The Benefits of Franchising and Vertical Disintegration

A model of franchising competition in locationally differentiated products is constructed. A franchisor (upstream firm) collects a marginal transfer fee per unit of output sold by a franchisee (downstream firm). For example, the marginal transfer fee can be realized as a markup on variable inputs supplied by the franchisor. A franchisor also collects a lump-sum rent (commonly called "franchising fee") from each franchisee. Acting in the first stage, a franchisor can manipulate the degree of competition in the downstream market through his choice of the marginal fee while keeping the franchisee’s profits at zero through the lump sum rent. Franchisees choose prices for the final goods in the second stage. It is shown that, at the unique subgame-perfect equilibrium, the marginal fee is above marginal cost. Compared to a regime of vertically integrated firms, prices are higher, there are more numerous outlets when contractual costs are small, and social surplus is lower in the franchising regime