Trust, Transaction Costs and Contractual Incompleteness in
Franchising
George Hendrikse
Rotterdam School of Management, Erasmus University
P.O. Box 1738, 3000 DR Rotterdam, 00-31-10-4088660, The Netherlands
ghendrikse@rsm.nl
Patrick Hippmann
Department of Business Administration
University of Vienna
Oskar-Morgensternplatz, 1090 Vienna, Austria
patrick.hippmann@univie.ac.at
Josef Windsperger
Department of Business Administration
University of Vienna
Oskar-Morgensternplatz, 1090 Vienna, Austria
josef.windsperger@univie.ac.at
Small Business Economics, December 2014 (forthcoming)
Abstract
The aim of this study is to address empirically the degree of contractual completeness in
franchising by combining transaction cost and relational governance perspectives. First, the
ratio of specific and residual decision rights is developed as a measure of contractual
completeness. Second, we extend the transaction cost perspective of contractual completeness
in franchising by arguing that franchisor’s and franchisees’ investments have a negative effect
on contractual completeness under bilateral dependence and a positive effect under unilateral
dependence. Third, we complement the transaction cost perspective by developing new
hypotheses regarding the impact of general and knowledge-based trust on contractual
completeness. General trust of the franchisor reduces the franchisor’s perception of relational
risk and hence the necessity to control the network relationship by more complete contract
planning, and knowledge-based trust increases information sharing between the partners and
hence the knowledge base for specifying more detailed contracts. The data from the German
franchise sector provide some support of the hypotheses.
Keywords: L24, D23
1 Introduction
Interfirm networks, such as strategic alliances, joint ventures, consortia,
cooperatives and franchise relationships, are governed by formal and relational
governance mechanisms. Formal governance mechanisms refer to contractual,
authoritative and ownership rules (Hansmann 1996; Hu and Hendrikse 2009;
Hippmann and Windsperger 2013; Zhang and Zhou 2013) and relational governance
mechanisms refer to the role of trust and norms in interorganizational relationships
(Macneil 1983; Zaheer and Venkatraman 1995; Thorgren and Wincent 2011). In recent
years, research on governance of interfirm networks has focused on three main research
streams: The first research stream investigates the relationship between formal contract
and trust, which can be divided into two groups (Cao and Lumineau 2015): Some
authors (e.g., Lui and Ngo 2004; Li et al. 2010) suggest that trust may be a substitute
for formal contracts as a more effective safeguard mechanism against opportunism risk.
On the other hand, trust and formal contracts may be complements (e.g., Poppo and
Zenger 2002; Liu, Luo and Liu 2009). Trust increases communication and knowledge
sharing and hence the knowledge base for designing more specified formal contracts.
Second, more recently, few studies focus on the impact of formal contract on trust by
distinguishing contract provisions according to their major functions (control,
coordination and adaptation) and separating different dimensions of trust (e.g.,
Malhotra and Murnighan 2002; Malhotra and Lumineau 2011). For instance, Malhotra
and Lumineau (2011) show that control and coordination provisions have a positive
effect on competence trust, and control provisions have a negative effect on goodwill
trust. The third research stream investigates the impact of trust on the use of formal
governance mechanisms (e.g., Gulati 1995; Zaheer and Venkatraman 1995; Hoffmann,
Neumann and Speckbacher 2010; Ryu, Min and Zushi 2008; Mumdziev and
1
Windsperger 2013). They show that trust as transaction cost savings mechanism
increases the tendency towards interorganizational cooperation and delegation. In this
study, we add to the third research stream by examining the impact of trust and
transaction cost variables on franchisor’s choice of completeness of franchise contracts.
Designing efficient contracts is one of the most important organizational tasks
in interfirm networks. However, the theory and practice of contracts exhibit a huge gap
(e.g., Lyons 1996; Lafontaine and Slade 1997; Masten 2000; Saussier 2000; Hendrikse
2003; Kaplan and Strömberg 2003; Furlotti 2007; Reuer and Ariño 2007; Eckhard,
Mellewigt and Weller 2009; Lumineau and Quélin 2012). On the one hand, contract
theory has developed by analyzing either contracts covering all possible contingencies
in the complete contracting models in the form of agency relationships (Hölmstrom
1979), or contracts assigning only residual decision rights in the property rights theory
(Grossman and Hart 1986; Bolton and Dewatripont 2005; Baker, Gibbons and Murphy
2008). On the other hand, actual contracts are incomplete (Klein, Crawford and Alchian
1978; Williamson 1979; Klein 1995; Hadfield 1990; Scott 2006) and contain both, they
specify various clauses covering certain contingencies and assign residual decision
rights regarding the issues left open (Grandori and Furlotti 2009). Specific decision
rights formulate in detail what the parties have to do in specific circumstances during
the contract period. Residual decision rights specify the identity of the party who has
the power to decide on the course of action in circumstances not covered by the specific
rights (Hansmann 1996; Arruñada, Garicano and Vázquez 2005; Higgins 2007; Hu and
Hendrikse 2009; Hippmann and Windsperger 2013). A contract is more complete if the
ratio of specific to residual decision rights provisions is relatively high.
For instance, applied to franchising, the franchise contract contains two types of
clauses (Hadfield 1990; Scott and Triantis 2006): specific decision rights provisions
2
which formulate in detail what the franchisor and franchisee has to do under certain
circumstances during the contract period, and residual decision rights provisions which
specify the franchisor’s and franchisees’ rights to make certain decisions during the
contract period. For example, the franchisor has to regulate the advertising tasks in the
contract. He has two possibilities: He can specify in detail the payment of certain
advertising fees based on sales and the different promotion and advertising measures,
or he can specify who has the right to make certain advertising decisions. In order to
determine the degree of contractual completeness of the franchise agreement, the
franchisor has to regulate the different tasks (such as training, pricing, advertising,
product design, promotion, procurement, recruiting, and investment) by formulating
specific and residual decision rights. The more specific decision rights provisions are
included in a franchise agreement relative to residual decision rights provisions, the
higher is the degree of contractual completeness.
In this study, we examine the impact of transaction cost and relational
governance factors on the franchisor’s choice of contractual completeness. We argue
that the franchisor will choose less complete contracts under high environmental
uncertainty and low free-riding risk as well as under a strong bonding effect of
franchisor’s and franchisees’ transaction-specific investments. Furthermore, the
franchisor’s choice of contractual completeness will be influenced by his/her trust
propensity (general trust) and his/her knowledge of the franchise partners’ ability and
intention derived from the interaction history (knowledge-based trust). The franchisor
will choose less complete contracts when his/her level of general trust is high requiring
lower control by formulating less refined contract terms. On the other hand, if the
franchisor has a positive interaction history with the network partners, the knowledge
base regarding their ability and intention will enable him/her to formulate more
3
complete contracts. We empirically test the effect of these transaction cost and
relational governance variables on contractual completeness using data from the
German franchise sector.
What is the contribution of the study? First, the study develops a new concept of
contractual completeness which is defined by the ratio between specific and residual
rights included in the contractual agreements. Thereby we provide a precise criterion of
differentiation between contractual completeness and contractual complexity; the latter
is mainly used in the strategic management literature (e.g., Barthélemy and Quélin
2006; Reuer and Ariño 2007; Lumineau and Quélin 2012). Second, previous research
has not investigated the role of trust as determinant of incompleteness of franchise
contracts. Based on the relational governance view (e.g., Macneil 1980; Zajac and
Olsen 1993; Gulati 1995; Zaheer and Venkatraman 1995; Dyer and Singh 1998; Baker,
Gibbons and Murphy 2002), we formulate new hypotheses regarding the impact of
knowledge-based trust and general trust on franchisor’s choice of contractual
completeness. General trust of the franchisor reduces the franchisor’s perception of
relational risk and hence the necessity to control the network relationship by more
complete contracts, and knowledge-based trust increases information sharing between
the partners and hence the franchisor’s knowledge base for specifying more detailed
contracts. Third, we extend the transaction cost view of completeness of franchise
contracts (e.g., Solis-Rodriguez and Gonzalez-Diaz 2012) by developing and testing
new hypotheses regarding the impact of transaction-specific investments and
environmental uncertainty on contractual completeness. Compared to Solis-Rodriguez
and Gonzalez-Diaz (2012), we argue that the effect of franchisor’s and franchisees’
transaction-specific investments on contractual completeness is influenced by the
dependence of the network partners. Franchisor’s and franchisees’ investments have a
4
negative effect on contractual completeness under bilateral dependence and a positive
effect under unilateral dependence. Based on our results, we can conclude that adding
trust to the transaction cost model of contractual completeness significantly increases
the explanatory power of the research model.
The rest of the paper is organized as follows: Section two investigates the
concept of contractual completeness. In section three we develop hypotheses to explain
contractual completeness in franchising. Finally, we present and discuss the results of
the empirical study.
2 The Concept of Contractual Completeness
2.1 Relevant Literature
Recent empirical studies show that contractual completeness is a very
heterogeneous concept without sufficient theoretical foundation (e.g., Crocker and
Reynolds 1993; Saussier 2000; Ariño and Reuer 2005; Luo 2002; Hensher 2010;
Mesquita and Brush 2008; Solis-Rodriguez and Gonzalez-Diaz 2012; Chao 2014).
Completeness is closely related to other concepts developed in the strategic
management and marketing literature: contractual complexity, contract extensiveness
and contract specificity.
Contractual complexity is measured by the number of key contractual
provisions (e.g., Parkhe 1993; Poppo and Zenger 2002; Reuer and Ariño 2002;
Barthélemy and Quélin 2006; Reuer, Ariño and Mellewigt 2006; Reuer and Ariño
2007; Hagedoorn and Hesen 2009). Recently, Mellewigt, Madhok and Weibel (2007),
Lumineau and Quélin (2012), Malhotra and Lumineau (2011) and Benaroch,
Lichtenstein and Wyss (2012) differentiate contractual complexity according to the
5
major functions of the contracts: control/safeguarding and coordination function. For
instance, Lumineau and Quélin (2012) operationalize the control function through five
key clauses, such as right to audit/inspection, safeguarding the system, control by a
third party, having a penalty and resolution clause, and the coordination function
through five key clauses, such as assignment of roles and responsibilities, indication of
duration and conditions of renewals, organizational and strategic coordination and
dispute resolution.
Similarly, contract extensiveness, that is, the extent to which obligations and
processes are specified in the contract (Anderson and Dekker 2005; Susarla,
Subramanyam and Karhade 2010), refers to different types of contractual provisions
regarding roles and responsibilities, decisions and control rights, dispute resolution,
contingency planning and communication (Mayer and Argyres 2004; Argyres and
Mayer 2007). Recently, Chen and Bharadwaj (2009) used four categories of contract
provisions to operationalize contract extensiveness: monitoring provisions, dispute
resolution, property rights allocation/protection and contingency provisions. The first
three cover the control function and the fourth the coordination function.
Furthermore, Mooi and Ghosh (2010) use contract specificity to operationalize
contractual completeness. Contract specificity indicates the extent to which contract
terms with respect to technical specifications of the product, implementation of
procedures, financial and legal considerations and overall contractual features are
specified in detail. This is similar to those used by Lusch and Brown (1996) and Wuyts
and Geyskens (2005).
Although these studies explain important aspects of contract design in interfirm
networks, they do not provide an answer to the question how to define and
operationalize the degree of contractual completeness. This is due to the fact that they
6
do not distinguish contract clauses according to two key features: Does a contract
clause precisely define a specific decision action under certain circumstances (Demsetz
1998) or does a contract clause define a specific decision procedure as residual right
(Grossman and Hart 1986; Chen 2000; Elfenbein and Lerner 2003; Higgins 2007; Hu
and Hendrikse 2009)? The law and economics literature on incomplete contracts
already provides some important results regarding the meaning of incompleteness of
contracts (Kaplow 1992; Scott 2003; Scott and Triantis 2005, 2006). According to this
research, contract clauses refer to rules and standards. The process of specifying
contract terms proceeds along a continuum that extends from narrow rules as
substantive provisions (or specific rights) to standards as procedural provisions (or
residual rights) (Scott 2006). In the following, we develop this concept of contractual
completeness in more detail.
2.2 Completeness and Specific versus Residual Rights
Three types of contracts can be distinguished in the theory of contracts. First,
complete contingent contracts were introduced by Arrow and Debreu in their models of
market equilibrium (Hendrikse 2003). These contracts can be made contingent on all
the relevant contingencies because all relevant information is known to all parties and
costlessly available. Second, complete contracts started to be analyzed in the late 1960s
and 1970s. The introduction of private information and hidden actions (e.g., moral
hazard problems) prevents contracts being based on all relevant contingencies.
However, contracts are still complete because they specify an action for each
information set, that is, complete contracts are made contingent on all the observable
information. Finally, Williamson (1975; 1979; 1983), Klein, Crawford and Alchian
(1978) and Grossman and Hart (1986) started the analysis of incomplete contracts.
7
Incomplete contracts are to be positioned at the other extreme in terms of the costs of
writing contracts because it is assumed, due to cognitive boundaries, that writing
contracts is prohibitively expensive or not possible. A contract which only specifies
who has the right to decide when a certain contingency arises is incomplete. It consists
only of residual rights specifying the person with decision authority. Actual contracts
consist usually of specific as well as residual rights, that is, some contractual clauses
regarding decision actions are specified, while the remaining contingencies are covered
by assigning residual right(s) to the contract parties. There are various reasons for
residual rights due to non-contractibility of decision actions. Examples of this are: a
lack of insight of the people involved, the costs of writing contractual clauses and
determining the optimal course of action, measurement costs, the imprecision of
language, and environmental uncertainty.
The above observations argue in favor of defining the incompleteness of
contracts in terms of specific decision rights (sDR) and residual decision rights (rDR).
Contractual completeness is defined as the number of specific decision rights divided
by the sum of specific decision rights and the residual decision rights. It follows
immediately from sDR/(sDR+rDR) = 1/(1+rDR/sDR) that a change in the
completeness of contracts is the same as a change in the ratio between specific and
residual rights (sDR/rDR). The higher the fraction of specific rights compared to
residual rights specified in the contract, the higher the degree of contractual
completeness; and the higher the fraction of residual rights is compared to specific
rights, the lower the contractual completeness. sDR/rDR depends on the contractibility
of knowledge. When contractibility is low, the use of assets is primarily regulated by
assigning residual decision rights, and when contractibility of knowledge is high, the
use of assets is primarily regulated by assigning specific decision rights to the contract
8
partners. For example, the franchisor has to regulate the procurement tasks in the
contract. He has two possibilities: He can specify in detail the procurement of the input
goods by specifying product quality and suppliers, or he can specify who has the right
to make the procurement decisions. A franchise contract is more complete when the
ratio between specific and residual rights is high. This view is compatible with the
adaptation view of governance (Simon 1951; Williamson 1975; Gibbons 2005; Tirole
2009) that formulates a trade-off between preplanning of decision actions (as specific
rights) and the planning of decision procedures (as residual rights).
To summarize, we can conclude that contractual completeness is defined by the
relationship between specific and residual decision rights. The lower the contractibility
of knowledge (e.g., due to high asset intangibility of and uncertainty), the lower is the
probability to formulate specific rights and the more residual decision rights regarding
the different value chain activities are assigned to the contract partners, and hence the
lower is the degree of contractual completeness.
2.3 Completeness versus Contractual Complexity
After defining contractual completeness, we address the question what is the
relationship between contractual complexity and contractual completeness. Although
recent studies differ widely in their approach and definition of complexity (e.g., Parkhe
1993; Kole 1997; Reuer and Ariño 2007; Barthélemy and Quélin 2006; Reuer, Ariño
and Mellewigt 2006; Mellewigt, Madhok and Weibel 2007; Hagedoorn and Hesen
2009; Malhotra and Lumineau 2011; Benaroch, Lichtenstein and Wyss 2012;
Lumineau and Quélin 2012), the main characteristics of contractual complexity can be
defined as follows: Complex contracts have detailed specification of promises and
obligations, responsibilities to be performed, procedures for monitoring, dispute
9
resolution and adaptation and determine in detail outcomes or outputs to be delivered.
The more clauses are specified in a contract, the higher is its degree of complexity.
Compared to our completeness concept, complexity refers to the sum of specific
decision rights and residual decision rights (rDR + sDR). Hence completeness and
complexity are related as follows: A more complex contract can be both more or less
complete (Eggleston, Posner and Zeckhauser 2000), depending on the attributes of the
transactions. If, under a low level of uncertainty (i.e., high contractibility situation) the
contract has a higher number of detailed provisions regarding the partners’ actions in
different environmental situations and a low number of provisions regarding residual
decision rights, the contract has a high degree of completeness and complexity. On the
other hand, if, under a high level of uncertainty (i.e., low contractibility situation) the
contract has a high number of provisions regarding the assignment of residual decision
rights and a low number of provisions regarding specific rights, the contract has a high
degree of complexity, but a low degree of completeness. Therefore, complexity and
completeness only go hand-in-hand when the use of assets can be specified in detail in
the contract due to high contractibility. On the other hand, complexity and
completeness are negatively related when the use of assets is costly and difficult to
specify in a contract due to low contractibility of knowledge but the contract specifies
in detail the assignment of residual decision rights. Consequently, consistent with the
view of Williamson (1985) and Ariño and Reuer (2005), we can conclude that
complexity is a design feature of a contractual agreement and contractual completeness
is relative to the attributes of the transaction (i.e., uncertainty and asset intangibility).
For instance, a franchise contract with a simple transaction (e.g., standardized system
know how under product franchising) may not be complex but relatively complete,
while a franchise contract with a complex transaction (e.g., complex and intangible
10
system know-how under business format franchising) may be complex but very
incomplete.
3 The Impact of Transaction Costs and Trust on Contractual Completeness in
Franchising
In recent years, few researchers in organizational economics and regulatory
theory have examined questions of contract design in franchising (e.g., Lafontaine and
Slade 2014). In organizational economics, most of the authors have studied interaction
effects between different contract provisions. Wimmer and Garen (1997) have shown
that specific assets act as an implicit bond and substitute for a reduced royalty rate in
inducing franchisee efforts. Brickley (1999) presented an agency cost explanation of
the complementarities between mandatory advertising and area development plans,
restrictions on franchisees’ outside activities and area development plans, and between
mandatory advertising and restrictions of outside activities. Bercovitz (1999) applied
transaction cost reasoning to analyze interactions between contract provisions. She
found that the initial fees and the duration of franchise contracts are positively related
with the relationship-specific investments. In addition, she argued that the hostage
function of specific investments could be increased by including termination
conditions. By applying Klein’s self-enforcing contracts view (Klein 1995, 1996),
Lafontaine and Raynaud (2000) examined complementarities between residual
claimancy rights and self-enforcement mechanisms, such as exclusive territory clauses,
multi-unit ownership guarantees, contract renewal and termination rights. They argued
that the dilution of the franchisee’s residual income rights requires the use of selfenforcement mechanisms to increase the franchisee’s incentive to maximize the
residual surplus of the network. Furthermore, Arruñada, Garicano and Vázquez (2001;
11
2005) and Windsperger (2003) advanced the literature by analyzing the entire system
of rights in franchise contracts. Arruñada, Garicano and Vázquez (2001) found some
complementarities between completion and termination rights, and between monitoring
rights and incentives in the automobile distribution, and Windsperger (2003) found
complementarities between residual decision rights and ownership rights. In regulatory
theory, Steinberg and Lescatre (2004) and Spencer (2006; 2008a) investigated
regulatory and contract design issues in franchising.
Although these studies offer explanations of certain contract clauses in
franchise relationships, they do not explain the factors that influence incompleteness of
franchise contracts. An exception is Solis-Rodriguez and Gonzalez-Diaz (2012) who
examine the determinants of contractual completeness in franchising from transaction
cost economics and capability perspectives. They show that contractual completeness
varies positively with transaction-specific investments, franchisor reputation and
interorganizational experience. First, we extend the transaction cost view of SolisRodriguez and Gonzalez-Diaz (2012) by arguing that the impact of franchisor’s and
franchisees’ transaction-specific investments depends on the symmetry or asymmetry
of transaction-specific investments. In addition, we add environmental uncertainty as
transaction cost variable. Second, we complement the transaction cost view by
examining the impact of knowledge-based trust and general trust on the franchisor’s
choice of contractual completeness.
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3.1 Transaction Cost View of Contractual Completeness
According to the transaction cost theory (e.g., Williamson 1979, 1985; Joskow
1990; Saussier 2000; Blumberg 2001), transaction-specific investments and uncertainty
(environmental and behavioral uncertainty) influence contractual completeness.
Transaction-specific investments
Based on transaction cost economics reasoning, transaction-specific investments
influence the network partners’ quasi-rents which can be expropriated by the less
dependent partner (Heide and John 1988; Windsperger 1996; Klein 1995, 2000).
According to Klein (1996, p. 449), an agreement is within the “self-enforcing range” if
the quasi rents of the partners exceed the potential hold-up gains from opportunistic
behavior. What is the impact of franchisor’s and franchisees’ transaction-specific
investments on completeness of franchise contracts? We distinguish two cases:
(I) Bilateral dependence. When both the franchisor and franchisees have to
undertake high transaction-specific investments (Heide and John 1988), both partners’
quasi-rents are likely to exceed the potential hold-up gains from opportunistic
behaviour. In this case, the franchise agreement is within the self-enforcing range. The
bonding effect of transaction-specific investments motivates both partners to behave
cooperatively in order to realize the relationship-specific quasi-rents (Williamson 1983;
Katz 2008). Additionally, inside the self-enforcing range of contracts, the parties
frequently disregard verifiable contract terms (e.g., measures of performance) in favour
of nonverifiable contract terms in order to enhance the relationship-specific surplus
(Scott 2003, p. 1676; Baker and Krawiec 2005). Consequently, the value-creating effect
of bilateral specific investments increases the self-enforcing range of franchise
contracts and reduces both franchisor’s and franchisees’ necessity for control by
13
specifying detailed contract terms. Hence the network partners will use more
incomplete contracts (Scott 2003). We can derive the following hypotheses:
H1a/H1b (Bilateral dependence): Franchisor’s and franchisees’ transactionspecific investments will negatively influence contractual completeness.
(II) Unilateral dependence. When the franchisor’s transaction-specific investments are
high (e.g., expenses for training, site selection, technical support) relative to the
franchisees’ investments, he/she is subject to increasing hold-up risk since the
franchisees may exploit the higher quasi-rent stream of the franchisor. In this case, the
relationship is outside the self-enforcing range of contracts. Hence the franchisor will
protect his/her investments against opportunistic expropriation on the part of
franchisees by using more complete contracts (Goldberg and Erickson 1987; Joskow
1988; Saussier 2000).
On the other hand, when franchisees’ transaction-specific investments are high
relative to the franchisor’s investments, he/she is subject to increasing hold-up risk by
the franchisor. In this case, the franchisee wants to protect his/her relationship-specific
quasi-rents against opportunistic expropriation on the part of franchisor by using more
safeguarding provisions. However, it is important to note that if there are diverging
interests between the franchisor and franchisees with regard to contractual
completeness, the franchisor’s greater bargaining power may not support the inclusion
of contract clauses to safeguard franchisees’ investments against expropriation risk
(Spencer 2008b; Ozmel et al. 2013). We formulate the following hypotheses:
H2a/H2b (Unilateral dependence): Franchisor’s and franchisees’ transactionspecific investments will positively influence contractual completeness.
14
Environmental Uncertainty
Environmental uncertainty refers to market, competitive and institutional uncertainty.
Based on transaction cost economics reasoning several studies investigate the impact of
environmental uncertainty on interorganizational networks (e.g., Heide and John 1990;
Noordewier, John and Nevin 1990; Stump and Heide 1996; Geyskens, Steenkamp and
Kumar 2006). According to the adaptation view of contractual governance (Simon
1951; Gibbons 2005; Tadelis and Williamson 2013), higher environmental uncertainty
prevents the franchisor from setting up detailed contract terms and increases the need of
ex-post adaptations by allocating residual decision rights (Gilson, Sabel and Scott
2009; Kosnik 2014). Ex-post adaptation problems result in high ex-post transactions
costs under high environmental uncertainty when highly specified contracts are set up
at the beginning of the contract period. Therefore, the higher the environmental
uncertainty, the more difficult and costly is the planning of decision actions by
formulating specific decision rights in the ex-ante period, and the more residual rights
are assigned to the franchise partner. This is summarized in the following hypothesis.
H3: Environmental uncertainty will negatively influence contractual
completeness.
Free-riding Risk
Agency problems arise from behavioral uncertainty due to shirking and free-riding.
Hence one major issue in franchise relationships is free-riding on the part of franchisees
(Klein 1980; Lal 1990; Kidwell, Nygaard and Silkoset 2007). The franchisor may use
specific contract provisions to protect against potential opportunistic behavior through
free-riding (Bercovitz 1999; Solis-Rodriguez and Gonzalez-Diaz 2012). Free-riding
15
hazards are positively related to the value of the brand name of the franchise system
(Klein 1995). The higher the brand name value, the higher the franchisor’s free-riding
risk due to behavioral uncertainty, and the more specific decision rights clauses are
included in franchise contracts. We derive the following hypothesis:
H4: The brand name value will positively influence contractual completeness.
3.2 Relational Governance View on Contractual Completeness
Based on Macneil (1980; 1983), Heide and John (1992), Dyer and Singh (1998)
and Dyer (1999), the relational governance view focuses on the role of trust, norms and
solidarity in interfirm relationships to reduce relational risk and facilitate information
sharing between the contract partners. Recent research results on interfirm alliances
show that trust is an important relational governance mechanism leading to higher
relational rents due to savings of transaction costs and/or an increase of transactional
value (e.g., Zajac and Olsen 1993; Dahlstrom and Nygaard 1995; Dyer and Chu 2000;
Puranam and Vanneste 2009; Hayter 2013; Gurcaylilar-Yenidogan and Windsperger
2014). Although several studies investigate the role of trust in franchise relationships
(e.g., Cochet, Dormann and Ehrmann 2008; Croonen 2008, 2010; Dickey, McKnight
and George 2008; Bertrandias, Fréchet and Lumineau 2010; Dant et al. 2013; Davies et
al. 2011; Mumdziev and Windsperger 2013), no study examines the impact of trust on
completeness of franchise contracts. In the following, we try to close this gap in the
franchise literature.
The concept of trust used in previous research is heterogeneous, due to the
multidisciplinary focus of trust research (e.g., Williamson 1993; Mayer, Davis and
Schoorman 1995; Nooteboom 1996; McKnight and Chervany 2006; Colquitt, Scott and
LePine 2007; Chua, Roy Yong Joo, Ingram and Morris 2008; Robert, Denis and Hung
16
2009; Malhotra and Lumineau 2011). However, the various types of trust can be
differentiated into two main facets (Yamagishi 2011; Yamagishi and Yamagishi 1994):
knowledge-based trust and general trust. Knowledge-based trust is based on
“information accumulated over a […] history of interactions with the partners”
(Yamagishi and Yamagishi 1994, p. 194). More specifically, it refers to the
ability/competency and the goodwill/intention of the partner (e.g., McAllister 1995;
Nooteboom 1996; Das and Teng 2004; Malhotra and Lumineau 2011). On the other
hand, general trust exists without having an interaction history with the trustee and is
mainly influenced by the trustor’s personality traits. In the following, we examine the
impact of trust on the franchisor’s choice of contractual completeness by differentiating
between the two types of trust.
Knowledge-based Trust and Contractual Completeness
Knowledge-based trust refers to trust that evolves over a period of repeated interactions
with an exchange partner. It has a cognitive effect by increasing the trustor’s
knowledge base about the ability and intention of the trustee derived from the
interaction history (Gassenheimer, Baucus and Baucus 1996). Repeated positive
interactions signal credibility and increase the ‘relationship-specific’ reputation and
trust in the exchange partner (Anderson and Weitz 1989; Ganesan 1994). Therefore,
knowledge-based trust facilitates information sharing and increases the knowledge base
for designing more complete contracts as formal governance mechanism (Lazzarini,
Miller and Zenger 2008).
Applied to the franchisor-franchisee relationships, franchisor’s positive
experience with franchisees during the contract relationship signals high credibility and
increases the franchisor’s trust in his/her network partners. In particular, knowledge-
17
based trust improves information exchange between the franchise partners and enables
the franchisor to formulate more detailed contract terms as “reference points” (Hart and
Moore 2008; Bozovic and Hadfield 2012) that specify the self-enforcing range of
contracts (Klein 2000). Consequently, under a high level of knowledge-based trust the
franchisor uses more complete contracts. We formulate the following hypothesis:
H5: Franchisor’s knowledge-based trust will positively influence
contractual completeness.
General Trust and Contractual Completeness
General trust means that an individual has a positive view of the others and considers
the others as trustworthy, even if he/she has no experience with those other people
(Yamagishi 2011; Yamagishi and Yamagishi 1994). Therefore, general trust leads to
the perception of lower relational risks by the trustor (Das and Teng 2004) and results
in the use of less specified contracts as formal governance mechanism. Applied to the
franchisor-franchisee relationship, under a high level of general trust the franchisor
perceives lower relational risk and hence lower agency and monitoring costs, under
given exchange hazards, which leads to a lower propensity of the franchisor to control
the franchise partners. When applied to the choice of contractual completeness, a hightrust franchisor expects lower agency and monitoring costs, under given exchange
hazards. Therefore, a high level of general trust reduces the franchisor’s necessity for
formal contract planning. Consequently, a high-trust franchisor is likely to use less
specified contracts by formulating fewer specific decision rights provisions. We derive
the following hypothesis:
H6: Franchisor’s general trust will negatively influence contractual
completeness.
18
Our research model based on transaction cost and the relational governance
perspectives of contractual completeness can be summarized as follows (see Figure 1):
First, by applying transaction cost theory, contractual completeness varies negatively
with bilateral transaction-specific investments of the franchisor and franchisees and
environmental uncertainty, and positively with unilateral transaction-specific
investments and the brand name value. Second, according to the relational view,
general trust mitigates contractual hazards due to the perception of lower relational risk
and reduces the franchisor’s necessity to preplan decision actions by formulating more
specific contract terms. Conversely, knowledge-based trust increases information
sharing and the knowledge base about the franchise partners and hence enables the
formulation of more refined contract terms.
Insert Figure 1
4 Empirical Analysis
4.1 Sample and Data Collection
Empirical data to test the hypotheses were collected from the German franchise
sector. The directory of the German Franchise Federation (DFV) and “Franchise
Wirtschaft” (a Bond’s Franchise Guide type directory published in Germany) list all
franchise systems operating in the country. Various demographic data (i.e., year system
was established, number of outlets, business sector, etc.) is also listed regarding each
system in the “Franchise Wirtschaft”. These directories list 837 franchise systems
operating in Germany and served as the sampling frame for this study. The judgmental
19
sampling was employed and the sample was drawn on the basis of the following two
criteria: (1) The system should have at least five outlets in Germany. (2) If the data
about the number of outlets is not listed in the directory, the system should have started
franchising in Germany before year 2008. The final sample consisted of 491 franchise
systems.
The data were collected via a self-administered questionnaire which was
developed in several steps. After several preliminary refinements, we conducted indepth interviews with franchise professionals from the Austrian and German franchise
associations and a pre-test with 20 franchisors in Austria. The respondents were
selected on their expertise and relevance to the subject under investigation. This
demonstrates the use of the key informant approach for data collection (John and Reve
1982). Accordingly, the key informants for this study were senior managers (general
managers or franchise expansion mangers) who are mainly responsible for the franchise
expansion. The information about the key informants was retrieved from the “Franchise
Wirtschaft”. The personally addressed questionnaires were mailed to the key
informants of all 491 relevant franchise systems in Germany. We received back 137
filled-out questionnaires with a response rate of 28%.
To check for non-response bias, we use two methods. First, non-response bias
was estimated by comparing early versus late respondents (Armstrong and Overton
1977), where late respondents serve as proxies for non-respondents. Second, the
respondents were compared to non-respondents in terms of age, size, advertising fee,
and royalties to determine whether non-response was a serious problem for the data.
These variables are available in the “Franchise Wirtschaft” for all of the listed systems.
We used these data to run independent sample t-tests in order to check whether the
20
sample is representative. We found no significant difference between the respondents
and the non-respondents (see Table 1). Based on Podsakoff et al. (2003), we used
Harman’s single-factor test to examine whether a significant amount of common
method variance exists in the data. After we conducted factor analysis on all items and
extracted more than one factor with eigenvalues greater than one, we felt confident that
common method variance is not a serious problem in our study.
Insert Table 1
4. 2 Measurement
To test the hypotheses the following variables are important: contractual
completeness, transaction-specific investments, environmental uncertainty, franchisor
brand name, and knowledge-based and general trust (see appendix).
Contractual completeness
Previous research uses very different measures for contractual completeness (e.g.,
Crocker and Reynolds 1993; Saussier 2000; Luo 2002; Ariño and Reuer 2005; Hensher
2010; Solis-Rodriguez and Gonzalez-Diaz 2012; Chao 2014). A large number of
studies use an index of clauses or subjective indicators (multidimensional constructs),
and some studies use the number of words (Kosnik 2014) or index of contingencies
(Solis-Rodriguez and Gonzalez-Diaz 2012) as measure for contractual completeness. In
addition, many studies do not explicitly distinguish between completeness and
complexity which is due to the fact that they do not differentiate the contract clauses
according to the feature of specific and residual rights (Chen 2000).
Based on our concept of contractual completeness, we use indicators for
specific decision rights and residual decision rights to measure contractual
21
completeness. Hence completeness addresses the extent to which provisions regarding
specific and residual rights of the franchisor and the franchisee are included in the
contract. Specific decision rights (sDR) are contract provisions which formulate in
detail what the contact partners have to do under certain circumstances, and residual
decision rights (rDR) are contract provisions which specify the contract partners’ rights
to make certain decision during the contract period. The general managers were asked
to rate specific and residual rights with a two-item seven-point Likert scale: (a) Specific
decision rights: “The tasks of the franchisor regarding the value chain activities at the
local outlets are specified in detail in the contract”; and “the tasks of the franchisees
regarding the value chain activities at the local outlets are specified in detail in the
contract” (Cronbach’s alpha is .871). (b) Residual decision rights: “The decisions of the
franchisor regarding the value chain activities at the local outlets are specified in detail
in the contract”; and “the decisions of the franchisees regarding the value chain
activities at the local outlets are specified in detail in the contract” (Cronbach’s alpha is
.909). Since completeness is operationalized by subjective indicators, we test the
impact of the transaction cost and relational governance variables on sDR and rDR
separately.
Transaction-specific investments
Based on Heide and John (1990) and Stump and Heide (1996), the franchisor’s
transaction-specific investments (INV_FOR) are operationalized by the following
scale: The general managers were asked to rate the transaction-specific investments
with a three-item scale: “To what extent does the franchisor bear the initial training
costs of the franchisee/the technical support at the beginning of the contract period/the
set-up costs of the outlet?”. Cronbach’s alpha for this scale is .632. The franchisee’s
22
transaction-specific investments (INV_FEE) are measured by franchisees’ initial
investments at the beginning of the contract relationship (Dnes 1993; Windsperger
2004).
Environmental uncertainty
Environmental uncertainty (ENV) results in high ex-post transaction costs under highly
specified contracts. Consistent with previous studies we operationalize environmental
uncertainty with a three-item scale (e.g., John and Barton A. Weitz 1988; Celly and
Frazier 1996). The franchisors were asked to provide their perception regarding the
fluctuation in the outlet level sales, unpredictability of the market, and volatility of
local economic situation. The reliability of this scale was assessed by Cronbach’s alpha
(.742).
Franchisor brand name
If a franchisor’s brand name (BRAND) is of high value, the franchisor will face a
higher free-riding risk. Franchisors were asked to indicate (on a four-item seven point
scale) how important their brand name is in terms of recognition and strength compared
to their competitors, and competitive advantage (e.g., Barthélemy 2008). Cronbach’s
alpha is .811.
Trust
We differentiate between knowledge-based trust and general trust (KTRUST,
GTRUST). Table 2 presents the results of the factor analysis.
Insert Table 2
23
Knowledge-based Trust (KTRUST): Derived from Yamagishi and Yamagishi
(1994) and Dyer and Chu (2000), KTRUST is measured using a four-item seven-point
Likert-type scale. The franchisors were asked to rate the level of trust based on their
interaction experience with the business partners (franchisees). Cronbach’s alpha for
this variable is .876.
General Trust (GTRUST): Based on Yamagishi and Yamagishi (1994) and
Lazzarini, Miller and Zenger (2008), we measure this variable with a three-item sevenpoint Likert-type scale. The franchisors were asked questions about their general
attitude and opinion towards trusting others. The items refer to ‘most people trust
others, most people are trustworthy and most people behave cooperatively if they are
trusted’. Cronbach’s alpha for GTRUST is .806.
Control Variables
Size (SIZE): We control for the firm size (e.g., Lyons 1996; Banerjee and Duflo 2000;
Susarla, Subramanyam and Karhade 2010). The SIZE of the firm refers to the total
number of outlets representing economies of scale through standardization. The larger
the total number of outlets, the larger are economies of scale through standardization
due to lower average contractual set-up costs, and hence the higher the tendency
towards using more specified contractual provisions (Lyons 1996). Therefore, we use
the number of total outlets as indicator for economies of contract standardization.
Age (AGE): Age is a proxy for inter-organizational experience and learning. Prior
relationships may allow for the design of more complete contracts because the
franchisor develops contract design capabilities (Argyres, Bercovitz and Mayer 2007;
Solis-Rodriguez and Gonzalez-Diaz 2012).
24
Contract duration (DUR): Since a long-term contract reduces the franchisor’s
flexibility to adjust the contractual relations in the ex-post period, the franchisor is
likely to specify more contingencies in the franchise contract to cover more
possibilities due to the long-term perspective of the relation (Chen and Bharadwaj
2009).
Sector (SEC): This is a dichotomous variable: 0 refers to product franchising and 1 to
services franchising. Since services franchising firms are characterized by more
intangible and hence less codifiable know-how compared to product franchising firms,
we expect a lower degree of contractual completeness for services firms.
4.3 Results
Table 3 presents the descriptive data for the sample in Germany.
Insert Table 3
We test our research model (see Figure 1) by conducting a seemingly unrelated
regression (SUR) analysis with contractual completeness operationalized by specific
and residual decision rights (sDR, rDR) as dependent variables. We examine the impact
of the transaction cost and relational governance variables on sDR and rDR separately.
The explanatory variables refer to transaction-specific investments of the franchisor
and franchisees (INV_FOR, INV_FEE), environmental uncertainty (ENV), franchisor
brand name (BRAND), knowledge-based and general trust (KTRUST, GTRUST),
SIZE, AGE, contract duration (DUR) and sector (SEC). Table 4 presents the
correlations of the variables used in the regression analysis. In addition, the variance
inflation factors are well below the rule-of-thumb cut-off of 10. In sum, we do not find
any collinearity indication.
25
Insert Table 4
Table 5 reports the results of the seemingly unrelated regressions (SUR)
(Zellner 1962) for sDR and rDR. We used SUR as it can be expected that equation
residuals are correlated. The Breusch-Pagan tests confirmed this assumption for all
three sets of equations with p=0.000. We proceed in three steps: In model 1a and 1b we
test the impact of the control variables (SIZE, AGE, DUR and SEC) on sDR and rDR,
in model 2a and 2b we test the transaction cost hypotheses (H1a, H1b, H2, H3) and in
model 3a and 3b the relational governance hypotheses (H4, H5).
Insert Table 5
Control variables: Based on the data from the German franchise sector, we find
that contract duration (DUR) has a positive and significant impact on both specific
rights and residual decision rights provisions (sDR, rDR). This may indicate that as the
length of franchise contract increases, so does its flexibility and specification by using
both more rDR and sDR provisions. In addition, we find that the coefficient of SEC is
negative and significant in model 1a and 1b indicating that the franchisor will use less
formal contract planning in the service sector compared to the product franchising
sector. The coefficients of the control variables (SIZE and AGE) are not significant.
Transaction cost hypotheses: We find that franchisees’ transaction-specific
investments (INV_FEE) have a negative and significant influence on the use of sDR as
well as rDR indicating that higher INV_FEE increase the bonding effect and reduce the
franchisor’s necessity to use more specified contract provisions as safeguarding
mechanism. In addition, the impact of franchisors’ transaction-specific investments
26
(INV_FOR) on rDR is positive and significant but their impact on sDR is not
significant. This may indicate that the franchisor who is strongly dependent on the
network partners, due to high transaction-specific investments, will rather formulate
more residual decision rights in the contract in order to protect his/her system-specific
knowhow and brand name against opportunism risk and to increase contractual
flexibility during the contract period. Furthermore, we find that the impact of
franchisor brand name (BRAND) on sDR is positive and significant. This implies that a
strong brand name may be associated with high free-riding hazards leading to more
complete contracts by formulating more specific decision rights provisions. On the
other hand, the coefficient of environmental uncertainty (ENV) is not significant. This
non-significant result is consistent with recent studies on contract design (e.g., Chen
and Bharadwaj 2009; Benaroch, Lichtenstein and Wyss 2012).
Relational governance hypotheses: We add knowledge-based and general trust
(KTRUST, GTRUST) as relational governance variables in our regression model
(model 3a, 3b). We find that the impact of general trust (GTRUST) on sDR is negative,
as expected, and highly significant. This is consistent with the view that high-trust
franchisors perceive a lower relational risk and expect fewer agency problems in the
ex-post period. Therefore, they will not set up highly specified contracts based on sDR
to control opportunism. On the other hand, the results show that knowledge-based trust
(KTRUST) does not significantly influence contractual completeness. Overall, we can
conclude that R Squared significantly increased from 0.266 to 0.324 when adding
knowledge-based and general trust (KTRUST, GTRUST) to the transaction cost model
(see Table 5), which indicates that trust is an important determinant of contractual
completeness in franchising.
27
5 Discussion and Implications
5.1 Discussion
The aim of the paper is to explain the franchisor’s choice of contractual
completeness by developing and testing hypotheses derived from the transaction cost
theory and the relational governance view. Starting from the recent literature, which
shows that contractual completeness is a very heterogeneous concept without sufficient
theoretical foundation, we develop a new concept of contractual completeness defined
by the ratio between specific and residual decision rights stipulated in contracts.
The results of the empirical study on incompleteness of contracts in the German
franchise sector provide some support of our hypotheses. First, according to the
transaction cost theory the use of specific rights (sDR) provisions varies negatively
with franchisees’ transaction-specific investments and environmental uncertainty, and
positively with the brand name. The data confirm the negative relationship between the
use of specific decision rights provisions and franchisees’ transaction-specific
investments. The bonding effect of franchisees’ transaction-specific investments
enables the franchisor to reduce formal control by formulating less complete contracts.
The negative relationship between franchisees’ transaction-specific investments and
completeness contradicts with the result of Solis-Rodriguez and Gonzalez-Diaz (2012).
This deviation is due to the fact that Solis-Rodriguez and Gonzalez-Diaz (2012) do not
take into account the different effects of franchisees’ and franchisor’s transactionspecific investments on completeness under bilateral and unilateral dependence.
Furthermore, the data support the positive impact of franchisor brand name on the use
of more specific decision rights provisions. Contrary to results in the contract literature
(e.g., Crocker and Reynolds 1993; Saussier 2000), the impact of environmental
28
uncertainty on contractual completeness is not significant. This might be due to the
ambiguous effect of uncertainty on formal governance in the transaction cost literature
(e.g., Walker and Weber 1984; Blumberg 2001; Poppo and Zenger 2002). On the one
hand, environmental uncertainty requires more adaptability (Klein 1989) and hence less
complete contracts, and on the other hand, the franchisor may increase control
(Noordewier, John and Nevin 1990) by formulating more specific rights when the
degree of uncertainty increases.
In addition, residual decision rights (rDR) vary negatively with the franchisees’
transaction-specific investments, which is compatible with the self-enforcing range of
contract view. High franchisees’ transaction-specific investments increase the selfenforcing range of contracts and hence reduce the franchisor’s general requirement for
formal contract planning by using both specific and residual decision rights provisions.
On the other hand, residual decision rights vary positively with the franchisor’s
transaction-specific investments. Residual decision rights provisions enable the
franchisor to react more flexibly if ex-post adaptation problems arise. Hence compared
to specific decision rights provisions, residual decisions rights provisions are more
efficient to protect against opportunism risk under high franchisor’s specific
investments. This may explain their non-significant impact on specific decision rights
(sDR) (see Table 5).
Second, based on the relational governance view, we investigate the relationship
between trust and contractual completeness. According to Yamagishi and Yamagishi
(1994), we differentiate between knowledge-based and general trust. Our data support
the view that franchisors’ general trust in their franchise partners results in the
perception of lower relational risk and therefore requires less specific decision rights
provisions in franchise contracts. However, the impact of knowledge-based trust on
29
contractual completeness is not significant in franchise relationships. One explanation
could be that the knowledge acquisition effect of repeated interactions with an
exchange partner is less relevant in franchising because the franchisor designs more
standardized franchise contracts, which are not closely adjusted to the interaction
history of the different franchise partners.
5.2 Implications
How does this study extend the results in the literature? The major contribution
of this study is the development of a new theoretical concept of contractual
completeness and its application to incompleteness of contracts in franchising by
combining transaction cost economics and the relational governance perspectives. First,
the franchise contract consists of two types of contract provisions: specific decision
rights which specify in detail what the franchisor and franchisee has to do under certain
circumstances during the contract period, and residual decision rights as contract
provisions which specify the franchisor’s and franchisees’ rights to make certain
decisions during the contract period. Contractual completeness is defined by the
relationship between specific and residual decision rights stipulated in contracts. A
franchise contract is more complete if the franchisor’s and franchisees’ value chain
activities at the local outlets are more regulated by specific rights and less by residual
rights. By defining contract provisions according to specific versus residual decision
rights features, we provide a precise criterion to distinguish between contractual
completeness and contractual complexity. Complexity does not explicitly differentiate
between specific and residual rights provisions in the contract.
Second, we extend the transaction cost view of contractual completeness in
franchising by testing new hypotheses regarding the impact of transaction-specific
30
investments and environmental uncertainty on incompleteness of franchise contracts.
Specifically, compared to Solis-Rodriguez and Gonzalez-Diaz (2012), we argue that
the effect of franchisor’s and franchisees’ transaction-specific investments on the
degree of contractual completeness is influenced by the dependence of the network
partners. Under bilateral dependence franchisor’s and franchisees’ transactioninvestments have a negative impact and under unilateral dependence they have a
positive impact on contractual completeness. Third, this is one of the first studies that
investigate the impact of different dimensions of trust on formal contracts (Lazzarini,
Miller and Zenger 2008; Cao and Lumineau 2015). Previous research has not
investigated the role of trust as determinant of contractual completeness in franchising.
We complement the transaction cost view by examining the impact of knowledgebased trust and general trust on the franchisor’s choice of contractual completeness.
Our results show that general trust is an important determinant of incompleteness of
franchise contracts. Therefore,
Overall, the paper adds to the existing work on interfirm networks that
combines transaction cost and relational governance perspectives. Consistent with the
interorganizational governance literature (e.g., Zaheer and Venkatraman 1995), the
extension of the transaction cost reasoning by the relational governance view
significantly increases the explanatory power of the research model.
The results of this study have some implications for the franchisor’s choice of
contractual completeness: For instance, our results suggest that the franchise contract
should contain relatively more specific decision rights provisions under a strong brand
name, low transaction-specific investments of the franchisees compared to the
franchisor and a low level of franchisor’s general trust: More specific decision rights
provisions will protect the franchisor against the free-riding and hold-up risks when the
31
brand name value is high and the franchise agreements are not self-enforcing due to
relatively low franchisees’ transaction-specific investments. In addition, more specific
decision rights provisions will ensure a higher level of control by the franchisor when
his/her level of general trust is low.
5.3 Limitations
This study has important limitations: First, the major limitation of our study
results from the operationalization of contractual completeness. The measurement of
contractual completeness is only a first step to operationalize contractual completeness.
We test the impact of the transaction cost and relational governance variables on
contractual completeness by using subjective indicators for specific and residual
decision rights. However, the generalizability of our results would require the
development of more valid indicators for specific and residual decision rights. Future
studies have to use objective measures based on provisions in franchise contracts.
Second, we measure all constructs from the franchisor’s point of view. For instance, we
use the franchisor’s perception to measure environmental uncertainty. This issue should
be addressed in future studies by collecting data from the franchisees.
Third, while our transaction cost and relational governance variables are
important determinants of contractual completeness, other variables not included in the
study may affect contractual completeness in franchising. In addition to the transaction
cost and relational governance explanations, variables derived from organizational
capability and bargaining power theory may influence incompleteness of franchise
contracts. According to the organizational capability theory (e.g., Mayer and Argyres
2004; Argyres and Mayer 2007; Solis-Rodriguez and Gonzalez-Diaz 2012), franchisors
develop contract design capabilities through interorganizational learning which enables
32
them to formulate more complete contracts. In addition, based on the bargaining power
perspective (e.g., Ben-Shahar and White 2006; Choi and Triantis 2012), we expect that
a strong bargaining power of the franchisor may influence the degree of contractual
completeness. For instance, Ozmel et al. (2013) show that the bargaining power of
alliance partners affect both the contractual complexity and the allocation of residual
rights in alliance contracts.
Finally, we made the distinction between specific and residual decision rights.
However, franchise contracts are characterized by two forms of incompleteness: One
form of incompleteness is covered by the residual decision rights. They do not specify a
course of action regarding many contingencies, but only the identity of the party who
has authority to decide when one of these contingencies arises. The other type of
incompleteness refers to the standardization of system-specific know how by using the
business format. It implies a certain “rule-governed behaviour” (Heiner 1983, p. 568;
Heiner 1986) and entails a certain rigidity because it standardizes behavior across
outlets regardless of the local circumstances. This raises the question regarding the
appropriate limits of uniformity (Kaufmann and Eroglu 1999). Battigalli and Maggi
(2002) label these two forms of incompleteness as discretion and rigidity. Future work
has to address the circumstances when these forms of incompleteness arise.
6 Conclusion
This study provides a transaction cost and relational governance explanation of
contractual completeness in franchising. We develop a new concept of contractual
completeness defined by the relationship between specific and residual decision rights.
Specific and residual decision rights provide a precise criterion to differentiate between
completeness and complexity of contracts. In addition, we extend the transaction cost
33
view of contractual completeness in franchising developed by Solis-Rodriguez and
Gonzalez-Diaz (2012) by differentiating between unilateral and bilateral transactionspecific investments and adding environmental uncertainty as determinant of the degree
of contractual completeness in franchising. Furthermore, we develop a relational
governance view of contractual completeness by examining the impact of knowledgebased and general trust on contractual completeness. Our results show that trust – in
particular general trust – is an important influencing factor on completeness of
franchise contracts. In conclusion, our empirical results suggest that franchisormanagers have to consider both transaction cost and relational governance determinants
for taking the right contract design decision.
We hope that our contribution inspires further research on incompleteness of
contracts in other interfirm networks, such as alliances, joint ventures, cooperative
networks or public-private partnerships.
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APPENDIX: MEASURES OF VARIABLES
Index of Contractual Completeness (COMPLETENESS): The general managers were asked to rate the
degree of contractual completeness with the following indicators:
(a) Specific decision rights (sDR): “The tasks of the franchisor regarding the value chain activities at the
local outlets are specified in detail in the contract”; “the tasks of the franchisees regarding the value
chain activities at the local outlets are specified in detail in the contract.” Two items, measured on a
7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha = 0.871.
(b) Residual decision rights (rDR): “The decisions of the franchisor regarding the value chain activities
at the local outlets are specified in detail in the contract”; “the decisions of the franchisees regarding
the value chain activities at the local outlets are specified in detail in the contract.” Two items,
measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree), Cronbach alpha =
0.909.
Environmental Uncertainty (ENV):
Three items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree),
Cronbach alpha = 0.742
1. The sales at the outlet level are very fluctuating.
2. It is very difficult to predict the market development at the outlet level.
3. The economic environment in the local market changes frequently.
Franchisee Transaction-specific Investments (INV_FEE): Initial investments required to start a new
franchised outlet.
Franchisor Transaction-specific Investments (INV_FOR):
Three items, measured on a 7 point Likert-type scale: To which extent the franchisor has toto bear
the following expenses? (1 not at all – 7 to a very great extent), Cronbach alpha = .632
1. Franchisee training at the beginning of the contract period
2. Technical support at the beginning of the contract period
3. Set-up of the outlet organization
Franchisor Brand Name (BRAND):
Four items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree),
Cronbach alpha = 0.811
1. Our brand is very strong compared to our competitors.
2. Our franchise system enjoys higher brand recognition compared to our competitors.
3. Our franchise system enjoys a good reputation for quality.
4. Our brand name is very important for us for achieving competitive advantage.
Trust:
Knowledge-based Trust (KTRUST):
Four items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree),
Cronbach alpha = .876
1. The cooperation is based on partnership basis.
2. The exchange of information between us and the partners goes beyond the agreed
scope.
3. There is great trust between us and the partners.
4. There is an atmosphere of openness and honesty between us and the partners.
General Trust (GTRUST):
Three items, measured on a 7 point Likert-type scale (1 strongly disagree – 7 strongly agree),
Cronbach alpha = .806
1. The majority of people trust others.
2. Most people are trustworthy.
3. Most people behave cooperatively if they are trusted.
Sector (SEC): 0 = Product franchising firms; 1 = Services firms
Size (SIZE): Number of outlets in the franchise system (franchised + company owned)
Age (AGE): Number of years since opening up the first franchised outlet in Germany
Contract Duration (DUR): Length of the contract in years
Figure 1. Research Model
Franchisor’s
Knowledgebased Trust
Franchisor’s
General Trust
Franchisees’
Specific
Investments
Specific In
H5
ab
H6
a
H1b
H2b
H1a
H2a
Franchisor’s
Specific
Investments
H3
Environmental
Uncertainty
H4
Franchisor
Brand Name
Control Variables
AGE
SIZE
SECTOR
DURATION
Contractual
COMPLETENESS
Table 1. Estimate of Non-response Bias
Means, (SD), and Counts1
Population
Respondents
10.102
11.190
(8.122)
(8.391)
N = 449
N = 121
112.718
155.949
(431.444)
(328.376)
N = 337
N = 118
1.002
0.930
(1.497)
(1.342)
N = 326
N=127
4.473
5.442
(6.282)
(7.452)
N = 446
N = 117
Age of Franchise System
(Years)
System Size (total outlets)
Advertising Fee (% of Sales)
Royalties (% of Sales)
t-value
-1.298
p-value
0.195
0.992
0.322
-0.478
0.633
1.408
0.16
The measures of Advertising Fee and Royalties were first tested by a MANOVA to ensure independence of these variables.
Table 2. Rotated Factor Matrix
Factor
Item
1
.776
2
.080
The exchange of information between us and the partners goes beyond the agreed scope
.642
.093
The majority of people trust other
-.009
.703
Most people are trustworthy
.034
.939
Most people behave cooperatively if they are trusted
.173
.659
There is great trust between ourselves and the partners
.899
.045
There is an atmosphere of openness and honesty between us and the partners
.922
.041
The cooperation is based on partnership basis
Table 3. Descriptive Statistics
N
Minimum
Maximum
Mean
Std. Deviation
rDR
100
1.00
7.00
5.1200
1.40547
sDR
98
2.00
7.00
5.1378
1.36936
ENV
127
1.00
7.00
3.7323
1.35956
INV_FOR
137
1.00
7.00
4.3723
1.25249
INV_FEE
123
0.00
100000.00
12668.5691
14701.97921
BRAND
137
1.33
7.00
5.6448
1.11306
KTRUST
136
1.00
7.00
5.7960
1.03914
GTRUST
136
1.00
7.00
4.5368
1.31979
SIZE
118
1.00
2520.00
155.9492
328.37593
AGE
121
1.00
34.00
11.1901
8.39078
DUR
119
1.00
20.00
6.8235
3.28104
SEC
127
0.00
1.00
0.6378
.48254
Table 4. Pearson Correlations
rDR
sDR.
ENV
INV_FOR
INV_FEE
BRAND
KTRUST
GTRUST
SIZE
rDR
1
sDR
.596**
1
ENV
.052
-.047
1
INV_FOR
.259**
.177
,009
1
INV_FEE
-.061
-.073
-,121
,177 *
1
BRAND
.098
.261**
-,109
,117
,135
1
KTRUST
.111
.074
-,288**
,042
,037
,297**
1
GTRUST
-.110
-.199
,160
,035
,039
,053
,171*
1
SIZE
.067
.057
,040
-,124
-,130
-,181*
,053
,041
1
AGE
.062
.196
,053
-,052
-,091
,128
,051
-,078
,453**
DUR
.170
.304**
-,365**
,158
,412**
,273**
,084
-,090
-,041
SEC
-.149
-.278**
-,028
-,085
,293**
-,140
-,085
,070
-,119
AGE
DUR
SEC
AGE
1
DUR
.242**
1
SEC
-,141
,015
** p < .01, * p < .05
1
Table 5: Seemingly Unrelated Regressions (SUR) of the determinants of Specific Decision
Rights (sDR) and Residual Decision Rights (rDR)
Model 1a
Model 1b
Model 2a
Model 2b
Model 3a
Model 3b
sDR
rDR
sDR
rDR
sDR
rDR
ENV
-0.043
0.043
-0.016
0.099
(0.107)
(0.107)
(0.113)
(0.116)
INV_FOR
0.164
0.365 ***
0.141
0.376 ***
(0.100)
(0.101)
(0.097)
(0.100)
INV_FEE
-0.253 **
-0.234 **
-0.230 **
-0.231 **
(0.118)
(0.119)
(0.114)
(0.117)
BRAND
0.213 *
0.084
0.257 **
0.044
(0.109)
(0.109)
(0.110)
(0.113)
KTRUST
-0.072
0.138
(0.105)
(0.108)
GTRUST
-0.237 **
-0.022
(0.098)
(0.101)
SIZE
0.016
0.073
0.129
0.174
0.167
0.145
(0.112)
(0.116)
(0.113)
(0.113)
(0.111)
(0.114)
AGE
0.048
-0.062
-0.046
-0.159
-0.084
-0.162
(0.114)
(0.118)
(0.112)
(0.112)
(0.109)
(0.112)
DUR
0.305 ***
0.238 **
0.357 ***
0.328 **
0.323 **
0.327 **
(0.105)
(0.109)
(0.130)
(0.130)
(0.125)
(0.129)
SEC
-0.215 **
-0.193 *
-0.115
-0.091
-0.105
-0.094
(0.102)
(0.106)
(0.102)
(0.102)
(0.098)
(0.101)
R²
0.155
0.092
0.266
0.265
p-value
0.004
0.074
0.000
0.000
Observations 84
84
83
83
*** p < 0.01; ** p < 0.05; * p < 0.1
Standard errors in parentheses. Variables are standardized.
0.324
0.000
83
0.279
0.000
83