Question

Many fast food restaurant chains like McDonalds and others have some stores which are directly owned by the company (McDonalds) which hires a manager and staff to manage the restaurants, and some stores that they sell a franchise to an outside company/individual who operates the restaurants and pays the company (McDonalds) a franchise fee and keeps the rest of the profits. The franchise fee will have to be paid no matter what the profits of the restaurant may be.

(a) What is the principal - agent problem in the company owned restaurants? Please explain.

(b) What is the principal – agent problem in the franchised restaurant? Please explain. You may assume that the owner is still McDonalds as McDonalds can cancel the franchise agreement if they want to, in which case the former franchisee will no longer be able to use the McDonalds brand to sell their food.

(c) In which case will the principal-agent problem be more severe? Please explain.

Answer 1

a) The principal-agent problem in the case of company-owned restaurants is that the manager is assigned the day to day functioning of the restaurant which is though supervised by the owner. Here the manager is receiving his salary which is fixed and hence he has less incentive to increase the profits. But if the company has policies of incentives and bonuses over and above the fixed salary, then he would put in more efforts without the supervision of the owner.

So the principal-agent problem is that the owner is not able to supervise the everyday activities but has control over the operations largely.

b) In this case, a company which has an established reputation and trademarks or certain processes issues licences known as a franchise to another party, thereby giving them the right to produce and sell goods and services under their name.

Here the principal-agent problem would be that there is a contractual relationship between the two parties and though the brand's name, the processes and other trademarks are used by the franchisee yet the complete control is in hands of the franchisee. Also since the contract defines that franchisee would pay a fixed fee, it gives flexibility to the franchisee to function the way it wants. There could be two aspects of it.

There is a direct relation between efforts and rewards and hence this motivates the franchisee to perform better. But the other aspect is that there could be situations where the quality of goods and services sold are of poor quality and this could directly impact the brand name in a negative way. So there is asymmetric infromation as the franchisor doesn't know if the franchisee is actually the right individual or company and also if after the contract quality goods are being delivered.

Though the company owns the right to cancel the agreement, the cases of poor food quality or poor services may have already tarnsihed the image of the brand or fast food chain in this case.

c) It is more severe in case of franchised restaurant. This is because the company does not directly have a control the operations of the unit but since its name and trademark is a part of the operations, it becomes a risky venture as the reputation of the firm is at stake.

(you can comment for doubts)