Franchises are peculiar in two ways: first, the authority of franchisees is largely informal rather than formal. The efficiency of franchises is often attributed to their initiative and autonomy. Yet, in franchise contracts, franchisees agree to submit to the sometimes arbitrary will of the chain. Second, a franchisee pays her chain a royalty based on revenues that are not depended on costs, despite such an arrangement creating distorted incentives for the chain. Why? One possible answer is the noncontrability of costs. Yet costs are contracted on in many economic relationships, so why not in this institution? This paper attempts to answer this question by relating the royalty scheme to the existence of informal authority. Although costs in theory might be contractible, in reality contractibility would require the gathering of information that would create incentives for a chain to interfere with franchisee actions, thus undermining innovative behaviour and reducing efficiency.
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Find related papers by JEL classification: D2 - Microeconomics - - Production and Organizations L2 - Industrial Organization - - Firm Objectives, Organization, and Behavior M4 - Business Administration and Business Economics; Marketing; Accounting - - Accounting
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