Externality and organizational choice in franchising

In this paper, we examine some implications of externality for the organization of firms. The need to control externality explains the selection, at the level of the chain, of full integration, dealerships or franchising systems, or systems of dual distribution where company and franchised outlets operate simultaneously, in preference to unrestricted retailing. We show that there could be a trade-off between managerial motivation and effective controlling of externality. This trade-off can explain the selection of particular organizational structures within franchising. In particular, non-separable externality, where the value of the externality depends upon characteristics of both the generating and affected unit, is costly to control contractually and could encourage integration.