Contractual Arrangements in Franchising: An Empirical Investigation

In this paper we conduct an empirical investigation of the recent explanations offered for the nature of a franchising contract. In particular, we focus on the arguments posited by Lal (1990) where it is suggested that since both the franchisor’s brand name investments and the franchisee’s service level affect retail demand and such decisions are not verifiable by the other party, the royalty payments are used to balance the incentives to both the franchisor and the franchisee for adequate investments in factors affecting retail demand. Lal hypothesizes that while the size of brand name investments should be inversely related to the royalty rate, the level of service provided by the franchise should be inversely related to the royalty rate. Lal also uses a mixed strategy equilibrium concept to analyze monitoring arrangement in franchising contracts and relates the service level offered by the franchise and the frequency with which the franchisor monitors a franchisee to several independent variables. Our empirical analysis conducted across seven different types of businesses provides support for most of these hypotheses. To reconcile the differences between the data and one of the propositions (rejected by the data), we extend the model in Lal (1990) to include heterogeneity in monitoring costs across franchisees. Finally, we collect additional data to test the empirical validity of the extended version of the model. In this way, we are not only able to understand the reasons for the differences between the data and hypothesized relationships but are also able to offer empirical validity to the post hoc reasoning used to reconcile these differences.