A Model of Free Riding Incentives in Franchise Chains


Seoul Journal of Business

June 2004, vol. 10, n°1, pp.81-104

Departments: Marketing

This paper explains the free riding phenomenon in franchise chains where all chain members benefit mutually from the positive network externality of service quality. Starting from a simple formal model with two independent outlets, we present the analytical form of the optimal reaction function in which two outlets interact through service quality externalities. With complete information, no outlet finds any interest in free riding on service quality at the expense of the other. Contrary to previous findings, the positive demand externality increases the optimal service quality through interactions among chain members with complete information. By relaxing the complete information assumption, we demonstrate that incompleteness of information is the main source of free riding incentives. Contrary to the prevailing explanation based on agency theory, incompleteness of information leads outlets facing a smaller externality to free ride more on service quality compared to its optimal level with complete information.