 1992 for a review of the empirical literature on this subject), its underlying insight remains compelling. Resources and motivations are likely to change over time in a franchise system, and such changes should impact the ownership structure of that system. In this paper, we explore some of the changes that take place within franchise systems as they proceed from the granting of the first franchise to maturity. The primary purpose is to determine whether the pattern of unit ownership, that is the mix of companyowned and franchised outlets, changes in a predictable manner over time.

The Dynamics of Franchise Contracting: Evidence from Panel Data

This paper provides the first systematic evidence on how franchi‐sors adjust their royalty rates and franchise fees as they gain fran‐chising experience. This evidence comes from a unique panel data set that we assembled on these monetary contract terms for about 1,000 franchisors each year for the 1980–92 period. We find that there is much persistence, over time, in franchise contract terms within firms. We find this despite sizable across‐firm differences in royalty rates and franchise fees. In addition, franchisors do not systematically increase or decrease their royalty rates or franchise fees as they become better established, contrary to predictions from some specific theoretical models. We conclude that variation in contract terms is mostly determined by differences across firms, not by within‐firm changes over time. Finally, we find no negative relationship, within firms, between up‐front franchise fees and royalty rates.

Incentive Contracting and the Franchise Decision

We examine theoretical predictions and econometric evidence concerning franchise contracting and sales-force compensation and suggest a number of factors that ought to influence the contracts that are written between principles and agents. For each factor, we construct the simplest theoretical model that is capable of capturing what we feel to be its essence. The comparative statics from the theoretical exercise are then used to organize our discussion of the empirical evidence, where the evidence is taken from published studies that have attempted to assess each factors effect on the power of agent incentives. We also discuss theoretical issues and empirical results pertaining to a few topics that have been addressed in the literature but that do not fit easily into our simple modeling framework. A surprising finding of our survey of retail contracting under exclusive marks is the robust nature of the evidence: although researchers assess different industries over different time periods using a number of proxies for a given factor, their empirical findings are usually consistent with one another.

Multi-Unit Ownership in Franchising: Evidence from the Fast-Food Industry in Texas

Using data on all restaurants opened in Texas between 1980 and 1995 by seven large U.S. fast-food chains, we examine the extent of multi-unit ownership among franchisees and analyze how franchisors allocate the ownership of new units. We show that franchisees with nearby units are much more likely to be assigned ownership of a new unit. Further, controlling for distance, franchisees are more likely to obtain a new unit whose market is contiguous and demographically similar to those surrounding their existing units. Finally, franchisors use these same criteria to select those units to retain as company owned.

Franchising growth and franchisor entry and exit in the U.S. market: Myth and reality

Abstract Franchising has been and continues to be a very popular way to do business for a number of retailers and service businesses. However, the type of franchising that has been growing the most, namely business-format franchising, has not grown at the kind of phenomenal rates that the trade press often suggests. Since the Department of Commerce (DOC) canceled its publication Franchising in the Economy, we no longer have access to census-type data on franchising in the U.S. However, looking at the period during which the DOC did publish these data, one finds that the number of business-format franchisors is highly correlated with the number of units in these chains. Thus, we use data from recent issues of various franchisor directories to assess the number of franchisors in the U.S., and infer from this how business-format franchising has grown in the U.S. We find that business-format franchising has been growing over the last decade at a rate that is, at best, commensurate with the growth of the economy as a whole. We believe that the confusion about the extent of growth in franchising arises, in part, from the fact that many new firms enter into franchising each year, leading to the notion that this way of doing business is growing tremendously. However, we show that many firms also exit from franchising each year, for a net growth rate much below the entry rate. This paper shows that franchising is not a panacea for entrepreneurs, whether franchisor or franchisee. From the franchisors viewpoint, the high rate of exits suggests that many firms fail despite franchising, and many others choose to stop franchising after trying it for a few years. Clearly, these firms have found that franchising is not right for them. Furthermore, the results show that the characteristics of the chain at the time it becomes involved in franchising, as described in the main franchisor directories—such as the royalty rate, the advertising fee, the franchise fee, the amount of capital required, and the sector of operation—have little capacity to explain “survival.” The main variable that affects “survival” among those that are typically reported in franchisor listings is the number of years that the franchisor has been in business before starting to franchise. Hence our results suggest this is one dimension in which franchisors can make decisions that affect the probability that they will be successful in franchising. Although we are unable to explain most of the variance in outcome, the results mostly imply that other, less easily observed or quantified characteristics of the chain and the franchisor, such as maybe the “innovativeness” of the product, the amount of support provided to franchisees, the financial backing of the franchisor, etc., likely influence “success” the most, and thus, are worth investigating further. From the perspective of franchisees, the amount of exit found here suggests that in the majority of systems, franchisees cannot expect that their franchisor will be around for the whole duration of their contract—which averages about 15 years according to the Department of Commerce. This does not mean that the majority of franchised businesses will find themselves in an “exiting” system—a small minority of very well-established franchisors accounts for the majority of franchised businesses, and these are likely to remain successful for years to come. But entrepreneurs buying franchises from less established systems are likely to face franchisor exit, either failure or departure. This paper confirms that franchisees should thoroughly investigate the franchise system they want to invest in, going beyond the information about royalty rates, advertising rates, rankings, etc., found in franchisor directories, and toward more product, market, and other less easily accessible information about the chain.

Retail contracting and costly monitoring: Theory and evidence

Abstract We reconcile seemingly conflicting hypotheses and evidence that surface in the principal-agent literature. Specifically, we examine the literature that deals with the effect of costly monitoring on retail-organizational form. Our principal-agent model of the optimal relationship between up and downstream firms allows the principal to garner two types of imperfect signals of agent effort: sales data and behavior data. The model yields predictions that we confront with the econometric evidence, which comes from both franchising and sales-force-compensation literatures. We find that, when variation in the informativeness and in the cost of increasing the informativeness of both signals is considered, the evidence is consistent with the theory.

Obtaining any Wald statistic you want

Abstract While the Wald test can be used to test a non-linear hypothesis in a linear or non-linear regression model it is known that a particular hypothesis can be written in many ways when non-linear forms are permitted. This paper illustrates that it is possible to obtain virtually any value of the Wald statistic at different significance levels. It is also shown that in small samples the use of the χ 2 or F approximation for the distribution of the Wald statistic can be misleading for some forms of the non-linear Wald test.

Franchising versus corporate ownership: The effect on price dispersion

Abstract This paper uses data on the prices charged at fast-food restaurants in the metropolitan Pittsburgh and Detroit areas to assess the effect of franchising on price dispersion within chains in fairly narrowly defined geographical areas. A review of reasons why firms may face more price dispersion under franchising guides the empirical analyses. Results indicate that 1) franchisors do not aim for fully uniform prices even on the corporate side of their chains, 2) the degree of price dispersion is highest for firms with both franchised and company-owned units, as predicted by models implying a systematic price differential between units operated under these different contracting mechanisms, and 3) price dispersion for fully franchised chains is greater than for fully corporate chains. These last two results, combined with evidence from court cases that franchisors sometimes try to control franchisee prices directly, suggest that franchisors indeed lose some amount of control over prices charged to customers when they use franchising as opposed to corporate ownership. Finally, I find a positive effect of the royalty rate on price dispersion. This suggests that double marginalization is behind at least some of the higher prices found in franchised units in the existing literature.

SURVIVAL AND GROWTH IN RETAIL AND SERVICE INDUSTRIES: EVIDENCE FROM FRANCHISED CHAINS *

Using data on franchised chains, which are the type of single-product entities emphasized in industry dynamics models, we show that age and size affect growth and survival even after controlling for chain characteristics and unobserved chain-specific efficiency. This implies that age and size affect firm growth and survival for reasons other than those emphasized in learning-type models. We also find that several chain characteristics affect growth and survival directly, and thus controlling for firm characteristics is important. Finally, we find that chain size increases rather than decreases exit among young chains, and chains converge in size over time.