Specific Investments in Franchisor–Franchisee Relationships: A Model

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Specific Investments inFranchisor–Franchisee Relationships: AModelManish Kacker a & Ruhai Wu aa Marketing Area, DeGroote School of Business, McMasterUniversity , Hamilton , Ontario , CanadaPublished online: 06 Feb 2013.

To cite this article: Manish Kacker & Ruhai Wu (2013) Specific Investments inFranchisor–Franchisee Relationships: A Model, Journal of Marketing Channels, 20:1-2, 120-140, DOI:10.1080/1046669X.2013.747863

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120

Specific Investments in Franchisor–Franchisee Relationships: A Model

MANISH KACKER and RUHAI WU Marketing Area, DeGroote School of Business, McMaster University,

Hamilton, Ontario, Canada

Transaction cost theory has largely considered specific investments as exogenous, leading to calls for studying them as endogenous decisions. We examine firms’ specific investment decisions through a game-theoretic model of bilateral, sequential decisions in an extant franchisor–franchisee relationship with information asym-metry. Our model shows specific investments can directly increase channel revenues and function as tools to credibly communicate demand information. Specifically, under certain conditions, it is optimal for a franchisor to make a specific investment even when it is not reciprocated by the franchisee. Here, the investment does not directly increase exchange value but only acts as a money-burning signal.

KEYWORDS franchising, transaction cost theory, specific invest-ments, game theory, information asymmetry, signaling

INTRODUCTION

Firms are often faced with situations where they are called on to make spe-cific investments1 in their ongoing vertical exchange relationships to fully realize new business opportunities. This holds true in franchising, where franchisors and franchisees are often called on to make such investments. For example, a number of franchise chains (e.g., Red Lobster [Anonymous,

1“Specific investments” have also been referred to as “specific assets,” “idiosyncratic investments,” “firm-specific investments,” “relationship-specific investments,” and “transaction-specific investments” in the literature. For expositional convenience, we limit ourselves to the term specific investments.

Address correspondence to Manish Kacker, Marketing Area, DeGroote School of Business, McMaster University, 1280 Main St. W., Hamilton, ON L8S-4M4, Canada. E-mail: [email protected]

Journal of Marketing Channels, 20:120–140, 2013Copyright © Taylor & Francis Group, LLCISSN: 1046-669X print/1540-7039 onlineDOI: 10.1080/1046669X.2013.747863

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Specific Investments 121

2003] and McDonald’s [Gogoi, Arndt, & Moiduddin, 2006]) have made exten-sive specific investments in remodeling stores. Typically, these remodeling investments have been relationship-specific for franchisees but not so for franchisors. However, this is starting to change, with chains realizing that their investments may also need to be outlet-specific. For example, effective store remodeling may require the tailoring of designs to an individual store’s specific location and environment, as evidenced by Starbucks’ recent efforts:

To shed the sameness, Mr. Rubinfeld is trying to give each store a feeling of “local-ness,” he said, reflecting the neighborhood and its architectural his-tory. At the University Village store in Seattle, for example, there is a long communal table hewn from an ash tree that fell in the Wallingford neigh-borhood of Seattle, and it is lined with electrical outlets because at night it is filled with students studying. At the Starbucks stores in the Capitol Hill neighborhood, bunches of wildflowers sit in mismatched jugs on tables found in antique shops. Beans are ground to order and poured through a cone like those used in artisanal coffeehouses. On the outdoor patio, coffee grounds are piled in a bucket with a handwritten sign encouraging neigh-bors to take them for composting in their gardens. (Miller, 2010)

The primary rationale for these specific investments can be found in their value creation benefits (Ghemawat, 1991; Ghosh & John, 1999). Such investments, either by lowering economic costs or by facilitating the realiza-tion of unique value propositions, enhance the pool of profits shared by the exchange partners ( Jap, 1999). However, by definition (Williamson, 1983), these investments have negligible salvage value when deployed outside the relationship. Therefore, under conditions of environmental uncertainty and bounded rationality, they imply potentially greater transaction costs, in terms of opportunistic behavior by the exchange partner (Williamson, 1985). The trade-off between potential efficiency gains and higher transaction costs associated with specific investments occurs for all types of specific assets: site, physical assets, human assets, dedicated assets (Williamson, 1983); pro-cedural assets (Zaheer & Venkataraman, 1994); or temporal assets (Malone, Yates, & Benjamin, 1987).

When should a franchisor make such specific investments? Are there conditions when a franchisor should make them even if they do not directly enhance exchange efficiency? Are there conditions where the franchisor should not worry about potential opportunism arising from these invest-ments? How do information asymmetries between the franchisor and fran-chisee (arising from environmental uncertainty and differing bounds on organizational rationality) impact the investment decision? We adopt a formal, game-theoretic modeling approach to investigate these questions and sub-stantively and methodologically enrich the transaction cost theory (TCT) lit-erature. In the next section, we review the TCT literature and highlight gaps that we seek to address through our work. Subsequently, we detail our

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122 M. Kacker and R. Wu

model, solution approach and results. Finally we conclude with a brief dis-cussion of the implications of our findings.

CONCEPTUAL DEVELOPMENT

An overview of the methodological and substantive diversity in the extensive TCT literature is presented in Table 1. Much of the TCT literature is empirical in form and treats specific investments as an exogenous variable. The focus of this stream of literature is on identifying governance mechanisms that best economize across neoclassical production costs as well as transaction costs. Under conditions when transaction costs are potentially largely (when envi-ronmental uncertainty and specific investments are high), the focus is on the choice of governance mechanisms that best safeguard against opportunism. Williamson (1975) viewed vertical integration as superior to market-based exchange under conditions of high transaction costs. Subsequent research in economics and marketing has identified other governance mechanisms and safeguards as well: Some examples include relational norms (Macneil, 1980; Heide & John, 1992); bilateral governance (Heide, 1994); hostages (Klein, 1980; Dyer, 1997); dependence balancing through offsetting investments (Heide & John,1988); qualification (Stump & Heide, 1996); and monitoring (Williamson, 1985; Rokkan, Heide, & Wathne, 2003; Heide, Wathne, & Rokkan, 2007).

A number of review articles in the TCT literature have recognized this emphasis on governance mechanisms and safeguards as the focal endogenous variable as well as the widespread consideration of specific investments as an

TABLE 1 TCT Literature

Method

Specific investments

Exogenous Endogenous

Conceptual/empirical Extensive body of extant literature in this quadrant (e.g., Anderson, 1985; Dyer, 1997; Heide & John, 1992; Heide, 1994; Heide & John, 1988; Heide, Wathne, & Rokkan, 2007; Klein, 1980)

Limited body of extant literature in this quadrant (e.g., Parkhe, 1993; Bensaou & Anderson, 1999; Stump & Heide, 1996; Stump & Joshi, 1998; Ghosh & John, 2005; Jap, 1999; Kang, Mahoney, & Tan, 2009)

Theoretical models Limited body of extant literature in this quadrant (e.g., Williamson, 1983; Riordan & Williamson, 1985; Hill, 1990; Grossman & Helpman, 2002; Masten & Crocker, 1985; Crocker & Masten, 1988; Chung, 1991; Hackett, 1993)

Some literature focused on ex-ante, pre-contract settings. No extant literature on specific investments in ongoing exchange relation-ships in this quadrant.

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exogenous variable. In a comprehensive review of empirical studies in market-ing involving transaction cost analysis, Rindfleisch and Heide (1997) synthe-sized 45 articles published from 1982 to 1996 that involve one or more of the central constructs of TCT. Of these studies, only 2 had used specific investments as a dependent variable whereas 31 studies had used specific investments as an independent variable. More recently, Carter and Hodgson’s (2006) review cov-ered 12 studies that focused on vertical integration as the dependent variable and specific investments as an independent variable as well as 15 studies that examined the effects of exogenous specific investments on other safeguards or opportunism. None of the 64 papers reviewed by David and Han (2004) con-sidered specific investments to be an endogenous variable.

The focus on governance mechanisms (and the corresponding treatment of specific investments as an exogenous variable) is also found in the some-what sparser literature stream of game theoretical TCT models ( John & Reve, 2010). Most of the research in this stream has revolved around the impact of exogenous specific investments on the choice of governance mechanism (e.g., Williamson, 1983; Riordan & Williamson, 1985; Hill, 1990; Grossman & Helpman, 2002); contract design (e.g., Masten & Crocker, 1985; Crocker & Masten, 1988; Chung, 1991); or channel profit allocation (Hackett, 1993).

The consistent but limiting focus on specific investments as only an exogenous construct has been recognized in the TCT literature. Williamson (2010) notes that asset specificity is a “design variable.” Rindfleisch and Heide (1997) indicate that studying the antecedents of some of the TCT variables such as asset specificity (a.k.a. TSI) is still in its early stages.

Macher and Richman (2008, p. 41) reiterate this concern and call for it to be addressed:

A second important gap in the existing empirical literature concerns the endogeneity of transaction cost variables, most notably asset specificity. Virtually all of the studies examined in this survey treat the specificity of assets and the level of a firm’s investment in those assets as exogenous. These are, however, choice variables.

The ensuing holes in the TCT literature are highlighted by Bensaou and Anderson (1999, p. 463): “Because specific investments are viewed as exog-enous to the governance structure decision, little attention has been focused on the origin of transaction specific assets.”

A relatively newer empirical literature stream focused on understanding the antecedents of specific investments has emerged. Parkhe (1993) identi-fied the perceptions of opportunistic behavior as a key antecedent of spe-cific investments. A number of other studies have yielded similar results for related relationship characteristics (e.g., Bensaou & Anderson [1999] found partner trustworthiness to have a positive effect on specific investments). Extant studies have also found specific investments made by the exchange

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partner to be a key antecedent of a firm’s specific investments (Stump & Heide, 1996; Stump & Joshi, 1998; Bensaou & Anderson, 1999; Ghosh & John, 2005). A third set of antecedents of specific investments revolve around task characteristics: size of the procurement and the use of multiple supply sources (Stump & Joshi, 1998); task features that demand buyer supplier coordination (Bensaou & Anderson, 1999); and complexity of interface (Ghosh & John, 2005). A fourth set of antecedents reflect the effects of the external environment, in terms of technological unpredictability (Stump & Heide, 1996); technological and market uncertainty (Stump & Joshi, 1998); environmental uncertainty and thinness of the supply market (Bensaou & Anderson, 1999); environmental dynamism and environmental demand ( Jap, 1999); technological and volume uncertainty; as well as number of suppliers (Ghosh & John, 2005). Finally, Kang, Mahoney, and Tan (2009) focus on the following benefits as key antecedents of specific investments: the economic value of inter-project knowledge spillover effects with the partner; the eco-nomic value of inter-project knowledge spillover effects with other firms; and the economic value of reputation spillover effects with other firms.

A review of this stream of literature reveals two limitations that present opportunities for contributing to the literature. First, Most of the previously identified antecedents of specific investments reflect factors that (a) reduce the threat of opportunism and lower transaction costs associated with spe-cific investment or (b) amplify the direct productivity enhancing effects of the specific investments. Notably, the signaling function of specific invest-ments in extant exchange relationships has not been fully investigated; while some research has looked at specific investments as a signal of organiza-tional commitment to the relationship, the private information-signaling function of specific investments in ongoing exchange relationships has been hitherto ignored in the TCT literature. Given the presence of various environ-mental uncertainties, it is very likely that a franchisor and its franchisees operate under conditions of information asymmetry. The use of specific investments by a better-informed firm to signal favorable information to its extant exchange partner has not been fully investigated.2 The signaling value

2It should be noted that signaling has been previously studied in the franchising literature. However, many of the studies have examined signaling (through specific investments as well as other mechanisms) at the commencement of the exchange relationship. In contrast, we examine the signaling function of franchisor-specific investments in an ongoing exchange relationship (where the franchisee is already a part of the franchise system). Gallini and Lutz (1992) use theoretical modeling to examine the signaling function of dual distribution and the fee structure of the franchise contract in attracting new franchisees. The use of contract terms to signal franchisor quality to prospective franchisees has also been theoreti-cally examined by Tirole (1988) and Desai and Srinivasan (1995). The same question is empirically exam-ined by Lafontaine (1993). Similarly, Michael (2009) empirically assesses whether and how franchisors use earnings claims to signal their quality to prospective franchisees. Michael (2000) empirically examines how ex ante franchisor-specific investments in tapered integration and buyer selection can lower ex post transaction costs. Here, too, the focus is on investments prior to the establishment of the contractual exchange relationship.

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of specific investments may be a potentially important antecedent of specific investments.

Second, extant studies of antecedents of specific investments have pri-marily investigated these relationships using cross-sectional surveys (Kothandaraman & Kacker, 2009). As has been extensively documented in the marketing literature (e.g., Rindfleisch, Malter, Ganesan, & Moorman, 2008), cross-sectional surveys may suffer from the limitations of common method bias (Podsakoff, MacKenzie, Lee, & Podsakoff, 2003). Moreover, causal inferences (Sobel, 1996) can be compromised in cross-sectional stud-ies (e.g., the relationship between trustworthiness and specific investments: while higher levels of trustworthiness can lead to specific investments, the existence of such investments can also be an important antecedent of trust in an exchange relationship). The challenges in making causal inferences can be overcome by using longitudinal studies and experimental methods (Dahlstrom & Nygaard, 1999). However, Rindfleisch et al. (2008) note that longitudinal research has its own unique set of problems and limitations. Kothandaraman and Kacker (2009) use experimental methods to show the direct and interactive effects of trust and interdependence (relative and total) on specific investments in extant vertical exchange relationships. Their results suggest that combining cross-sectional survey research with experi-mental studies may facilitate overcoming concerns of common method bias and causal inference in cross-sectional survey research. Another approach for overcoming these concerns is to complement cross-sectional survey research with internal validity-enhancements through theoretical modeling (Moorthy, 1993).

We seek to address the previously mentioned gaps in the literature by using a formal game-theoretical modeling approach to investigate and iden-tify a new, signaling rationale for making specific investments in ongoing exchange relationships.

MODEL

We model bilateral, sequential specific investment decisions3 in a franchisor–franchisee exchange relationship characterized by information asymmetry, with one firm (the franchisor) better informed than the other (the franchisee). After the firms make the investment decisions, both firms undertake market-ing actions, sales are realized, and revenues are allocated between the firms

3It is important to distinguish between such bilateral, sequential specific investment decisions and a hostage exchange, where two firms simultaneously make specific investments. Examples of bilateral, sequential specific investments abound in practice (e.g., the decision of a supplier to dedicate personnel to develop and deliver a customized training program about the supplier’s unique products to a retailer’s sales force at the retailer’s site, followed by the retailer’s decision to commit salespeople away from selling activities to undertake this training and invest in learning about the supplier’s unique products).

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in accordance with the exogenous royalty rate specified in the franchise con-tract. This sequence is summarized in the model timeline in Figure 1, followed by a description of the model parameters, decisions, and functions.

Specific Investments

We focus on bilateral sequential specific investments in our model. Such specific investments have a beneficial impact on sales and enhance exchange efficiency only when both parties make their respective specific investments. The franchisee will not make a specific investment if the franchisor does not make a specific investment. However, if the franchisor makes the specific investment and the franchisee does not reciprocate, there is no direct benefi-cial impact of the franchisor’s investment on channel sales. We set up the model to reflect these properties of the specific investments. When deciding the specific investment, the franchisor first decides whether or not to make the specific investment, or SIS = 1 or 0. If it makes the investment, its cost is cSIs. Observing the franchisor’s decision, the franchisee then decides whether to make its specific investment, or SIr = 1 or 0. If it does so, its cost is cSIr. The specific investments directly increase sales only if both firms make them, or SIS.SIr = 1.4

Marketing Actions, Revenue Allocation, and Profit Functions

After the franchisor and the franchisee make decisions on the specific invest-ment, they simultaneously undertake their respective, ongoing marketing efforts es and er (e.g., product development and national advertising to con-sumers by the franchisor; retail outlet management and service to customers by the franchisee). We assume both firms have the same quadratic cost function for their marketing efforts, that is, ( ) 2, where or .i ic e be i s r= = The channel revenue R, is then generated and shared proportionally between the franchi-sor and the franchisee. Specifically, the franchisor and the franchisee get ρ and 1 – ρ of the channel revenue respectively, with ρ being the contractually specified ongoing royalty rate on sales revenues. Note that ρ is exogenously

4This relationship distinguishes the franchisor’s specific investment from an unproductive sunk cost.

FIGURE 1 Model timeline.

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determined. This is consistent with business practice e.g., in franchising, such royalty rates are determined at the outset of long term franchise con-tracts and tend to be stable over time (Lafontaine and Shaw, 1999).

Given the franchisor’s and the franchisee’s proportional share of the channel revenue, their net profits are, respectively,

ρπ

ρ⎧ − − =

= ⎨ − =⎩

2

2

1

0sSI s s

ss s

R c be if SI

R be if SI, and

2

2

(1 ) 1.

(1 ) 0rSI r r

r

r r

R c be if SI

R be if SI

ρπ

ρ⎧ − − − =

= ⎨ − − =⎩

Information Asymmetry and Impact of Uncertainty on Revenues

Channel revenues depend on whether the firms make specific investments, their marketing efforts, and the market demand. Specifically,

( )( )

θλθ

⎧ + ⋅ =⎪= ⎨ + ⋅ =⎪⎩

0

1s r s r

s r s r

e e if SI SIR

e e if SI SI.

Here, λ > 1, represents the positive effect of the combination of franchisor and franchisee specific investments on channel revenue. θ is a random vari-able that describes the impact of the market demand on sales. We assume θ can be one of two values, θh or θl, where θh > θl > 0. θh is realized with a probability of α while θl is realized with a probability of 1 – α. The franchisor and the franchisee have asymmetric information on the market demand, or θ. Consistent with many examples of business practice, we assume that the franchisor has superior information about the product and the market. Hence, it knows the true θ before it makes decisions on SIS and es. The fran-chisee, with relatively inferior information, knows only the distribution of θ.5

ANALYSES

In our model, there are two types of potential outcomes: “separating equilib-rium” outcomes and “pooling equilibrium” outcomes. For the former, the franchisor chooses SIS based on whether θ = θh or θl. Consequently, the fran-chisee infers the value of θ by observing SIS and optimizes SIr and er, given the value of θ. For the “pooling equilibrium” outcomes, the franchisor chooses a constant SIS no matter whether θ = θh or θl. Here, the franchisee

5Our model is generalizable to situations where neither firm is fully informed but the franchisor is better informed than the franchisee.

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cannot infer the value of θ, but optimizes SIr and er based on the distribution of θ. In the next subsection, we examine the separating equilibrium out-comes. We then assess the pooling equilibrium outcomes. Finally, we iden-tify the conditions for the optimality of each of the separating and pooling equilibrium outcomes in the third subsection.

Separating Equilibria

We use backward deduction to explore optimal strategies for the franchisor and the franchisee in a separating equilibrium. We first consider their respective decisions on es and er when SIs and SIr have been determined. At this stage, the franchisee has interpreted the true value of θ and the franchisor and the franchisee have incurred costs on any specific invest-ments made by them. Therefore, their optimization problems and solutions are as follows:

Case 1: If SIS . SIr = 1, or the franchisor and the franchisee both decide to make specific investments,

For the franchisor: ( ) 2max se s r se e beρθλ + − .

Its optimal marketing efforts level depends on the market demand

value: *

,.

2s SIe

bθ

ρ θλ=

For the franchisee: As the franchisee can interpret the true value of market demand θ by observing SIs, its optimization objective is:

( ) ( ) 21 .max se s r re e beρ θλ− + −

Its optimal marketing effort level is θ

ρ θλ−=*

,

1.

2r SIe

b

The franchisor’s and the franchisee’s profits are, respectively,

ρ ρπ θ λ ⎛ ⎞= − −⎜ ⎟⎝ ⎠2 2 1

2 2 ss SIcb

and ρ ρπ θ λ− −⎛ ⎞= − −⎜ ⎟⎝ ⎠2 21 1

12

.2 rr SIcb

Case 2: If SIS ⋅ SIr = 0, the franchisor or the franchisee or both of them decide not to make specific investments,

To the franchisor: ( ) 2max se s r se e beρθ + − .

Its optimal marketing effort level is *

, .

2s no SIe

bθ

ρ θ=

To the franchisee: ( ) ( ) 21max re s r re e beρ θ− + − .


,

1.

2r no SIe

bθ

ρ θ−=

The franchisor’s profit is then

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ρ ρ ρ ρπ θ θ⎛ ⎞ ⎛ ⎞= − − −⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠2 21 1

2 2 2 2ss SIc orb b

, depending on whether it makes the

specific investment. The franchisee’s profit is 21 1 1

2 2 rr SIc orb

ρ ρπ θ− −⎛ ⎞= − −⎜ ⎟⎝ ⎠21 1

12 2b

ρ ρθ− −⎛ ⎞−⎜ ⎟⎝ ⎠ , depending on whether it makes the specific investment.

The analyses of case 1 and case 2 show that an effective specific invest-ment not only directly increases channel revenues but motivates the franchi-sor and the franchisee to increase marketing efforts and thereby indirectly enhances channel revenues. The analyses also show that the market demand (θ) has a positive impact on the marketing efforts by the franchisor and by the franchisee: Knowing that the market demand is high (θh), both firms increase marketing efforts, and channel revenues are raised. Finally, the anal-yses show that when the market demand is high (θh), the impact of specific investments on the firms’ marketing efforts and profits is stronger than that when market demand is low (θl).

We now consider the franchisor and the franchisee’s decisions on spe-cific investment.

Lemma 1: If SIs = 0, then SIr = 0. Lemma 1 is intuitive. As the franchisor acts first, and a direct increase in

revenues from specific investments requires investments from the franchisor and the franchisee, the franchisee will make its specific investment only if the franchisor does so first.

Lemma 2: If the franchisor adopts a separating strategy, choosing different SIs given θh and θl, the franchisor will set SIs = 1 if θ = θh and SIs = 0 if θ = θl. The franchisor will not set SIs = 0 if θ = θh, and SIs = 1 if θ = θl.

Proof: Lemma 2 can be proved by contradiction. Assuming the franchisor adopts a separating strategy, it sets SIs = 0 if θ = θh, and SIs = 1 if θ = θl. It sets SIs = 1 when θ = θl if the specific investment’s positive impact on the franchi-sor’s profit outweighs the franchisor’s cost of making the specific investment. Then, when θ = θh, given the foregoing analyses of case 1 and case 2, the specific investment has a higher positive impact on the franchisor’s profit and the franchisee’s profit than when θ = θl. Therefore, the franchisor should set SIs = 1 when θ = θh. This contradicts the assumption of separating strategy.

Lemma 2 shows that the franchisor has only one possible separating strat-egy: that it sets SIs = 1 if θ = θh and SIs = 0 if θ = θl. The franchisee can then tell the true value of θ by observing SIs. The franchisee’s decision on SIr may or may not vary given different θ. Its decision depends on the cost of making its spe-cific investment and the impact of the bilateral specific investments on its rev-enues. Therefore, there are two possible separating equilibria (SE1 and SE2):

SE1: * *

, ,

* *

, ,

if , 1, 1, ,

if , 0, 0, ,

h h

l l

h s r s s r rSI SI

l s r s s r rno SI no SI

SI SI e e e e

SI SI e e e e

θ θ

θ θ

θ θ

θ θ

⎧ = = = = =⎪⎨

= = = = =⎪⎩

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In this equilibrium, if θ is at θh , the franchisor will make its specific investment. The franchisee will then infer θh and make its specific investment. Given the bilateral specific investments and their direct beneficial impact on revenues, both firms put in high marketing efforts. If θ is at θl, the franchisor will not make its specific investment. The franchisee will then infer θl. In the absence of bilateral specific investments, both firms put in low marketing effort. Therefore, the franchisor’s and franchisee’s profits in the two situations are:

ρ ρ ρ ρθ θ π θ λ π θ λ

ρ ρ ρ ρθ θ π θ π θ

− −⎧ ⎛ ⎞ ⎛ ⎞= = − − = − −⎜ ⎟ ⎜ ⎟⎪ ⎝ ⎠ ⎝ ⎠⎪⎨ − −⎛ ⎞ ⎛ ⎞⎪ = = − = −⎜ ⎟ ⎜ ⎟⎪ ⎝ ⎠ ⎝ ⎠⎩

2 2 2 2

2 2

1 1if , 1 1

2 2 2 2

1 1if , 1 1

2 2 2 2

s rh s h SI r h SI

l s l r l

c cb b

b b

SE2: * *

, ,

* *

, ,

if , 1, 0, ,

if , 0, 0, ,

h h

l l

h s r s s r rno SI no SI


SI SI e e e e

SI SI e e e e

θ θ

θ θ

θ θ

θ θ

⎧ = = = = =⎪⎨

= = = = =⎪⎩

In this equilibrium, if θ is at θh, the franchisor will make its specific investment. The franchisee will then infer θh. However, because of the high cost of making its specific investment, the franchisee will not do so. In the absence of a corresponding specific investment by the franchisee, the franchisor’s specific investment has no direct positive impact on chan-nel revenues. Knowing this, the franchisor and the franchisee choose their optimal marketing efforts. If θ is at θl, the franchisor will not make its specific investment. The franchisee will then infer θl. Without bilateral specific investment and recognizing that θ is at θl, both firms put in low marketing efforts. The franchisor’s and franchisee’s profits in the two situ-ations are:



− −⎧ ⎛ ⎞ ⎛ ⎞= = − − = −⎜ ⎟ ⎜ ⎟⎪ ⎝ ⎠ ⎝ ⎠⎪⎨ − −⎛ ⎞ ⎛ ⎞⎪ = = − = −⎜ ⎟ ⎜ ⎟⎪ ⎝ ⎠ ⎝ ⎠⎩

2 2

2 2

1 1if , 1 1

2 2 2 2

1 1if , 1 1

2 2 2 2

sh s h SI r h

l s l r l

cb b

b b

The franchisor’s decisions are the same in SE1 and SE2. When the franchisor chooses the separating strategy, whether the model leads to SE1 or SE2 is determined by the franchisee. The franchisee will choose SE2 instead of SE1 if and only if

ρ ρ ρ ρθ λ θ− − − −⎛ ⎞ ⎛ ⎞− − < −⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠2 2 21 1 1 1

1 12 2 2 2rh SI hcb b

, or ( )ρ θ λ− − <2

2 211

4 rh SIcb

.

(1)

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Lemma 3: SE1 dominates SE2 if ( )ρ θ λ− − ≥2

2 211

4 rh SIcb

; otherwise, SE2 domi-nates SE1.

Pooling Equilibria

We use backward deduction to explore optimal strategies used by the fran-chisor and the franchisee in a pooling equilibrium. We first consider deci-sions by the firms regarding their respective marketing efforts (es and er) when SIs and SIr have been determined. At this stage, the franchisor and the franchisee have incurred costs on any specific investments made by them. As the franchisor chooses SIs regardless of θh or θl, the franchisee cannot infer the true value of θ. It knows only the distribution of θ, or it knows that only with a probability of α, θ = θh and with a probability of 1 – α, θ = θl. Thus, it can choose only its marketing effort to maximize its expected profit, and its optimal marketing effort is independent of whether θ is actually θh or θl. However, the franchisor knows the true value of θ. Its optimal deci-sion on marketing effort depends on whether θ is actually θh or θl. The franchisor’s and the franchisee’s optimization problems and solutions are as follows:

Case 3: If SIs ∙ SIr = 1, or the franchisor and the franchisee both decide to make specific investments,

To the franchisor: ( ) 2max se s r se e beρθλ + − .

Its optimal marketing efforts level is *

, 2s SIe

bθ

ρ θλ= .

To the franchisee: ( ) ( ) ( )*

,1 (1 ) 1max r

he h s r lSI

e eθ

α ρ θ λ α ρ θ λ− + + − −

( )θ+ −* 2

,ls r rSI

e e be .

Its optimal marketing effort level is ( )( )α

ρ λ αθ α θ−= + −*

,

11

2r h lSIe

bρ λ θ−= 1( )

2E

b, where ( ) ( )( )θ αθ α θ= + −1h lE is the expectation of θ.

The franchisor and the franchisee’s profits are, respectively,

( )ρ ρρπ λ θ λ θ θ−

= + −2

2 2 21( )

4 2 ss SIE cb b

and

( ) ( ) ( )ρ θρ ρπ λ θ λ θ θ−−= + − −

2

2 2 21(1 ) ( )

2 2 2 rr SI

EE c

b b.

Case 4: If SIs ∙ SIr = 0, the franchisor, the franchisee, or both of them decide not to make specific investments,

To the franchisor: ( )ρθ + − 2maxs

s r se

e e be .

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, 2s no SIe

bθ

ρ θ= . To the franchisee:

( ) ( ) ( )( )* * 2

, , 1 1 .max 1 ( )

rh l

e h s r l s r rno SI no SIe e e e be

θ θα ρ θ α ρ θ− + + − − + −


,

1( ).

2r no SIe E

bα

ρ θ−=

The franchisor’s profit is then ( )2 22 21

( ) 4 2 4ss SIE c orb b b

ρ ρρ ρπ θ θ θ θ−

= + −( )1

( )2

Eb

ρ ρθ θ

−+ , depending on whether it makes the specific investment.

The franchisee’s profit is ( ) ( ) ( )2

2 1(1 ) ( )

2 2 2 rr SI

EE c or

b b

ρ θρ ρπ θ θ θ−−= + − − ,

( ) ( ) ( )2

2 1(1 ) ( )

2 2 2

EE

b b

ρ θρ ρ θ θ θ−− + − depending on whether it makes the

specific investment. We now consider the franchisor’s and the franchisee’s decisions on

making specific investments. In a pooling equilibrium, the franchisor chooses a constant SIs regardless of θh or θl. Specifically, it can choose SIs = 1, or SIs = 0. The franchisee cannot tell the true value of θ by observing SIs. Thus, its decision on SIr is based on its expected profit based on the distribution of θ. If the franchisor chooses SIs = 0, by Lemma 1, the franchisee chooses SIr = 0. If the franchisor chooses SIs = 1, the franchisee can choose SIs = 1 or SIr = 0, depending on its cost of making the specific investment and the increase in its expected revenues caused by the specific investment.

Lemma 4: The channel outcome, where SIs = 1 and SIr = 0, is not a pooling equilibrium outcome.

Lemma 4 is intuitive. If the franchisee does not make the specific invest-ment (SIr = 0), the franchisor’s specific investment does not directly impact channel revenues. The franchisor’s marketing efforts and its revenue will be the same as those in the outcome where SIs = 0 and SIr = 0. Yet the franchisor has an extra cost cSIs in the former outcome. Therefore, in a pooling equilib-rium outcome, anticipating that the franchisee will not cooperate, the fran-chisor will not make the specific investment.

Therefore, there are two possible pooling equilibria (PE).

PE1:

á

* *

, ,

* *

, ,

if , 1, 1, ,

if , 1, 1, ,

h

l

h s r s s r rSI SI

l s r s s r rSI SI

SI SI e e e e

SI SI e e e e

θ α

θ

θ θ

θ θ

⎧ = = = = =⎪⎨

= = = = =⎪⎩

In this equilibrium, the franchisor does not reveal information about θ by always making the specific investment. However, its marketing effort level

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(es), which is not observed before the franchisee makes decisions on SIr and er, varies given different θ. The franchisee makes its specific investment. Its marketing effort level is based on the distribution of θ. The franchisor’s prof-its and franchisee’s profits in the two situations are:

( ) ( )

( ) ( ) ( ) ( )

( ) ( )

( ) ( ) ( ) ( )

22 2 2

2

2 2 2

22 2 2

2

2 2 2

1

4 2if ,

1 1

2 2 2

1

4 2if ,

1 1

2 2 2

s

r

s

r

s h h SI

h

r h h SI

s l l SI

l

r l l SI

E cb b

EE c

b b

E cb b

EE c

b b

ρ ρρπ λ θ λ θ θθ θ

ρ ρ ρ θπ λ θ λ θ θ

ρ ρρπ λ θ λ θ θθ θ

ρ ρ ρ θπ λ θ λ θ θ

−⎧= + −⎪

⎪ =⎪ − − ⎛ ⎞

= + − −⎪ ⎜ ⎟⎝ ⎠⎪⎨

−⎪ = + −⎪=⎪

− − ⎛ ⎞⎪ = + − −⎜ ⎟⎪ ⎝ ⎠⎩

PE2: * *

, ,

* *

, ,

if , 0, 0, ,

if , 0, 0, ,

h

l

h s r s s r rno SI no SI


SI SI e e e e

SI SI e e e e

θ α

θ α

θ θ

θ θ

⎧ = = = = =⎪⎨

= = = = =⎪⎩

In this equilibrium, the franchisor conceals θ as it does not always make the specific investment. However, its marketing effort level (es), which is not observed by the franchisee before its makes decisions on SIr and er, varies given different θ. The franchisee does not make the specific investment either. Its marketing effort level, based on the distribution of θ, is constant across different θ. The franchisor’s profits and franchisee’s profits in the two situations are:

( ) ( )

( ) ( ) ( ) ( )

( ) ( )

( ) ( ) ( ) ( )

ρ ρρπ θ θ θθ θ

ρ ρ ρ θπ θ θ θ

ρ ρρπ θ θ θθ θ

ρ ρ ρ θπ θ θ θ

−⎧= +⎪

⎪ =⎪ − − ⎛ ⎞

= + −⎪ ⎜ ⎟⎝ ⎠⎪⎨

−⎪ = +⎪=⎪

− − ⎛ ⎞⎪ = + −⎜ ⎟⎪ ⎝ ⎠⎩

22

2

2

22

2

2

1

4 2if ,

1 1

2 2 2

1

4 2if ,

1 1

2 2 2

s h h

h

r h h

s l l

l

r l l

Eb b

EE

b b

Eb b

EE

b b

It is noteworthy that, according to Lemma 4, a necessary condition of PE1 is that the franchisee cooperates with the franchisor in terms of ensuring bilat-eral specific investments when the latter always makes its specific invest-ment, regardless of whether θ is θh or θl. Or, r1, 1 1, 0

( ( .) )s r s r

r SI SI SI SIE Eπ π

= = = =≥

In detail,

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( ) ( ) ( ) ( )

( ) ( ) ( ) ( )

ρ ρ ρ θλ θ λ θ θ

ρ ρ ρ θθ θ θ

⎛ ⎞− − ⎛ ⎞+ − −⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠

⎛ ⎞− − ⎛ ⎞≥ + −⎜ ⎟⎜ ⎟⎝ ⎠⎝ ⎠

2

2 2 2

2

2

1 1

2 2 2

1 1

2 2 2

rSI

EE E c

b b

EE E

b b

Or ( ) ( ) ( )ρ ρλ ρ θ θ− −⎛ ⎞− + ≥⎜ ⎟⎝ ⎠2 2 21 1

12 2 rSIE E c (2)

Lemma 5: PE1 dominates PE2 if ( ) ( ) ( )ρ ρλ ρ θ θ− −⎛ ⎞− + ≥⎜ ⎟⎝ ⎠2 2 21 1

12 2 rSIE E c

and ( ) ( ) ( ) ( )ρ ρλ θ ρ θ⎛ ⎞− + − ≥⎜ ⎟⎝ ⎠2 2 21 1

2 2 sSIE E cb

; otherwise, PE2 dominates PE1.

Assessment and Comparison of Separating and Pooling Equilibria

In sum, there are four possible equilibrium outcomes: two separating and two pooling equilibrium outcomes. These are summarized in Table 2. Below, we list the conditions under which each equilibrium holds.

Proposition 1: SE1 holds if

(1) ( )ρ θ λ− − ≥2

2 211

4 rh SIcb

,

(2) ( ) ( )

( ) ( )( )

ρ ρ ρ ρ ρθ λ α θ λ αθ α θ

ρ ρλ αθ α θ

⎛ ⎞⎛ ⎞ ⎛ ⎞α − − + − − ≥ + −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

−+ + − −

22 2 2 2 2 2

22

1 1 1 ( 1 )2 2 2 2 4

11

2,

s

s

h SI l h l

h l SI

cb b b

cb

(3) ( ) ( )

( ) ( )( )

ρ ρ ρ ρ ρθ λ α θ αθ α θ

ρ ραθ α θ

⎛ ⎞⎛ ⎞ ⎛ ⎞α − − + − − ≥ + −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

−+ + −

22 2 2 2 2

2

1 1 1 ( 1 )2 2 2 2

2.

4

11

sh SI l h l

h l

cb b b

b

Proposition 2: SE2 holds if

(1) ( )ρ θ λ− − <2

2 211

4 rh SIcb

,

(2) ( ) ( )

( ) ( )( )

ρ ρ ρ ρ ρα θ α θ λ αθ α θ

ρ ρλ αθ α θ

⎛ ⎞⎛ ⎞ ⎛ ⎞− − + − − ≥ + −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

−+ + − −

22 2 2 2 2

22

1 1 1 ( 1 )2 2

,

2 2 4

11

2

s

s

h SI l h l

h l SI

cb b b

cb

,

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135

TAB

LE 2

Sum

mar

y of So

lutio

n A

ppro

ach a

nd R

esults

Optim

al s

trat

egie

sO

ptim

al S

I sO

ptim

al S

I rO

ptim

al e

sO

ptim

al e

r

Separ

atin

g outc

om

es1

or

0, d

epen

din

g on θ

1 or

0, d

epen

din

g on θ

, re

veal

ed b

y SI

s

e* s, dep

endin

g on θ

e* r, dep

endin

g on θ

, re

veal

ed

by

Sis

1 or

0, d

epen

din

g on θ

0, indep

enden

t of

θ re

veal

ed

by

SIs

e* s, dep

endin

g on θ

e* r, dep

endin

g on θ

, re

veal

ed

by

Sis

Poolin

g outc

om

es1

, in

dep

enden

t of

θ1,

dep

endin

g on F

(θ)

e* s, dep

endin

g on θ

e* r, dep

endin

g on F

(θ)

1 , in

dep

enden

t of

θ0,

dep

endin

g on F

(θ)

e* s, dep

endin

g on θ

e* r, dep

endin

g on F

(θ)

0 , in

dep

enden

t of

θ0

e* s, dep

endin

g on θ

e* r, dep

endin

g on F

(θ)

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(3) ( ) ( )

( ) ( )( )

ρ ρ ρ ρ ρα θ α θ αθ α θ

ρ ραθ α θ

⎛ ⎞⎛ ⎞ ⎛ ⎞− − + − − ≥ + −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

−+ + −

22 2 2 2

2

1 1 1 ( 1 )2 2 2 2 4

11

2.

sh SI l h l

h l

cb b b

b

Proposition 3: PE1 holds if

(1) ( ) ( ) ( )ρ ρλ ρ θ θ− −⎛ ⎞− + ≥⎜ ⎟⎝ ⎠2 2 21 1

12 2

,rSIE E c

(2) ( ) ( ) ( ) ( )ρ ρλ θ ρ θ⎛ ⎞− + − ≥⎜ ⎟⎝ ⎠2 2 21 1

2 2,

sSIE E cb

(3) ( )( ) ( ) ( )( )

( )

ρ ρρ λ αθ α θ λ αθ α θ

ρ ρ ρ ρα λ θ α θ

−+ − + + − −

⎛ ⎞⎛ ⎞ ⎛ ⎞> − − + − −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

222 2 2 2

2 2 2

11 1

4 2

1 1 1 .2 2 2 2

s

s

h l h l SI

h SI l

cb b

cb b

Proposition 4: PE2 holds if

(1) ( )( ) ( ) ( )( )

( )

ρ ρρ αθ α θ αθ α θ

ρ ρ ρ ρα θ λ α θ

−+ − + + −

⎛ ⎞⎛ ⎞ ⎛ ⎞> − − + − −⎜ ⎟ ⎜ ⎟⎜ ⎟⎝ ⎠ ⎝ ⎠⎝ ⎠

222 2

2 2 2

11 1

4 2

1 1 12 2 2 2s

h l h l

h SI l

b b

cb b

, and

(2) ( ) ( ) ( ) ( )ρ ρλ θ ρ θ⎛ ⎞− + − ≥⎜ ⎟⎝ ⎠2 2 21 1

2 2 sSIE E cb

, or

(3) ( ) ( ) ( )ρ ρλ ρ θ θ− −⎛ ⎞− + ≥⎜ ⎟⎝ ⎠2 2 21 1

12 2

.rSIE E c

DISCUSSION

We focus our discussion on the key result captured in Proposition 2. This proposition identifies conditions where it is optimal for a franchisor to pursue a separating strategy and make a specific investment, knowing that (a) the franchisee will not make a corresponding specific investment (including when the franchisee behaves opportunistically by reneging on promises to do so) and that (b) the franchisor’s specific investment will not directly enhance channel revenues. Here, the franchisor’s specific investment does not directly increase exchange efficiency or lower transaction costs, two oft-cited reasons for making specific investments previously advanced in the TCT literature. Instead, the franchisor’s specific investment performs a purely information-signaling function that leads to the franchisee’s putting in a

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higher level of marketing effort. Proposition 2 suggests that such an equilib-rium outcome occurs when

(a) λ is relatively low (i.e., the incremental direct revenue impact of bilateral specific investments is relatively low);

(b) cSIs is relatively low (i.e., the cost of making the specific investment for the franchisor is relatively low);

(c) cSIr is relatively high (i.e., the cost of making the specific investment for the franchisee is relatively high);

(d) ρ (the franchisor’s share of revenues) is not too high, nor too low—otherwise franchisor and franchisee marketing efforts are too low and the signaling value of the franchisor’s specific investments is limited; and

(e) The distribution of θ is sufficiently volatile: If environmental uncertainty is sufficiently large, the signaling value of the franchisor’s specific invest-ments is meaningful.

CONCLUSION

In sum, our theoretical model identifies a new, signaling rationale for making specific investments that allow existing vertical exchange relationships to fully leverage business growth opportunities. We contribute to the TCT, mar-keting, and franchising literatures in a number of ways. We address the pau-city of formal TCT models ( John & Reve, 2010) as well as the lack of research that considers specific investments as an endogenous, design variable (Rindfleisch & Heide, 1997; Macher & Richman, 2008; Williamson, 2010). We add to the nascent literature on antecedents of specific investments in ongo-ing exchange relationships by identifying a new rationale for specific invest-ments—the signaling of private information. This motivation for making spe-cific investments is distinct from the direct production and transaction cost–reducing or value-enhancing explanations previously identified in this literature stream (e.g., Parkhe, 1993; Stump & Heide, 1996; Stump & Joshi, 1998; Bensaou & Anderson, 1999; Ghosh & John, 2005, Kothandaraman & Kacker, 2009). Specifically, we identify conditions where a franchisor should make a specific investment in an extant franchisor–franchisee relationship even when that investment does not directly enhance exchange efficiency. In doing so, we show that there are situations where a franchisor should make specific investments knowing fully that the investment is not safeguarded and that the franchisee will act opportunistically. These insights have mean-ingful implications for franchising practitioners, particularly franchisors con-sidering specific investments in exchange relationships with franchisees. Our findings are also relevant to other vertical exchange contexts where channel revenues are shared among exchange partners through a royalty-based mechanism.

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Specific Investments in Franchisor–Franchisee Relationships: A Model