An Extended Transaction Cost Model of Decision Rights Allocation
The Case of Franchising
Nada Mumdziev
Center for Business Studies
University of Vienna
Brunner Strasse 72
A-1210 Vienna, Austria
Email:
Josef Windsperger
Center for Business Studies
University of Vienna
Brunner Strasse 72
A-1210 Vienna, Austria
Tel: +43 1 4277 38180, Fax: +43 1 4277 38174
Email:
Abstract
The purpose of this paper is to develop an extended transaction cost approach of decision rights allocation in franchising networks. Specifically, this study demonstrates that when considering trust in transaction cost theory, (TCT) supplements the explanation offered by the TCT on the allocation of decision rights in franchising networks. We found that transaction-specific investments have a positive effect on the allocation of decision rights to franchisees. These findings imply that franchisors tend to delegate decision rights to franchisees when they are able to reduce formal control, due to the bonding effect of franchisees’ transaction-specific investments. Contrary to the traditional transaction cost view and compatible with the incentive view of delegation, we found that behavioural uncertainty has a positive effect on the allocation of decision rights to franchisees. These findings imply that franchisors tend to delegate decision rights to franchisees when they encounter difficulties in measuring franchisees’ performance and controlling their behaviour. Furthermore, we found that trust functions as moderator in the relationships between the transaction cost variables and franchisor’s propensity to delegate the decision making power to the franchisees. Overall, our study contributes to the literature by constructing and testing an extended transaction cost model to explain the structure of decision rights in franchising networks.
1. Introduction
Successful franchise firms govern their contractual relations by efficiently allocating decision rights between the franchisor and franchisees. Decision rights refer to the use of both the franchisor’s system-specific assets, such as knowledge and skills in site selection, store layout, product and brand development, buying and merchandising, and the franchisees’ local market assets, such as their local market know how in advertising, customer service, quality control, human resource management and product management (Windsperger 2004; Mumdziev and Windsperger 2011). This study presents an extended transaction cost analysis on the allocation of decision rights in franchising networks by considering trust as moderator on the relationship between the transaction costs variables and franchisee’s fraction of decision rights.
Trust can be defined as the expectation that an exchange partner will not engage in opportunistic behavior, even in the face of tempting short-term incentives (e.g. Bradach and Eccles 1989; Mayer et al. 1995). Traditional transaction cost literature has neglected the impact of trust on inter organisational cooperation (e. g. Williamson 1975, 1985) as it primarily focuses on transaction cost effects of environmental uncertainty, behavioural uncertainty and transaction-specific investments. However, Williamson acknowledged in a later study (1991) that trust functions as a shift parameter by influencing the comparative cost of governance. Another justification for incorporating trust into the TC model comes from the alliance literature, which shows that trust influences the governance of inter-organisational relationships (e. g. Bradach and Eccles 1989; Gulati 1995; Zaheer and Venkatraman 1995; Noteboom et al. 1997; Alvarez et al. 2003; Lui and Ngo 2004; Poppo and Zenger 2002; Gulati and Nickerson 2008; Lazzarini et al. 2008). The results of this work indicate that trust lowers transaction costs in inter-organisational relationships, especially when the opportunism risk is high.
The role of trust as a moderator has received less attention in the inter-organisational network literature. Recently, Mellewigt et al. (2007) analyse the moderating role of trust in the relationship between asset specificity and contractual complexity. They conclude that trust mitigates opportunism risk and reduces contractual complexity as a control device. Ryu et al. (2008) test if trust plays a moderating role in the relationship between environmental uncertainty and the propensity for vertical control in the buyer-supplier relationship. The results confirm that firms tend to loosen vertical control when they trust their exchange partners. Furthermore, Hoffmann et al. (2010) analyse the role of trust in the firm’s decisions to vertically integrate or cooperate. Results confirm both an opportunism-mitigating effect of trust that lowers transaction costs, and an opportunism independent effect that increases the transaction value of the cooperation.
Despite the large number of studies on trust in alliances, few studies investigate the role of trust within the franchising context (Dickey et al. 2007; Cochet et al. 2008; Lopez-Fernandez and Lopez-Bayon, 2011; Davies et al. 2011). Dickey et al (2007) and investigate the influence of trust on franchisees’ behavior and attitude toward franchisor. They argue that trust will be developed as a mechanism of reducing franchisees’ opportunistic behavior in areas that are not covered by the contract. Cochet et al. (2008) analyse franchisors’ reliance on relational governance mechanisms (such as trust) to attenuate agency problems which arise from franchisee autonomy. They found evidence that franchise firms use relational governance to counterbalance their loss of control associated with allocation of decision autonomy to individual franchisees. Lopez-Fernandez and Lopez-Bayon (2011) found that trust arising from past relationships has a positive effect on delegation of decision rights. Davies et al. (2011) construct and test a relational exchange model that demonstrates how trust affects franchisee compliance. They show that trust reduces non-compliant opportunistic behaviour. Similar to Dickey et al. (2007), they show that trust reduces the likelihood of franchisees’ non-compliance with franchisor’s operational guidelines.
In this study, we propose an extended transaction cost model of decision rights allocation in franchising. According to the transaction cost theory, the allocation of decision rights aims at reducing transaction costs, due to transactional uncertainty and transaction-specific investments. We demonstrate that considering trust in the TCT model supplements the explanation offered by TCT on the allocation of decision rights in franchising networks. Trust influences the impact of transaction cost variables (such as uncertainty and transaction-specific investments) on the delegation of decision rights, because it alleviates opportunism risk and increases information sharing between the franchisor and franchisees. Specifically, we argue that trust moderates the impact of behavioural uncertainty, environmental uncertainty and transaction-specific investments on the delegation of decision rights to franchisees. We found that behavioural uncertainty and transaction-specific investments have a positive effect on the allocation of decision rights to franchisees. These findings imply that franchisors tend to delegate decision rights to franchisees when they encounter difficulties in measuring franchisees’ performance and behaviour monitoring. This also is likely to occur when they are able to reduce formal control, due to the self-enforcing effect of transaction-specific investments. In addition, we found that trust increases the impact of environmental uncertainty and transaction-specific investments on the allocation of decision rights to franchisees and decreases the positive relationship between behavioral uncertainty and delegation of decision rights.
This study contributes to the literature in three important ways. Firstly, we extend the franchise literature that deals with decision rights in franchising (Arrunada et al. 2001; 2005; Windsperger 2004; Azevedo 2009; Mumdziev and Windsperger 2011; Lopez-Fernandez, Lopez-Bayon 2011) by developing a transaction cost explanation of the allocation of decision rights. Secondly, we extend the literature which deals with trust in franchising (Dickey et al. 2007; Cochet et al. 2008; Lopez-Fernandez and Lopez-Bayon, 2011; Davies et al. 2011) by analyzing the impact of trust on decision rights allocation between franchise partners. Thirdly, this study extends the transaction costs literature by testing the role of trust as a moderator between the transaction costs variables (uncertainty and transaction-specific investments) and the franchisors’ propensity to allocate decision rights to the franchisees. Adding trust as a moderator has considerably increased the explanatory power of the TC model. Overall, we extend the TCT by investigating the moderating role of trust in the relationships between the transaction cost variables and the franchisor’s propensity to delegate decision rights to the franchisees. This provides new insight by demonstrating that considering trust in TCT supplements the explanation offered by TCT on the allocation of decision rights in franchising networks.
The paper is organised as follows: Section two presents the extended transaction cost model of decision rights allocation in franchising. Section three presents the results of the empirical analysis. In section four we summarise and discuss the results, and in section five we draw some conclusions.
2. Research Model and Hypotheses
Our research model consists of three transaction costs determinants: behavioural uncertainty, environmental uncertainty and transaction-specific investments. We test their effect on the decision rights allocation to franchisees as a dependent variable. Furthermore, we add trust in the model. Specifically, we hypothesise that trust moderates the impact of behavioural uncertainty, environmental uncertainty and transaction-specific investments with regard to the delegation of decision rights (see Figure 1).
Insert Figure 1
2.1 Behavioural uncertainty, trust and decision rights
Transaction cost theory views behavioural uncertainty as arising from the difficulties of accurately monitoring the contractual performance of exchange partners (Williamson 1985). Anderson and Gatignon (1986) define this concept as internal uncertainty, which exists when the firm cannot accurately measure agent’s performance. In the application of a TC model to explain firms’ make-or-cooperate decision, Hoffmann et al. (2010) find that higher performance measurement difficulties significantly increase the firms’ tendency to vertically integrate. Behavioural uncertainty increases the risk of opportunism that arises in the form of various dishonest and detrimental behaviour, such as cheating, shirking or distortion of information. In order to reduce the risk of franchisee’s opportunistic behaviour, the franchisor exercises greater control over the transaction partner’s activities (Williamson 1985; Gatignon and Anderson 1988). One way is to impose stronger control by centralising decision making. According to this traditional transaction cost view (Williamson 1975; Hennart 1991), we expect a negative relationship between behavioural uncertainty and franchisees’ portion of decision rights. Therefore, we formulate the following hypothesis:
H1: Franchisees’ portion of residual decision rights is negatively related with franchisors’ perception of behavioural uncertainty.
If a franchisor perceives the franchisee as trustworthy, this will influence his perception of behavioural uncertainty and hence its propensity to use formal control mechanisms. Trustworthy franchisees need to be less monitored under high difficulties to measure the performance of the network partners. As a result, the higher trust as informal control device, the lower the franchisor’s necessity for hierarchical control by centralising decision making in the case of performance measurement difficulties becomes. Consequently, we can derive the following hypothesis:
H1a: The relationship between behavioural uncertainty and franchisee’s portion of decision rights is less negative under high trust.
2.2 Environmental uncertainty, trust and decision rights
According to the control view of governance (Williamson 1975), firms will increase their information-processing capacity if the coordination requirements increase with environmental uncertainty. Stinchcombe (1990) asserts that organisations implement more elements of hierarchy when the degree of uncertainty increases. Similarly, Noordewier et al. (1990) show that environmental uncertainty is positively related with firm’s level of control. Therefore, when franchisors perceive increased environmental uncertainty (such as market volatility and low predictability of sales volume), they intend to increase control over operational decisions at the local markets. We subsequently formulate the following hypothesis:
H2: Franchisees’ portion of residual decision rights is negatively related with environmental uncertainty.
In high-trust relationships that facilitate information exchange and reduce opportunistic behaviour between the partners, franchisors will rely more on delegation of decision rights to franchisees when environmental uncertainty increases. Therefore, the negative effect of environmental uncertainty on the allocation of decision rights is expected to be lower if franchisors trust their franchise partners. We formulate the following hypothesis:
H2b: The relationship between environmental uncertainty and the franchisee’s portion of the decision rights is less negative under high trust.
2. 3 Transaction-specific investments, trust and decision rights
According to the transaction cost theory, transaction-specific investments increase the partners’ quasi-rents that can be expropriated by the less dependent partner (Williamson 1985; Klein 2000). When the transaction-specific investments of the franchisees are high, their quasi-rents are likely to exceed the potential hold-up gains from opportunistic behaviour. This bonding effect increases the self-enforcing range of contracts (Klein 1995, 1996). In this situation, the hostage effect of transaction-specific investments motivates the franchisees to behave cooperatively in order to realise the relationship-specific quasi-rents (Williamson 1983; Katz 2008).
This incentive effect of transaction-specific investments may influence the allocation of residual decision rights in the following way: Based on the traditional TC-view, decision rights are control devices to mitigate opportunism risk. The higher the opportunism risk for the franchisor, the higher is the degree of control by the headquarters. On the other hand, high franchisees’ transaction-specific investments result in lower opportunism risk, thereby requiring a lower level of control by the franchisor. Therefore, the higher the franchisees’ specific investments, the lower their motivation to behave opportunistically becomes, and the lower the franchisor’s need to monitor and control the franchisees by centralisation of decision making becomes, and hence the more residual decision rights are transferred to the franchisees. We can derive the following hypothesis:
H3: Franchisees’ portion of residual decision rights is positively related with franchisees’ transaction-specific investments.
Since transaction-specific investments result in high quasi-rents, which in turn increase the franchisee’s motivation to cooperate, higher trust increases the quasi-rent-generating effect of transaction-specific investments. Through this, the self-enforcing range of contract increases (Hwang 2006). In this case, the franchisor reduces hierarchical control by transferring a higher fraction of decision rights to the franchisees, compared to a situation with a lower level of trust. Therefore, we expect that trust will positively interact with the effect of the transaction-specific investments on the allocation of decision rights to franchisees. In other words, the positive effect of transaction-specific investments on the allocation of decision rights to the franchisees will be stronger in a high-trust situation. We formulate following hypothesis:
H3a: The relationship between transaction-specific investments and franchisee’s portion of the decision rights is more positive under high trust.