In-House and Arm’s Length: Productivity Heterogeneity and Variation in Organizational Form[“Vertical Integration and Technology: Theory and Evidence]

This paper analyzes firm boundaries in the US hotel industry. Hotel properties of a given brand are often managed either by a chain employee or by a franchisee. We document that brand properties with the lowest and the highest occupancy rates are more likely to be managed at arm’s length by franchisees. Variation in organizational form is consistent with a model in which the incentives embodied in management contracts vary with property-level productivity. We infer that most hotel chains franchise low-productivity relationships to keep property-level fixed costs low and franchise the most productive relationships to create high-powered incentives for franchisees. Franchisees of high-productivity properties face stronger incentives than the managers of both chain-managed properties and low-productivity franchises because the performance incentives in franchise contracts are proportional to hotel revenues and complement the incentives from franchisees’ property control rights. (JEL D23, F12, L23, D22)