Why Do Firms Impose Vertical Restraints: Evidence from Franchise Contracts

Abstract

Franchising is a business form in which one firm (the “franchisor”) licenses another firm or individual (the “franchisee”) to operate businesses using the franchisor’s trademarks and proprietary business methods. Vertical restraints—contractual controls imposed by an upstream firm on the operations of a downstream firm, such as price, supplier and customer restrictions—are the essential features of franchise contracts. The presence or absence of particular vertical restraints determine which business decisions the franchisor seeks to control, and which it seeks to delegate to local managers. There are several theories seeking to explain why firms impose vertical restraints. One explanation focuses on agency costs and the role of vertical restraints in restraining franchisee opportunistic behavior. Another emphasizes the role of risk and uncertainty and the need for brand owners to delegate authority to local managers with superior information. Finally, some explanations point to the role of vertical restraints in labor discipline, arguing that firms deploy vertical restraints to target a vulnerable (low-skill, high-turnover, low-wage) workforce for downstream employment. By removing non-labor variables from the franchisee’s profit-maximizing choice set, vertical restraints compel franchisees to focus on minimizing labor costs and extracting labor effort for their profit margins, to the exclusion of alternative profit-maximizing strategies like charging higher prices, substituting cheaper inputs, investing in training, or motivating employees with efficiency wages. Using a data set created from 530 franchise contracts, I examine which franchisor characteristics predict the likelihood of imposing vertical restraints. I find that agency cost, risk, and worker characteristic variables are significantly associated with the likelihood of imposing vertical restraints, but that much of the variation in the likelihood of imposing vertical restraints remains unexplained.