The manager will have to be closely monitored. The franchisee, on the other hand, becomes the residual claimant on the new restaurant business and, accordingly, has a stronger incentive to reduce shirking and other forms of opportunistic behavior by the employees.
We note above that monitoring costs (or the costs associated with keeping track of manager and worker performance) are not eliminated through franchising. This is the case because the franchisees have some reason to shirk (albeit that the incentive to shirk is impaired by the franchise agreement that leaves the franchisee an important residual claimant). Customers often go to franchised outlets because they have high confidence in the nature and quality of the goods and services offered. McDonalds customers know that they may not get the best burger in town when they go to a McDonalds, but they do have strong expectations on the size and taste of the burgers and the cleanliness of the restaurant. McDonalds has a strong incentive to build and maintain a desired reputation for its stores, and therein lies the monitoring catch. Each franchisee, especially those that have limited repeat business, can “cheat” (or free ride on McDonalds overall reputation) by cutting the size of the burgers or letting their restaurants deteriorate. The cost savings for the individual cheating store can translate into a reduced demand for other McDonalds restaurants. This is a prisoner’s dilemma in which all stores can be worse off if noncooperative behavior becomes a widespread problem. So, McDonalds must set (and has strong incentives to do so) production and cleanliness standards and then back up the standards with inspections and fines, if not outright termination of the franchise contract.
McDonalds (and any other franchiser) also controls quality by requiring the individual restaurants to buy their ingredients -- for example, burger patties and buns -- from McDonalds itself or from approved suppliers. McDonalds has good reason to want its franchisees to buy the ingredients from McDonalds, not because (contrary to legal opinion) it gives McDonalds some sort of monopoly control, but because McDonalds has a problem in monitoring outside suppliers.48 Outside suppliers have an incentive to shirk on the quality standards with the consent of the franchisees that, individually, have an interest in cutting their individual costs. Moreover, by selling key ingredients, the franchiser has an indirect way of determining if its royalties are being accurately computed. So-called “tie-in sales” are simply a means of reducing monitoring costs. Of course, the franchises also have an interest in their franchiser having the lowest possible monitoring cost: it minimizes the chances of free riding by the franchisees and maintains the value of the franchise. Similarly, a franchiser like McDonalds (as do the franchisees) has an interest in holding all franchisees to uniform prices that are higher than individual McDonalds might want to choose. By maintaining uniform retail prices, McDonalds encourages its franchisees to incur the costs that must be incurred to maintain desired quality standards.
These points help explain up-front payment and royalty provisions in franchise contracts. The value of the franchise to the franchisee – and what the franchisee will pay, at a maximum, for the franchise – is equal to the present value of the difference between two income streams, the income that could be earned with and without the franchise. The greater the difference, the greater the up-front payment the franchisee is willing to make. However, the franchisee is not likely to want to pay the full difference up-front. This is because the franchiser would then have little incentive to live up to the contract (to maintain the flow of business and to police all franchisees). The franchiser could run off with all the gains and no costs. As a consequence, both the franchiser and franchisee will likely agree to an up-front payment that is less than the difference in the two income streams identified above and to add a royalty payment. The royalty payment is something the franchisee, not just the franchiser, will want to include in the contract simply because the franchiser will then have a stake in maintaining the franchisee’s business. A combination of some up-front payment and royalty is likely to maximize the gains to both franchisee and franchiser.
Franchising also has risk problems no matter how carefully the contract may be drawn. Typically, franchisees invest heavily in their franchise, which means the franchisee has a risky investment portfolio because it is not highly diversified. This can mean that the franchisee will be reluctant to engage in additional capital investment that could be viewed as risky only because of the lack of spread of the investment. As a consequence, franchisers will tend to favor franchisees that own multiple outlets. A franchisee with multiple outlets can spread the risk of its investments and can more likely internalize the benefits of its investments in maintaining store quality (customers are more likely to patronize, or fail to do so, at another of the owner’s outlets).
Obviously, both ownership and franchise methods of expansion have costs and benefits for investors. We can’t here settle the issue of how a firm like McDonalds should expand, by ownership of additional outlets or by franchising them. All we can do is point out that franchising should not be as important when markets are “local.” It should not, therefore, be a surprise that franchising grew rapidly in the 1950s with the spread of television that greatly expanded the market potential for many goods and services and when transportation costs. The chances for opportunistic behavior can be lowered through franchising, but hardly eliminated.49 If the franchisee buys the rights to the franchise and then invests in the store that has limited resale value, the franchiser can appropriate the rents simply by demanding higher franchise payments or failing to enforce production and quality standards with the franchisees, increasing the take of the franchiser but curbing the resale value of the franchise. On the other hand, if the franchisee pays for the building that has a limited resale value, the franchisee can, after the fact, demand lower franchise fees and special treatment (to the extent the franchiser must incur a cost in locating another franchisee).
Began declining rapidly, which allowed people to move among local markets.50 Franchising will tend to be favored when there is a low investment risk for the franchisee and when there are few incentives for free riding by both franchisee and franchisers. We should expect that franchises should be favored the greater the monitoring costs (implying the farther the store location is from the franchiser, the more likely the expansion will be through franchising, a conclusion that has been supported by empirical studies51). Also, we would expect stores at locations with relatively few repeat customers to be company owned. A better way of putting that point is the fewer the repeat customers in a given location, the greater the store will be company owned. When a store has few repeat customers, the incentive to cheat is strong, which means that the franchiser will have to maintain close monitoring to suppress the incentive for the franchisee to cheat or free ride – which implies there may be fewer cost advantages to franchising the location.52 If monitoring costs go down, we should expect firms to increase their ownership of their outlets.
Much of what we have written in this chapter is based on the presumption that people will behave opportunistically. We see the presumption as well grounded, given the extent to which people do behave that way in their daily dealings (and most managers have no trouble identifying instances of opportunistic behavior in workers, suppliers, and investors). We may, however, have given the impression that we believe that all people are always willing to behave opportunistically, which is simply contradicted by everyday experience. The business world is full of saints and sinners, and most people are some combination of both. We simply base our discussion here and in later chapters on a presumption that people will behave opportunistically not because such an assumption is fully descriptive of everyone in business, but because that is the threat managers want to protect themselves against. Business people don’t have to worry about the Mother Teresa’s of the world. They do have to worry about less-than-perfect people. (And they do have to worry about people who pretend to be like Mother Teresa before any deal is consummated.) They need to understand the consequences of opportunistic behavior in order that they can appropriately structure contracts and embedded incentives.
This suggests that the size and specialization of firms will change over time in response to technological advances that alter the relative costs of market transactions and the costs (as well as the efficiency) of managerial control. In other chapters we discuss the effects that improvements in communication, transportation, and management information systems are having on the size and focus of firms. The trend for firms to downsize and to refocus on their “core competencies” can be explained, at least in part, by the reduced cost of smaller, more specialized firms dealing with each other through market exchange in collaborative productive efforts. But no matter how specialized firms become, resources will continue to be allocated differently within firms than they are across markets. The reason firms will continue to exist is that over some range of productive activity, it is more efficient for resources to be directed by managerial control than by market exchange.53
MANAGER’S CORNER: Fringes, Incentives, and Profits
Varying the form of pay is one important way firms seek to motivate workers – and overcome the prisoners’ dilemma/principal-agency problems that have been at the heart of this chapter. And worker pay can take many forms, from cold cash to an assortment of fringe benefits. However, it needs to be noted that workers tend to think and talk about their fringe benefits in remarkably different terms than they do about their wages. Workers who profess that they “earn” their wages will describe their fringes with reference to what their employers “give” them. “Gee, our bosses give us three weeks of vacation, thirty minutes of coffee breaks a day, the right to flexible schedules, and discounts on purchases of company goods. They also provide us with medical and dental insurance and cover 80 percent of the cost. Would you believe we only have to pay 20 percent”.
Here, we have shown how opportunistic behavior can arise in the most basic of management decisions, whether to “make or buy.” An important task of a good manager is being constantly attentive to the trade-off between the advantages of buying and those of making, and one of the major worries is the extent of opportunistic behavior in that decision. In assessing this trade-off managers need to be aware that the decision is dependent upon the nature of what is to be bought or produced and that bureaucratic tendencies within a firm can distort decisions in favor of producing in-house even though buying would be more efficient. The firm that loses sight of this tendency may soon be out-competed by smaller firms that rely less on internal allocation and more on specialization and market transactions to produce at lower cost.
53 It should be pointed out.
If either the workers or the employers who make such comments are in fact telling the truth, then the company should be a prime candidate for a hostile takeover. Someone -- a more pragmatic and resourceful businessperson -- should buy the owners out, and the workers should want that someone to buy the company because they could then share in the gains to be had from the improved efficiency of the company.
Our arguments here will be a challenge to many readers since it will develop a radically different way of thinking about fringe benefits. It will require readers to set aside any preconceived view that fringes are a gift or that fringes are either provided or they are not. The approached used here employs what we call marginal analysis, or the evaluation of fringes in terms of their marginal cost and marginal value. It is grounded in the principle that profits can be increased so long as the marginal value of doing anything in business is greater than the marginal cost.
This principle implies that a firm should extend its output for as long as the marginal value of doing so (in terms of additional revenue) exceeds the marginal cost of each successive extension. It should do the same with a fringe: provide it so long as it “pays,” meaning so long as the marginal cost of the fringe is less than its marginal value (in terms of wages workers are willing to forgo and greater production) for the firm. This way of looking at firm decision-making means that changes in the cost of fringes can have predictable consequences. An increase in the cost of any fringe can give rise to a cut in the amount of the fringe that is provided. An increase in the value of the fringe to workers can lead to more of the fringe being provided.
Workers As Profit Centers
We don’t want to be overly crass in our view of business (although that may appear to be our intention from the words we have to use within the limited space we have to develop our arguments). We only want to be realistic when we surmise that from our economic perspective (the one that is likely to dominate in competitive business environments), the overwhelming Employers use some of the same language, and their answers to any question of why fringes are provided are typically equally misleading, though probably more gratuitous. The main difference is that employers inevitably talk in terms of the cost of their fringes. “Would you believe that the cost of health insurance to our firm is $4,486 per employee? That means that we spend millions, if not tens of millions, each year on all of our employees’ health insurance.
When making decisions on fringe benefits employers face two unavoidable economic catches: First, fringes are costly, and some fringes, like health and dental insurance, are extraordinarily costly. Second, there are limits to the value workers place on fringes. The reason is simply that workers value a lot of things, and what they buy, directly from vendors or indirectly via their employers, is largely dependent on who is the lowest cost provider.
Yes, workers buy fringe benefits from employers. They do so when the value the workers place on the fringes exceeds the cost of the fringes to the firms. When that condition holds, firms can make money by, effectively, “selling” fringes -- for example, health insurance -¬to their workers. How? Most firms don’t send sales people around the office and plant selling health insurance or weeks of vacation to their employees like they sell fruit in the company cafeteria, but they nevertheless make the sales. They do it somewhat on the sly, indirectly, by offering the fringes and letting their particular labor market conditions adjust. If workers truly value a particular fringe, then the firms that provide the fringe will see an increase in the supply of labor available to them. They will be able to hire more workers at a lower wage and/or be able to increase the “quality” (productivity) of the workers that they do hire.
Firms are paid for the cost of providing fringe benefits primarily in two ways: One, their real wage bill goes down with the increased competition for the available jobs that results from the greater number of job seekers (who are attracted by the fringe). This reflects the willingness of workers to pay employers for the fringe benefits. Two, employers gain by being more discriminatory in whom they hire, employing more productive workers for the wages paid and increasing sales.
No matter what happens in particular markets, we know several things about the pattern that will emerge in the fringe-benefit market:
•Many firms (but not all) can make money by “selling” fringes to their workers.
•Firms won’t provide the fringes if the combined gains from lower wages and better workers are not greater than the cost of the fringes.
We expect employers and workers to treat fringes like they do everything else, seeking some optimum combination of fringes and money wages. Again, this means that employers and workers should be expected to weigh off their additional (or marginal) value against their additional (or marginal) cost. An employer will add to a fringe like health insurance as long at the marginal value (measured in money wage concessions or increased production from workers) is greater than the marginal cost of the added fringe. Similarly, workers will “buy” more of any fringe from their employer so long as its marginal value (in terms of improved health or reduction in the cost of private purchase) is greater than its marginal cost (wage concessions).
While we can’t give specifics, we do know that managers are well advised to search earnestly for the “optimum” combination (which means some experimentation would likely be in order) even though the process of finding the optimum is beset with imprecisions. The firms that come closest to the optimum will be the ones that can make the most money from their employees. They will also be the ones that provide their employees the most valuable compensation for the money spent -- and so will have the lowest cost structure and be the most competitive. By trying to make as much money as possible from their employees, firms not only stay more competitive, they also benefit their workers as well.
So far, we have considered only fringes in which the added cost of the fringe to the firm is less than the value of the fringe to the workers. What if that were not the case? Returning attention to Figure 6.2, suppose that the cost of the fringe to firms were greater than the value of the fringe to workers (in the graph, the distance bc is greater than the distance ac), what would happen? The straight answer: Nothing. The fringe would not be provided. The reason is obvious: Both sides, workers and owners, would lose. The resulting drop in the wage would be less than the cost of the fringe to the employers, and the resulting drop in the wage would be greater than the value of the fringe to the workers. (To see this point, just try drawing a graph with the vertical drop in the demand greater than the outward shift of the supply.) Such a fringe would not -- and should not -- be provided simply because it is a loser to both sides.
