Improving Channel Coordination through Franchising

In this paper, we explore the role of franchising arrangements in improving coordination between channel members. In particular we focus on two elements of the franchising contract, namely, the royalty structure and the monitoring technology. We begin with a simple analysis where a manufacturer distributes its product through a retailer and the retail demand is affected by the retail price and the service provided by the retailer. In this context we show that neither royalty payments nor monitoring are needed for full coordination. We then extend the model to allow for free riding by franchisees and show that although monitoring helps affect the behavior of the franchisees, royalty payments are still unnecessary to coordinate the activities of the franchisor and the franchisees. Finally, we show that in environments where factors affecting retail sales are controlled by both the franchisor and the franchisee, royalty payments provide the necessary incentives for the franchisor while monitoring systems are used to ensure that franchisees also behave in the best interest of the channel. Our general results are found to be consistent with those in Brickley and Dark (1987) and Norton (1988), who conclude that franchising is affected by principal-agent problems. Our theory finds special support in the work of Lafontaine (1988) where it is concluded that the incidence of franchising is related to cost of monitoring and the importance of franchisor investments.