A Model of Free Riding Incentives in Franchise Chains

Abstract

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.