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Unformatted text preview: Dual Organizational Structure of Franchise Contracts K.J. Wainwright Simon Fraser University May 29, 2002 1 I n t r o d u c t i o n In service based industries one of the fastest growing forms of market structure is that of franchise agreements. Cer- tain aspects of franchise contracts tend to be idiosyncratic in nature thereby attracting a great deal of interest by academics and business analysts in recent years. Various explanations have been proposed for the widespread use of franchise contracts in certain industries. While a great deal of the franchise contract has been explained in the literature, there remains certain aspects of this form of arrangement that has yet to be addressed. This paper in- tends to address two of these issues as well as proposing an alternative modelling approach to franchise contracts. The second section of this paper describes the basic structure of franchise contracts. The third section dis- cusses the various explanations that have been proposed to explain franchising. The fourth section sets two aspects of the franchise contract that has not been addressed in the literature. The first of these is existence of both cor- porate owned outlets and franchised outlets within the same organization. Some authors have predicted that one form or the other would come to dominate the organiza- tion. Others have tried to explain under which conditions one form would be preferred by the parent company (or Franchisor). Yet many organizations exist as a mixture of both types of contracts and have chosen both forms of contract when expanding the number of outlets. The sec- ond unexplained observation is apparent rigidity in various organizations’ franchise fee structure; both over time and between individual franchisees. The fifth section presents a model that proposes that both these observations can be explained when franchise agreements are modelled in a spatial context. The sixth section presents a digression into a dynamic model that uses optimal control theory to analyze explicitly the length of term of a franchise agree- ment, addressing attributes of franchise contracts designed to influence the term of commitment by the franchisee. A summary of empirical evidence is found in the Appendix. 2 Structure of the Franchise Con- tract A basic result derived in modern property rights litera- ture is that when any given set of rights is exchanged, the principals involved will select the institutional framework that minimizes the sum of production and transaction costs 1 . The most commonly observed of these arrange- ments (or governance structures) are price mediated mar- kets and centralized employment within firms 2 . These are not the only forms of arrangement within which trans- actions are carried out, and the distinction between the two mentioned above is not as clear as it is suggested....
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