Abstract
This article builds a simple theoretical model for the optimal expected length of a franchise contract. The main outcome is that fixed specific investment positively impacts contract duration confirming previous theoretical conjectures. Additionally, other variables such us the price–cost margin of the franchise, the brand name or the discount factor also play a relevant role. The empirical analysis using a large sample of franchises operating in Spain confirms the main conclusions of the model. However, the connection found between investment and duration, although statistically robust, is weak from an economic point of view. This result suggests the possibility that, in general, most franchisees are not in equilibrium because of the high standardization of this contract term across franchises. In these cases, the expectation of renewal is likely to be a crucial element of adjustment.
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Notes
Guriev and Kvassov (2005) also consider the possibility of investment by both parties. In this case, the longer is the contract duration of the fixed term contract the higher is the seller’s share in the total instantaneous return to investments. The conclusion of the analysis is, therefore, equivalent.
With respect to the rest of the parameters, it is important to note that the ratio of fixed cost over average absolute margin compatible with the equilibrium decreases as the discount factor increases. Additionally, the parameter representing the impact of experience (ρ) on present discounted outcomes has a negative impact on duration. That is, higher values of the parameter imply that the point of maximum profits is reached earlier. These parameters are assumed industry specific and encapsulated in the fixed effects in the empirical model.
In some cases (mainly for contracts of 5 years of duration) the possibility of renewal is explicitly included in the contract. However, in order to be in accordance with the theoretical model, we are interested in the value of the variables at moment zero. In any case, as commented along the text, this possibility could be an essential factor of adjustment for the franchisee.
In fact, the correlation between both variables is high for most sectors.
There exist the possibility that investment numbers underestimate real investment more for those franchises requiring a small monetary amount because of the existence of implicit investments (e.g. managerial time). Unfortunately, data availability makes not possible to control for this possible bias.
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We are grateful to an anonymous referee for helpful comments and suggestions. This research is dedicated to our children: Lara and Rafael.
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García-Herrera, A., Llorca-Vivero, R. How time influences franchise contracts: the Spanish case. Eur J Law Econ 30, 1–16 (2010). https://doi.org/10.1007/s10657-009-9124-8
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DOI: https://doi.org/10.1007/s10657-009-9124-8