Franchising and the Principal-Agent Problem

How franchising solves some incentive problems between owners and managers, but creates others like free-riding on the brand's reputation.

Franchising is a way to deal with incentive problems.

The principal-agent problem

When a principal (brand) hires an agent (manager), the agent may not work as hard as the principal wants, since the agent doesn’t keep the profits.

Franchising’s solution

Franchisees own their outlets and keep profits, so they have strong incentives to work hard and control costs.

New problem: free-riding

A franchisee may cut quality to save money, such as using cheaper ingredients.
Customers blame the brand, harming all outlets.
The franchisee captures savings while others share the damage.

This is a free-rider problem on the brand’s reputation.

Solutions

Standards and inspections.
Mystery shoppers.
Approved suppliers only.
Termination clauses for violations.

Highway outlets

Franchisees in highway locations, where customers rarely return, have stronger incentives to cut quality; brands often monitor them more or own them directly.

The cheaper cheese

A franchisee secretly uses cheaper cheese to boost profits. Customers complain online about the brand's pizza everywhere. Inspections catch the practice.

Thinking franchising removes all incentive problems

It creates free-riding on the brand's reputation.

Key takeaways

Franchising aligns owners' incentives with effort.
Franchisees may free-ride on brand reputation.
Standards, inspections and approved suppliers control quality.
Outlets with few repeat customers need more monitoring.