Incomplete contracts and the choice between vertical integration and franchising

Previous studies have demonstrated that geographical dispersion of outlets leads to an incentive for firms to franchise. Geographical dispersion alone, however, does not provide a full explanation of the firm's decision to franchise. Certain industries with highly dispersed retail outlets, such as supermarkets, almost never franchise. This paper uses the incomplete contracting paradigm to demonstrate how the inability to contract over local outlet costs can drive the firm's decision to franchise or integrate. Since only owners have incentives to reduce cost, ownership of the local outlet should rest with the party with the greatest ability to control cost. The theory is then applied to several industries.