Towards a More General Theory of Franchise Governance
Seth W. Norton
Aldeen Professor of Business
Wheaton College
Wheaton, IL 60187 USA
July 2003
Abstract
The paper examines the nature of franchising and various business practices in terms of economic governance systems. Markets versus hierarchy, problems of collective action, and tournaments and imitation are linked to alternative types of franchise organization and different franchise activities.
Keywords:
Markets, Hierarchies, Authorized Franchised System, Business Format Franchising, Multiunit Franchising.
I. Introduction.
Franchising is a remarkable organizational form. In the common economic parlance, it is a hybrid organizational form (Brickley and Dark 1987, Norton 1988, Shane 1996). In a related vein, Coughlan, Anderson, Stern, and El-Ansary (2001) describe it as an “inherently contradictory marketing channel.” There is ambivalence to two independent firms acting in consort both in investing in relationship specific assets and carrying out continuously coordinated routine business.
Franchising is also remarkable in its success. As a marketing channel, it thrives in North American and Europe and is emerging in many nonwestern economies. Coughlan et. al. (2001) indicate that more than 40 percent of retail sales in the US pass through some franchised operations and some observers project the fraction will soon exceed 50 percent. Moreover, after a much later introduction in Europe, franchising is now surging there as well. Indeed, there is considerable evidence that franchising as an organizational form is flourishing globally.
It is noteworthy that scholars of franchising have made remarkable progress in the past few decades in understanding franchising. Important theoretical and empirical studies have provided coherent explanations for the existence of franchised marketing channels and understanding the conditions that promote its existence. Moreover, related research has enlightened our understanding of various features of franchising—its fundamental economic organization, the choice between franchised and non-franchised channels, the choice between company-owned and franchisee-owned units, the structure of franchised contracts, the determinants of franchise fees and royalties, the nature of termination procedures, the role of capital structure, and others (Brickley and Dark 1987, Dnes 1993, Lafontaine 1992, Mathewson and Winter 1985, Minkler 1992, Norton, 1988a, 1988b, 1995, Rubin 1978, Sen, 1993, Shane 1996).
Despite the prodigious quantity of research on franchising, some important gaps exist in our understanding of this organizational form. Moreover, continuing evolving markets create new challenges to understanding the franchised marketing channel. One important gap that is a foundation of evolving franchised arrangements is the nature of franchise system governance. While some progress has been made in this area, governance remains a fertile area for franchise research. For example, Bradach’s (1998) study of five major restaurant chains that use franchised marketing channels provides considerable detail regarding governance issues, identifying who has the right to make strategic and tactical decisions and how those decisions are made. Similarly, Windsperger (2003) examines the link between decision rights in franchised systems and the incidence of intangible knowledge assets of franchisors and franchisees. However, a unifying framework for analyzing the governance of franchised systems does not exist. The intent of this paper is to examine several types of alternative franchise governance arrangements in light core concepts in the new institutional economics and related literature. Besides expanding our understanding of alternative forms of franchising, the framework attempts to add to our understanding of the evolution of individual franchise systems over the course of a franchise system’s life and in response to innovations.
It is essential to recognize that although governance issues are often linked to ownership, they are not identical. Indeed, Hansman (1996) documents numerous cases where they are separate. Consider the largely publicly owned corporation. Ownership rights to residual income rest with shareholders, yet the overall governance—most decision rights rest with directors and managers. In franchised arrangements, ownership and governance often coincide for franchisees but numerous decision rights affecting franchisees are in the franchisors’ purview. Thus, while much franchise research addresses the distribution of company owned versus franchisee outlets, the issue of governance is much broader and subtler than the determinants of the dichotomous ownership issue.
The remainder of the paper is organized as follows. Section II identifies three different forms of franchising and their dominant characteristics. Section III identifies three governance arrangements that are foundational to the core of modern economies and describes the coordinating role of the respective governance systems. Section IV links the governance arrangements with the franchise taxonomies and with components of governance arrangements, as well as some implications for franchised channels. Section V contains a summary and conclusions.
II. Forms of Franchising
Franchising is a common term in daily life, business discourse, and the law. Nevertheless, the term is used in different contexts and with different meanings. Coughlan, Anderson, Stern, and El-Ansary (2001, 546) employ the European Union’s description of franchising as a “…package of industrial or intellectual property rights.” The EU identifies three features of franchising—a common name or sign, with a uniform presentation of the premises, communication of know-how from franchisor to franchisee, and continuing provision of commercial or technical services by the franchisor to the franchisee.
Coughlan, et. al. (2001) point out that the EU description may be too restrictive.
Franchising has been associated with a variety of institutional arrangements. In US business history, franchising has been the declared form of distribution in numerous prominent industries—e.g. automobiles, farm equipment, and sewing machines. Accordingly, Coughlan et. al. (2001) note that when franchising is conceived more broadly than the EU description, the border between franchising and other marketing channels is not clear.
Despite potential ambiguity, scholars have developed taxonomies for franchising. Stern and El-Ansary (1988) describe some of these. Some taxonomies focus on the type of business—e.g. accounting and tax services, ice cream stores, vending machines, etc. Other taxonomies focus on a contractual feature—leasing, co-ownership, comanagement, etc. For tractability, Coughlan, et. al. (2001) provide a simple, workable dichotomy—authorized franchised systems and business format franchising.[1]
A. Authorized franchised system
Authorized franchised systems are also known as product and trade name franchising.
Sellers are known as dealers, distributors, resellers and agents. These selling units can operate at the wholesale or retail level. Wholesale examples include soft drink bottlers or distributors of electrical and electronic equipment. Retail examples include appliances, automobiles, computers, household furniture, televisions, and tires.
Products are sold through the respective resellers, but there is considerable control by the manufacturer regarding the product presentation, and manufacturers can provide substantial business support—business operations as well as product specific training, technical support, advertising, selecting outlet locations and others.
B Business Format Franchising
Business format franchising is the form of franchising most commonly associated
with the franchise concept (Coughlan, et. al., 2001). A franchisor licenses an entire way of doing business under a brand name. This variety of franchising is prevalent in accounting services, auto accessories, auto rentals, campgrounds, cleaning systems, fast food, food retailing, motels/hotels, real estate, and schools.[2]
Business format franchising involves packaging a mode of business, attracting a
supply of capable and dedicated entrepreneurs, selecting superior prospects, training them in the minute details of the business operations, providing assistance in setting up the business at specific outlets, and maintaining an ongoing business that is profitable for the franchisor and the collective franchises. The relationship entails continued provision of beneficial services such as advertising and new product development by the franchises and continued provision of royalties from the franchisees to the franchisors.
C. Franchisees as Confederations
Franchisees are noted for their independent spirits and style (Bradach 1998), but they
certainly recognize the value of collective action in communicating with the franchisor organization and in concerted efforts when some business action warrants activity on a scale greater than that of individual franchisees. Consequently, franchisees often organize themselves into confederations.
Franchisee organizations are common both for authorized franchised systems (Pashigian
1961) and business format franchising (Vaughn 1979). Moreover, franchisors treat them seriously, due to the potentially adversarial relationship and due the enormous potential gains from franchisor—franchisee cooperation (Enrico and Kornbluth 1986, Bradach 1998).
In addition to franchisee associations that deal collectively with the franchisors,
franchisees also organize themselves collectively for common business purposes (Bradach 1998). For example, franchisees operate purchasing cooperatives to obtain supplies for franchisees. Advertising and group marketing activities are often run through franchisee cooperatives. For example, Love (1995) reports that regional franchise advertising cooperatives emerged somewhat spontaneously in the McDonald’s system so that by 1967 (only 12 years after Ray Kroc, the chain’s founder, entered the franchise business) all major regional markets had them. Bradach (1998) notes that KFC, Pizza Hut, and Hardee’s also relied on franchise cooperatives.
III. Economic Governance Systems
All economic organizations, ranging from households to nation-states, must decide (i) what is to be produced, (ii) how to produce the selected output, and how to divide the benefits of what is produced (Stigler 1987). Production is treated in the broadest possible sense to include all valuable human endeavor and treated as equal to the value of consumption. In contemporary economics, the new institutional economics approach examines institutions that address those basic economic decisions. Two institutions are particularly salient in modern economies—markets or the “price mechanism” and firms or “hierarchy.” Both entail processes and solutions to the three questions listed above and thus both entail the coordination of human behavior.
A. Markets/Price Mechanism.
Solving the coordination of human effort and answering the basic economic questions
through the price mechanism is somewhat mysterious because it entails multiple interactions that are not so evident. Adam Smith’s term “the invisible hand” captures the mystery. Exploring the means by which markets coordinate human effort is important to delineate the roles prices play in influencing human behavior. The coordinating function of the price mechanism relies on two features of prices—prices as incentives and prices as reporters.
1. Prices as Incentives
Prices direct both buyers and sellers. Prices are a powerful means to encourage buyers and sellers to cooperate so that the maxim value is attained. Prices induce producers to use inputs and technology such that costs are minimized and prices induce consumers to use products so that buyers economize on more expensive goods.
Prices compel economic agents to use more expensive resources sparingly. The compulsion is paradoxical because the price system functions on mutual benefits for buyers and sellers. However, in the mystery of the invisible hand, the compulsion occurs because the parties bear the cost of not economizing and reap the benefits from doing so. Accordingly, it is common to associate the price mechanism with leading to strong motivation for people to respond sensibly and profoundly to the benefits and costs implied by the price system.
It merits noting that more than just price is captured in the price system. Despite some observes to render “quantity” decisions as in the domain of firms, quantity is well within the domain of the price mechanism. Profit maximizing behavior in a “perfectly competitive” market or in an oligopoly with rivals with Cournot conjectures are central to the functioning of the price system. Quantity decisions are strictly related to price decisions.
Similarly, product quality variations (Chamberlin 1933 or Rosen 1975) fall under the rubric of the price mechanism as do variations in the value of time to both producers and consumers (Becker 1965). In all cases, prices of commodities or implicit prices for product characteristics or the value of time, serve to compel economic agents to make choices that recognize the relative costs of their options.
The price mechanism is always subject to market failure, such as monopoly power, but the coordinating role of prices is still present. Moreover, value maximizing behavior is plausible under a wide variety of circumstances. Milgrom and Roberts (1992) state the case simply:
A vast amount of recent research in economics, both theoretical and experimental, has focused on the behavior that is induced by the incentives that arise under various market institutions. Related studies try to determine when this behavior will lead (approximately) to the efficient outcome identified by the neoclassical model. The theoretical work employs many different approaches, but the common conclusion is that in most economies with sufficiently large number of participants, competition between agents will eliminate monopoly and result in essentially competitive prices and outcomes. Furthermore, the experimental work indicates the number of participants necessary to make a market tolerably competitive need not be unrealistically large.
The incentive effects of the price mechanism constitute an important set of issues regarding marketing channel design.
2. Prices as reporters
Prices play a second role in coordinating economic behavior. Prices have informational content—indicating buyers and sellers willingness to acquire or sell goods. The point pertains to observed transactions prices, but it also to pertains to asking and bid prices. Consumers or producers reflect their subject values and their assessment of their production costs that ultimately may lead to market exchange.
Friedrich Hayek’s interpretation of prices as reporters of information content is particularly relevant for central questions regarding economic coordination. Hayek addressed the role of the information content of prices (broadly defined) in the mid-20th century debate with Keynes and other advocates of central planning regarding the role of markets versus centralized planning in coordinating economic life—in answering the basic economic questions posed above. Some critics of market coordination stressed the lack of realism in the perfect competition model and concluded that the resultant market failure rendered central planning a superior way to direct an aggregate economy as opposed to the decentralized direction implied by the invisible hand.
Hayek did not deny the absence of perfect information in actual markets. Instead, Hayek compared the quality of information in an admittedly imperfect, decentralized price system with the quality of information in decisions rendered by a centralized planner. Hayek asserted that the imperfect information dispersed among decentralized decision makers in a price mechanism led to superior outcomes than those based on aggregations of data employed by central planners who used summary data to direct the basic economic decisions of decentralized decision makers.