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
Disadvantage of related diversification
- More interdependencies
- E.g., share assets
- More complexity
- = More costly to manage
Managing the diversified firm
Diversification arises as a response to market failure … but risks shifting transaction costs into the boundary of the firm!
Sharing inputs Interdependencies between business lines Changing an activity creates ripple effects throughout the rest of the operation (more ”reciprocal interdependencies”, cf. Session 7)
Internal costs:
- Joint designing, scheduling and mutual adjustments.
- Setting transfer prices.
- Designing incentives for cooperation.
Handling interdependencies and costs requires ongoing communication/constant management effort.
