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Reputation Life Cycle: The Case of Franchising

Law-and-economics conventional analysis contends that franchise termination laws, prohibiting opportunistic termination by franchisor, are superfluous. Well-rooted in traditional law-and-economics opposition to such legislation is the belief that the reputation mechanism serves as a sufficient control against opportunistic termination by franchisors. This article questions the idea that reputation concerns can be a substitute for regulation of franchise relationships. The article argues that the reputation mechanism suffers from an inherent deficiency, which disqualifies it from serving as a substitute for franchise termination legislation. In short, the reputation mechanism often has a limited life cycle consisting of three stages: creation, erosion and collapse. At the early stages of the franchisor organizational life cycle, the reputation mechanism may have some deterring effects on the franchisor. At these stages, the incentive of the franchisor is normally to attract new franchisees and thus the franchisor attaches greater importance being perceived as fair in the eyes of potential franchisees. As the franchisor’s financial resources increase, the effectiveness of the reputation mechanism will be eroded. Particularly, the franchisor’s incentive to attract new franchisees will decrease. Similarly, its incentive to maintain its present franchisees will decline. Instead, the franchisor, having greater financial resources, will gradually shift towards owning the units himself. Following the continuing decrease in the franchisor’s financial constraints and the decrease in its incentive to maintain and attract new franchisees, the reputation mechanism may collapse. This may particularly occur when the reputation-related costs decrease to a minimum level, at which they will be lower than the franchisor benefits from opportunistic termination of the franchise contract.