The Dynamics of Franchise Contracting: Evidence from Panel Data

In this paper, we model the determinants of franchise contract terms, namely royalty rates and franchise fees, using a unique panel data set of about 1000 franchisors for the period 1980-1992. We focus on the extent to which firms adjust the terms of their contracts as they become better established, and find that adjustment is relatively infrequent and that firms do not systematically raise or lower their royalty rates or franchise fees when they do adjust them. These results tend to refute a number of existing theories of franchising that are based on risk-sharing, asymmetric information, and certain incentive structures, but support those based on franchisor opportunism and to some extent double-sided moral hazard. Our results also suggest that when industrial organization economists do not have access to panel data, their work may well suffer from the omitted variable bias caused by unobserved firm effects.