The Franchise Dilemma: Agent Motivations, Contracting, and Opportunism in Hybrid Governance

Abstract

Transaction cost economics (TCE) suggests that organizations will handle transactions so as to minimize the costs involved in carrying them out. Increasingly, organizations turn to hybrid forms of governance such as franchising to have greater control than in market exchange, and to avoid disadvantages associated with vertical integration. Franchising is common in sectors where organizations need to operate through diffused distribution networks with outlets that are located close to customers and managed by individuals with local knowledge. It is for this reason that the success of such operations strongly depends on both, the proper selection (ex-ante) as well as the management of franchisees (ex-post). However, two key assumptions of TCE, bounded rationality and opportunism, advocate a focus on the ex-post contracting of partners. As a consequence, research has focused on appropriate contracting so as to minimize moral hazard (in the form of opportunism) and transaction costs. While the limitations of formal contracting have been well established in the literature, less is known about the safeguarding limits of relational contracting. Although some studies suggest that relational contracting is efficient, there is also evidence that it is dependent on organizational governance form and situation whether relational contracts are resistant to opportunism. From an agency theory perspective, franchisors (principals) have to consider the motivations of the individual franchisee (agent) before determining contractual arrangements. However, little research has been carried out to investigate the combined effects of individual motivation and ex-post contracting on opportunism. We suspect a dilemma for franchisors: While franchisees are often selected on the basis of their entrepreneurial capacities, we hypothesize that some entrepreneurial motivations are positively linked to opportunism, which in turn is associated with higher transaction costs for the franchisor. On the other hand, if selecting franchisees based on their likely non-opportunistic behavior, their performance in the system might be lower than expected.