Lecture 9 - Franchising & Diversified Firms Flashcards
Types of Hybrid Governance Structures
- Long-term supplier contracts
- Supply chain systems (e.g., Toyota shares substantial decisions regarding the design of its cars with its privileged subcontractors)
- Quasi-integration (i.e., firms own some of the key assets of their suppliers, e.g., the big U.S. auto producers)
- Supplier parks, i.e., a cluster of suppliers located adjacent to, or close to, a final assembly point – physical (e.g., Volkswagen in Brazil) or “virtual” (e.g., Toshiba’s network of 200 direct partners and 600 “grandchild companies”)
- Strategic alliances: Relatively enduring cooperative arrangements; partners jointly plan and monitor substantial activities using contracts to coordinate and build relational trust (as in the alliances in the airline industry or biotech/pharma alliances)
- Joint ventures: simultaneously contractual agreements between two or more organizations and a separate legal (and usually organizational) entity with its own purpose
- Franchising:
Key Issue in Franchising
Contractual hazards VS. contractual safeguards
Hybrid form characteristics
- Hierarchy
o Routine
o Advice - Market
o Residual claimant
o Working for themselves
Franchising involves
- Trademark
- Fixed time period
- Specific geographical area
- Training
- 3 payments
Franchising payment system
- franchisee fee
- payment for training etc.
- percentage of sales
Why franchising?
- Franchising when there is geographical distance between producer and distributor;
- monitoring the input performance of distributor is costly – agency cost
- Each party (franchisor, franchisee) specialize (development, marketing, production, distribution; (constrained) delegation makes sense
- By making franchisees residual claimants, franchising contracts provide incentives for franchisees to pick efficient actions
Problem with Franchising – Latent Contractual Hazard
- Incentives for the (any) franchisee to reduce quality to freeride on the brand/trademark; additional safeguards are required (discussed in K&L article)
**Solution – Contractual Safeguards: **
* leaving rents downstream to franchisees so they lose out if they’re caught
* Choosing franchisees who are liquidity-constrained
Franchising: Incentives / Safeguards:
- Leave downstream rents to create incentives for the franchisee to choose efficient actions
- Requiring investments in specific assets
- Franchisor owning the trademark / brand, land & buildings
- Franchisee not allowed to have another job
- Easy to terminate a franchisee
Bargaining power & Franchisor oppertunism
- McDonalds has the majority of the bargaining power, but it doesn’t turn into franchisor opportunism
- The royalty fee reduces the franchisor’s incentive to opportunism / moral hazard and incentivizes him to invest in marketing and upgrading the concept
- Another reason: franchisees are liquidity constrained and face difficulties borrowing enough at a reasonable rate
Dual Distribution
A mix of wholly-owned outlets & franchised outlets
Why dual distribution
Monitoring
* For some outlets geographical distance is low enough that monitoring is feasible
Signaling
* Signal to prospective franchisees that the franchisor has a strong stake (ownership of outlets) in the overall operation.
* not an opportunistic fly-by-night operator.
(Perhaps mainly relevant for upstart chains; note McD has reduced its share of owned restos).
Learning
* Franchisees have lower costs of learning about local markets.
This knowledge may, however, be useful in other parts of the chain.
* Franchisors learn from local franchisees; deploy, test new learning in company-owned outlets b/f rolling it out across the chain
The diversified firm: Key issue
Internal costs of coordination when diversifying
Business ecosystem
- Many heterogeneous actors that are largely legally independent, but at the same time technologically and economically interdependent.
- Potentially many coordination, cooperation problems.
- Often coordinated by a central, big player through a platform, by standards and by rules of membership.
- Little vertical integration, often much diversification by the central player.
Background theory: Diversified firms
CF:
* Shares of diversified firms sell at a discount
ToF:
* Diversification can be value-increasing
* Firms tend to accumulate excess resources –> strong incentive to monetize these (zero opportunity costs) –> when market contracts and hybrids fail –> related diversification
* Not a managerial moral hazard, but superior knowledge on how to use resources
Multiproduct firms: Why do they exist?
Economies of scope
* But if transaction costs are low, market can handle such asset sharing
Excess, fungible resources
* Learning and routinization frees resources
* (e.g., managerial talent, improving coordination release work and machine time, etc.).
* Such excess resources may have no opportunity costs (i.e., they are idle).
* They may be ”fungible”, i.e., applicable to new, different uses.
* Strong incentive to deploy them to such uses, i.e., diversification growth through related diversification.
Market failure considerations (transaction costs)
* Excess resources deployed within firms, resulting in expansion (diversification), when market contracting is not feasible
* Causes of market failure:
* Excess specific physical capital: Hold-up risk.
* Excess specific human capital: Hold-up risk.
* Excess knowledge resources: Costly to articulate tacit knowledge & Arrow’s information paradox (difficult to trade knowledge)
* Excess financial capital (cash): Managers may have superior knowledge about the attractiveness of certain opportunities than stockholders/the financial market.
Synergies
But what about the hierarchy side of things? (cf. integration as the option of last resort).
Think of hierarchy failures
* Agency problems
* Coordination & cooperation problems
