Adoption, Transfers, and Incentives in a Franchise Network with Positive Externalities

We study franchise arrangements that allow franchisees with exclusive territories to own their customers. This permits franchisees to benefit from positive externalities in the franchise network through interfranchise transfers based on the purchases by their customers at other franchises on the network. Using the structure of a single franchisor and many franchisees, we show that, in general, interfranchise transfers between franchisees and incentives for franchisee investment in the expansion of their customer base are critical both to the size and to the benefits derived from the franchise network. Specifically, we find that when individual franchisees make investments in marketing effort to increase their customer base, the franchisor's setting of the interfranchise transfer trades off the positive effects on network size with the negative effects of removing franchisee incentive for investment. This result is due to the fact that interfranchise transfers encourage adoption, but discourage full investment in marketing effort. As compared to first-best franchisee investment, use of the royalty and the inter-franchise transfer directly dissipates franchisee profits, and indirectly dissipates franchisee profits through less than universal adoption, thereby causing franchisees to underinvest. As compared to traditional franchise systems, however, use of the interfranchise transfer results in franchises making greater investments than they otherwise would.