WHY ARE ROYALTY RATES HIGHER IN SERVICE-TYPE FRANCHISES

Royalty payments from a franchisee to a franchisor serve as incentive for the franchisor to provide appropriate levels of qualify and brand name invest ment. However, since they also distort the service provide d try the franchisee, we should expect relatively lower royalty rates in franchises that are primarily service-oriented. Casual examination of royalty rates across product-oriented and service-oriented franchis es shows that the opposite is true, with service-type franchises enjoy ing higher royalty rates. We resolve this apparent puzzle. The basic a rgument we put forth is that in product-type franchises, a franchisor can charge a wholesale price on goods transferred to the franchisee, t hus using an alternative instrument that also serves as an incentive f or the franchisor. Moreover, in general, a franchisor will use both wh olesale price and royalty to minimize distortions in retail price and service at the retail level. We then test the predictions of our model on different industries and find confirmation for the same.