Observable something the contracting parties see Verifiable something that the

Observable something the contracting parties see

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Distinction: “observable” versus “verifiable”. Observable: something the contracting parties see Verifiable: something that the courts also see
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19 What is the optimal organizational form? Choice #1: Stores are owned by McDonalds Manager is an employee with incentives governed by monitoring / internal career concerns Choice #2: Stores are independently owned and relationship with McDonalds governed by franchise contract Many items will be left out of the contract and will be either left up to the manager or negotiated ex post as they arise Notice: either way, the economies of scope from McDonalds’ brand, menu, etc., are realized.
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20 What is the optimal organizational form? Fundamental tradeoff: Independent franchisee will have stronger incentives to maximize the store’s profit Weaker incentives to maximize McDonalds’ profit
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21 Incentives under independence Manager has strong incentives to maximize the profit of her store Exert more effort Respond quickly and optimally to local demand conditions Steal market share from neighboring locations Manager has weak incentives to take actions which benefit McDonalds as a whole Introducing salads that are important to image but not popular locally Changing signs / redesigning store Promoting McDonalds’ brand in a city Cooperate with neighboring locations
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22 Incentives under independence When unforeseen contingencies arise, they will have to be negotiated Haggling cost Possibility that negotiations break down and profitable investments are not made
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23 Incentives under ownership Manager has weaker incentives to maximize the profit of her store Effort is difficult to monitor Compensation cannot be tied perfectly to store profits Manager will therefore be comparatively more willing to invest in things that benefit the whole company More willing to trade off own store’s profits May have incentives tied to the success of the company overall Headquarters can make some decisions directly (new signs, new product offerings)
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24 Incentives under ownership Headquarters may be able to make key decisions cheaply without haggling costs On the other hand, there may be additional costs of bureaucracy Internal “rent seeking” General organizational costs and red tape
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25 The flip side The same incentive problem also applies in reverse... If stores are franchises, McDonalds will have limited incentive to make investments that increase individual store profits Marketing, training for employees, etc. If stores are owned by McDonalds, its incentives will be stronger
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Relationship- Specific Investments and “Hold Up” 27
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28 Relationship-specific investments A relationship-specific investment is an action that: Is costly Increases the total value created in a relationship Has less value if the relationship breaks down
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29 Example: Coal plant Imagine the white board is the great plains There’s a coal mine on the left of the board,
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