Observable something the contracting parties see Verifiable something that the

Distinction: “observable” versus “verifiable”. – Observable: something the contracting parties see – Verifiable: something that the courts also see

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.

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

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

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

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)

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

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

Relationship- Specific Investments and “Hold Up” 27

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