Abstract
The organizational form of franchising has been shown to yield higher profits and faster growth through reducing agency costs. Why then does anyone not franchise? In this paper I argue that the diffuse residual claims of the franchise system reduce overall system quality, and that this problem is inherent in the nature of franchising. The theory is tested by examining evidence from both the restaurant and the hotel industries, including chains that franchise and ones that own all of their units. In both industries, quality is negatively related to the percent franchising in the chain, controlling for size, growth in units, monitoring costs, market segment, ownership structure, multi-chain operation, and price. The results suggest that the franchise contract increases free-riding and decreases quality in decentralized service chains, and that quality is not contractible in this setting.
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