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behavior, and free-rides less. Consistent with this, Brickley(1999) finds that area development
agreements - contracts through which franchisees are initially given the right to open several
outlets - are significantly more likely to be used by franchisors involved in non-repeat
customer industries, where free-riding is especially an issue.

[16]
Consistent with this, Kaufmann and Lafontaine (1994) present evidence that franchisors
monitor the behavior of their store managers much more often than that of franchisees.
Further, Bradach (1997) finds that the franchisors he studies use elaborate supervision and
monitoring schemes for their store managers, but that they shun the use of the same
mechanisms for their franchisees.
5 Specific contract terms and implementation
So far, we have focused our discussion on the role of residual claims and self-
enforcement in aligning franchisee and franchisor incentives without providing much
detail as to how these mechanisms are implemented or supported via specific contract
terms. In this section, we briefly describe how specific franchise contract terms serve to
implement these two mechanisms. We begin with residual claims.

5.1 Franchise contract terms supporting franchisees' residual claimant status

Contract terms defining the financial obligations of franchisees, along with contract terms
that allow franchisors to ensure franchisee performance of these obligations, and finally
franchisee prerogative to transfer ownership of a franchise all contribute to establish
residual claimancy rights within franchise contracts. The financial terms define the
apportionment of residual claims among parties to the franchise contract; the franchisor's
access to specific type of information ensures that the defined apportionment of residual
claims is correctly effected; and the franchisees' prerogative to transfer ownership of a
franchise ensures that franchisees can appropriate the current and future profits due to
their effort and investments.
As mentioned in section 3, residual claimancy incentives would be fully implemented if
franchisees purchased their businesses for a fixed fee only. However, the optimal
(second-best) linear contract involves sharing when the franchisee is risk averse or when
there is a need to give incentives to the franchisor as well as the franchisee. In that
context, the financial terms that implement residual claims in franchise contracts include
not only the up-front franchise fee, but also most notably the royalty rate and advertising
fee, both of which are normally defined as a proportion of revenues, and clauses
specifying input purchase requirements when these inputs are sold at a markup.[17]

To the financial terms of the contract, one must add contract terms that allow the
franchisor to obtain accurate accounting and sales information to calculate royalties and
advertising fees. Specifically, one usually finds clauses defining precisely the store
revenue that is subject to royalty payments and advertising fees. Other clauses indicate
the method and frequency with which the relevant revenue data must be transmitted to
the franchisor. Still other clauses stipulate the circumstances under which the franchisor
will be able to conduct his own store audits and other forms of financial verification to
ensure the validity of the information she receives.

Finally, contract terms that accord franchisees the right to transfer their franchise to
someone else serve an important role in implementing residual claims as well as self-
enforcement incentives. Franchisees usually own or finance much of the franchise's
assets (which may, or may not include the actual building within which the franchise is
housed), and are allowed to sell their franchise at any time (subject to approval of the
buyer by the franchisor).[18] The ownership of the franchise, and its inherent
transferability through sale, makes the franchisor's promise of future residual claims (and
related future rent) credible (Lutz 1995). As such, they give franchisees' incentives to
invest resources and effort in future as well as current revenues and returns.

5.2 Franchise contract terms supporting the self-enforcement mechanism
As explained earlier, self-enforcement incentives require that contracting parties always
be better off by continuing to operate within the contract than by risking discontinuation.
Contract terms can implement this condition by increasing the expected gains from
continuation (W2) and/or decreasing the expected gains from deviation (W1). The former
involves increasing expected ongoing rent through favorable financial terms as well as,
potentially, entry restrictions, lengthy contract duration, a high likelihood of renewal, and
a policy of allowing or fostering multi-unit ownership among franchisees. The latter
involves restricting franchisee conduct through terms stipulating, for example, specific
operating procedures, acceptable input sources, minimum advertising expenditure levels,
or suggested pricing levels.
5.2.1 Increasing expected rent (W2t)
The financial terms of the contract described above determine the apportionment of
revenues between franchisor and franchisee, and the amount of rent left downstream
with the franchisee. In fact, as noted in section 3, once the optimal sharing parameter
(sum of royalty rate and advertising fee) is determined, there is a maximum fixed fee that
the franchisor can charge for the franchise. This maximum fixed fee is equal to the
present value of the expected returns (ex post rent) of the franchise over the duration of
the contract, given the chosen share parameter. If the franchisor sets the franchise fee at
this level, there is no expected rent ex ante from owning the franchise. There is, however,
ex-post rent downstream which may suffice to ensure franchisee performance. If the
franchise fee is set at a lower level than this maximum, there is both ex ante and ex post
rent left downstream in the franchised chain. The level of ex ante rent earned by the
franchisee in fact is exactly equal to the difference between the present value of the
stream of ex post rent expected over the duration of the contract and the initial fee. Thus
holding the franchise fee fixed, factors that increase expected rent ex post also lead to
higher expected ex ante rent.
Restricting new entry into the franchised chain ensures a degree of ongoing market
power for individual franchisees. In concert with the allocation of exclusive territories,[19]
such entry restrictions limit intra-brand competition and thus increase the amount of ex
post rent for franchisees. After setting the financial terms of the contract, it is therefore
through the number of franchises sold in each market that the franchisor most directly
affects the level of revenues and rent for franchisees. Moreover, these decisions
determine the density of outlets and thus the level of all forms of externality across
outlets in the market.

By stringently qualifying prospective franchisees, the franchisor also helps ensure that
chain homogeneity and quality, and thus franchisee rent, are maintained over the long
run. The franchisor seeks motivated individuals with the demonstrated ability to manage
the day-to-day operations of an outlet while respecting the franchise chain's restrictions
and its rules. Furthermore, to acquire a particular franchise, a prospective franchisee
must satisfy certain franchisor requirements, often including a minimum net worth and/or
some level of prior business experience. During the training period the franchisor and the
franchisee also each gain important information for assessing the fit between the two.
The franchisor can assess the strengths and weaknesses of the potential franchisee
while the franchisee can determine whether the business activity and franchisee role are
right for that individual. The thorough selection process screens out prospective
franchisees whose lack of motivation or ability could erode brand value, there by
providing current franchisees a measure of security against dissipation of their expected
rent.
The length of the franchise contract also affects the amount of rent franchisees can
expect to earn within the franchise relationship. The average length of franchise
contracts in the United States is about fifteen years according to the US DOC, with most
of them lasting from five to twenty-five years. The main advantage of longer-term
contracts is that the franchisee can count on appropriating the returns to his long-term
investments and is therefore more apt to make such investments. In addition, all else
2
equal, long-term contracts directly imply higher levels of future rent (W ), which in turn
reduce free-riding problems. On the other hand, long-term contracts may increase the
cost of self-enforcement by making it more difficult to "end" the relationship itself via non-
renewal or termination. Courts may be more reluctant to endorse early termination of
long-term contracts, or they may require that franchisors compensate franchisees more
when they terminate a long-term contract. Moreover, a shorter-term contract makes it
less costly for a franchisor to wait until contract expiration and simply refuse to renew. In
this case, the use of short-term contracts would enable franchisors to avoid termination
[20]
and its associated costs altogether. In sum, decisions regarding contract duration
must balance the need for franchisee investment and the costs of enforcement.
Finally, the probability of contract renewal and the availability of additional outlets within
the chain play very similar roles as contract duration in the motivation of franchisees.
Specifically, renewal implies that the franchisee can expect his stream of ex post rent to
continue beyond contract expiration. The higher the probability of this event, the higher is
the amount of rent associated with maintaining the relationship.[21] As for additional
outlets, they can also serve to extend the period of expected rent ex post beyond the
expiration of the first contract.[22] However, they can be even more valuable as an
incentive mechanism if franchisees can expect to earn rent ex ante from these (i.e. if the
franchise fee or purchase price for additional outlets is below the present value of
expected returns from these generally, or for this particular franchisee because he
already owns other units in the same market and will benefit from additional market
[23]
power or efficiencies with the new unit).
5.2.2 Restricting the gains from deviation (W1t)
Most franchise contracts include terms stipulating that the franchisee must operate his or
her outlet according to the norms set by the franchisor in the operations manuals. In fact,
these manuals and the detailed instructions they provide are often included in the
[24]
contract by reference. Moreover, the contract usually includes a clause indicating that
the franchisor can modify these manuals as needed. The franchisor therefore can
impose a large set of detailed rules on the franchisee's operations, and has the option of
changing these rules in midstream. From an incentive perspective, these rules provide
an evolving series of fairly objective criteria that can be used to justify and facilitate
contract termination. They also limit the franchisee's opportunities to free ride and thus
the profits he can obtain from free-riding generally.

Other specific contract clauses limit the franchisees' options and thus increase franchisor
control. These include input purchase requirements or approved supplier clauses,[25]
minimum advertising expense requirements, and suggested prices.[26] Non-compliance
with such restrictions is easily verified by the court system. In that sense, their use
reduces franchisees' opportunities to maximize their profits at the expense of the overall
system.

Finally, if all these clauses and control mechanisms prove insufficient to induce the
desired behavior from franchisees, or are simply too costly to implement, the franchisor
can choose to vertically integrate any particular outlet. In that case, since managers are
not typically paid based on profits or revenues (and do not have a stake in future profits
or revenues either), the franchisor loses the incentive effects associated with residual
claims. However, an efficiency wage can be put in place, and the store manager can be
further motivated by the hope of promotion, in the form of a transfer to an outlet in a
more desirable location, or to higher levels of the franchisor's corporate hierarchy. In fact,
most franchisors own and operate a number of outlets in their system.[27] In that sense,
the option of vertically integrating outlets is a very viable one.

In sum, franchisors use a number of contract clauses and incentive mechanisms that
allow the franchise system to benefit from the effort and dedication of the individual
franchisee/owner while limiting his or her ability to impose negative externalities on other
franchisees or the franchised chain. Many of these clauses simultaneously support both
types of incentive mechanisms used in franchise contracting. For example, financial
contract terms simultaneously apportion residual claims and determine the amount of
rent in the relationship. Similarly, sporadic audits are necessary to ensure that the
revenues are declared and shared according to the terms of the contract, and
termination, an essential component of the self-enforcement mechanism, is also the
ultimate penalty imposed on a franchisee who does not fully disclose revenues. In fact, it
should be clear from the discussion above that the terms of franchise contracts generally
complement one another not only in their support of the two incentive mechanisms
discussed here, but, fundamentally, in supporting the franchise system as a whole.

[17]
In some business-format franchises, the royalty rate or advertising fee is replaced by an
ongoing fixed payment. Abstracting from issues of termination or failure, these are equivalent
to an up-front fixed fee from an incentive perspective.

[18]
Franchisors may also have a right of first refusal.

[19]
Various surveys indicate that in the United States, about two out of every three franchisors
offer exclusive territories to their franchisees. Furthermore, "master franchise" agreements all
involve some form of territory. Master franchise agreements take one of two main forms: area
development agreements, where the selected franchisee normally develops and owns all the
outlets on his territory, and sub-franchising agreements, where the "master franchisee" is
expected to recruit and support (i.e. play the role of franchisor for) franchisees he establishes
on his territory.

[20]
Legal rules against termination imposed in some US states apply also to non-renewals, but
the latter remain easier and less costly to implement.

[21]
Often, franchisors request the payment of a new fixed fee upon renewal. This fixed fee
should be deducted from expected ex post rent over the renewal period, and the result
multiplied by the probability of renewal, to get an estimate of the ex ante expected amount of
rent from renewal.

[22]
In fact, if the probability of renewal is very low, and the likelihood of additional outlets
almost nil, the expected rent of the franchisee, and thus his incentives not to free ride or
damage the brand, will diminish gradually over the duration of the contract.

[23]
See Kalnins and Lafontaine (2001) for further discussion of the potential benefits
franchisees can derive from owning multiple units in a market.

[24]
Operations manuals are usually very detailed, to the point of including, for example,
pictures of what plates should look like when served in a restaurant chain, including the
position of each item on the plate.

[25]
Siegel et al.v. Chicken Delight, Inc., 448 F. 2d43 (9th circuit, 1971) established that input
purchase requirements were a form of tying for business format franchisors as long as the
inputs were a separate product from the brand. As a result, business-format franchisors in the
United States rely on approved suppliers rather than input purchase requirements to control
input quality.

[26]
Resale price maintenance is per se illegal under US antitrust laws. However, a 1997
Supreme Court decision has made maximum resale prices for all intents and purposes legal.
(See Blair and Lafontaine 1999 for more on this.)

[27]
On average, US franchisors operate about 20 percent of all their units, despite about 25
percent of franchisors operating none. Similarly, in France, about 78 percent of all franchised
systems include both franchised and corporate units. See Lafontaine (1992) and Lafontaine
and Shaw (2001) for US data, and Allam and Le Gall (1999) for French data. One finds a
number of theories in the literature as to why franchisors might want to combine company
owned and franchised outlets within a given chain. It is beyond the scope of the present
chapter to review this fairlyextensive literature, but see Lafontaine and Slade (2001) for a
review of the empirical literature on this topic.
6 Non-franchised systems with common mark or reputation
concerns
We have so far discussed how self-enforcement (and the many contract clauses that
support it) work together with residual claims to give franchisees the right set of
incentives. Fundamentally, we have argued that the franchised system relies on rent to
prevent the profit maximizing franchisee from "hurting" the brand in his quest for higher
profits. But the need to "protect the brand" or the system is not unique to franchising. In
this section, we show through two examples how our analysis also applies to non-
franchised systems with a common mark or common reputation concerns.

"Labels rouges" (literally red labels) are used in France to certify the high quality of
various agricultural products. These "labels rouges" are government-endorsed marks
that groups of producers can collectively create and work under. The creation of such a
label requires that all producers in a vertical chain be involved, and that these producers
collectively define a set of rules and specifications, codified in the "Cahier des Charges,"
under which they promise to operate (see M©nard, 1996; Westgren 1999, for a
description of the organization of production under "labels rouges" in the poultry industry).
Different groups of producers within the same agricultural sector can create different
"labels rouges" with different rules and specifications. However, all of these must satisfy
some minimum requirements to be approved as "labels rouges." From the consumer's
perspective, the different "labels rouges" can be distinguished because they each have
their own individual identity. For example, in the French poultry industry, there are now
[28]
more than 80 different "labels rouges."

When they create a "label rouge," producers must also organize and form a
"Groupement qualit©," which owns the collective mark and is responsible for the
enforcement of the rules. This "Groupement qualit©" is fundamentally an association of
producers, and all producers must enter into a contract with this association before they
can sell under this mark.

As each member of a "label rouge" is an independent and separate business, the
producers are all full residual claimants. Consequently, they may free ride on the
common mark or simply maximize their own profits without necessarily taking into
account the effect of their behavior on others in the group. Thus the group must institute
incentive and control mechanisms. And indeed, many of the clauses found in producer
contracts with the "Groupement Qualit©" are best understood as ways to make the
contracts self-enforcing. In particular, the "Groupement Qualit©" has the right to regularly
inspect and monitor the behavior of individual producers, and the option to terminate the
membership of any producer whose production does not satisfy the rules and
specifications set forth in the "Cahier des Charges." Moreover, group members earn rent
“ they can sell their product at a premium because the label effectively differentiates it
and identifies it as a high-quality product, and this price premium is protected by
territorial exclusivity clauses (e.g. territorial exclusivity for slaughterhouses within a given
label) (see Raynaud and Valceschini 1999 for details).

In sum, the contractual structure of a "label rouge," and in fact of production cooperatives
more generally, tends to be very similar to that of a franchised system. Within these
systems, individual producers are residual claimants as franchisees are. But the system
also includes a central entity that contracts with all producers, as the franchisor does.
This central entity also monitors individual producer behavior to make sure producers
abide by the rules. Finally, like a franchisor, the central entity can exclude producers that
do not abide by the rules and, as a result, cause them to lose access to a stream of rent.

In a similar vein, Arru±ada (1996) shows the similarities between franchising and the way
in which "Civil Law" notaries are organized as a profession in Spain. He notes that under
Civil Law, notaries provide private contracting services for which their customers pay
them directly. However, these notaries also provide a public good in that they keep
records and perform research to ensure the validity of various contracts. The effort they
put in these validation activities affects the quality of contracts in the economy, and thus
entails significant externalities. The notary, as a residual claimant, would maximize his or
her revenues by focusing effort on the production of the private good only. But without
any validation activities, the whole civil notaries' system breaks down “ the reputation of
the whole system depends on each notary doing a thorough job of validating and record
keeping. Arru±ada (1996) argues that rent, owing to entry restrictions and price controls
for notarized services, and the potential loss of this rent, complements the incentives
associated with residual claimancy and ensures the provision of the public as well as the
private goods.

[28]
For instance, "poulets de Lou©" and "volailles de Challans" where Lou© and Challans are
different geographical regions.
7 Conclusion
The two types of incentive mechanisms found in franchise contracting are those related
to the franchisee's status as a residual claimant, as captured in the principal-agent
literature, and those related to self-enforcement. The latter focuses on giving franchisees
something to lose if the relationship is ended, and combining that with some regular
monitoring and termination rights so that the franchisee will indeed have to worry about
this potential loss if he does not behave as requested. The literature has generally
treated these mechanisms as separate and even substitute incentive mechanisms. Yet
empirically they coexist. We have explained this coexistence based on the notion of
complementarities. Specifically, we have argued that residual claims give strong
incentives to maximize profits, sometimes at the expense of the brand and other group
members. The combination of rent and termination rights in that context are tools that the
franchisor can use to curb this profit maximization motive when it is harmful to the overall
franchised system. Similarly, relying solely on rent and termination rights would leave the
franchisor vulnerable to shirking by franchisees on the day-to-day operations as it would
be very costly for the franchisor to do the type of monitoring necessary to prevent this
type of misbehavior. Since outlet revenues provide a good measure of franchisee effort
for these types of activities, residual claims are the more appropriate incentive tool.

Our argument that self-enforcement and residual claims go hand in hand in franchising
and in other similar settings fits in particularly well with Holmström and Milgrom's (1994)
[29]
work on the role of complementarities in the design and workings of incentive systems.
Though we have focused on a particular institutional setting, that of the franchise
relationship, we have noted that the points raised here apply in many other settings
where legally autonomous businesses share a common brand or reputation concern.
Aside from production cooperatives, which we used as our main example, one can think
for example of cartel enforcement and labor negotiations with common unions as other
settings where the need to motivate individual members can conflict with the needs of
the group and hence the value of group membership. Further work into the specifics of
how these groups organize their joint activities would be most useful in clarifying further
the role of complementarities in contracting and organization more generally.

[29]
See also Atheyand Stern (1998) on this. Ichniowski, Shaw and Prennushi (1997) and
Cockburn, Henderson and Stern (2000) provide evidence of complementarities in incentive
mechanisms in steel production and the pharmaceutical laboratory context, respectively.
Finally, Brickley(1999) considers complementarities between a few specific contract clauses
in franchising.
Notes
Chapter 18 was originally published as "Cr©ance r©siduelle et flux de rentes comme
m©canismes incitatifs dans les contrats de franchise; compl©ments ou substituts?," in
Revue d'Economie Industrielle (92, 2000).

We thank two referees and David Leibsohn for their comments, and our respective
institutions for their support.
1. See FTC, "Disclosure Requirements and Prohibitions Concerning
Franchising and Business Opportunity Ventures" (16 CFR § 436.1 et
seq.), and EU rule 4087/88; 1988.
2. According to the US Department of Commerce (DOC) (1988), franchise
contracts in the United States can last anywhere from five years to
perpetuity, with an average of about fifteen years.
3. See Lafontaine (1992). Also, these fees are fairly stable over time. See
Lafontaine and Shaw (1999) for empirical evidence on this.
4. In product and trade name franchising, franchisees do not pay these
salesbased royalties. However, the markups charged by the franchisor
on every unit of input can be equivalent to sales royalties under certain
conditions. (See Lafontaine and Slade 2001 for more on this.)
5. To simplify the algebra, we ignore issues of contract duration and
discounting. This in no way affects the generality of the result that a fixed
price contract resolves all incentive issues when franchisees are risk
neutral. Note that F could be set at any level not exceeding a2/2. But any
2
F below a /2 means that the franchisor does not make as much as he
could, and the franchisee does better than required by his participation
constraint. We come back to this below.
6. Sharing occurs also, for example, in sharecropping, licensing, film
distribution, and publishing contracts.
7. If the franchisee is risk averse while the franchisor is risk neutral, as in
our previous setting, sharing will arise as an optimal response still. In this
case, the share parameter will play the double role of providing
incentives to the franchisor as well as insurance to the franchisee.
8. See Lafontaine and Slade (2001) for a review of the empirical literature
on franchise contracting.
9. See Lutz (1995) for more on this.
10. For self-enforcement to work, the franchisor must be able to evaluate, ex
post, whether or not the franchisee's performance is satisfactory even if
the desired effort is too complex to specify in the contract.
11. Indeed, only high-performance franchisees can expect renewal and
additional outlets within the same chain. These decisions therefore entail
rent that gives further incentives to franchisees. See Kaufmann and
Lafontaine (1994) for more on this.
12. This assumes that franchisees can earn profits in the long run, i.e. that
they do not operate in a perfectly competitive or monopolistically
competitive market. If profits were dissipated in the long run, there would
be no rent in the long run, and thus no self-enforcement. In other words,
Klein's analysis presumes that branding allows franchisees to
differentiate their product enough that they earn positive profits in the
long run (that the franchisor may or may not extract fullyup-front - we
come back to the issue of rent extraction below).
13. We assume that W2t varies over time. See Williams (1996) and Brickley
(2001) for an argument that as the market changes, the amount of rent
may change in a way that makes integration the preferred option. The
franchisor who then terminates or does not renew a franchise contract
can be thought of as exercising the equivalent of a "call option."
14. Brickley and Dark (1987) also point out that franchisees tend to under-
invest in their outlets as they must assume most of the investment risk.
While this effect is due to risk aversion rather than the presence of an
externality, it again implies that the franchisee will not act in the best
interest of the chain as a whole.
15. Also, by granting franchisees several outlets that are close to one
another, the franchisor may benefit even more as the franchisee then
internalizes more of the horizontal effects of his behavior, and free-rides
less. Consistent with this, Brickley(1999) finds that area development
agreements - contracts through which franchisees are initially given the
right to open several outlets - are significantly more likely to be used by
franchisors involved in non-repeat customer industries, where free-riding
is especially an issue.
16. Consistent with this, Kaufmann and Lafontaine (1994) present evidence
that franchisors monitor the behavior of their store managers much more
often than that of franchisees. Further, Bradach (1997) finds that the
franchisors he studies use elaborate supervision and monitoring
schemes for their store managers, but that they shun the use of the
same mechanisms for their franchisees.
17. In some business-format franchises, the royalty rate or advertising fee is
replaced by an ongoing fixed payment. Abstracting from issues of
termination or failure, these are equivalent to an up-front fixed fee from
an incentive perspective.
18. Franchisors may also have a right of first refusal.
19. Various surveys indicate that in the United States, about two out of every
three franchisors offer exclusive territories to their franchisees.
Furthermore, "master franchise" agreements all involve some form of
territory. Master franchise agreements take one of two main forms: area
development agreements, where the selected franchisee normally
develops and owns all the outlets on his territory, and sub-franchising
agreements, where the "master franchisee" is expected to recruit and
support (i.e. play the role of franchisor for) franchisees he establishes on
his territory.
20. Legal rules against termination imposed in some US states apply also to
non-renewals, but the latter remain easier and less costly to implement.
21. Often, franchisors request the payment of a new fixed fee upon renewal.
This fixed fee should be deducted from expected ex post rent over the
renewal period, and the result multiplied by the probability of renewal, to
get an estimate of the ex ante expected amount of rent from renewal.
22. In fact, if the probability of renewal is very low, and the likelihood of
additional outlets almost nil, the expected rent of the franchisee, and thus
his incentives not to free ride or damage the brand, will diminish
gradually over the duration of the contract.
23. See Kalnins and Lafontaine (2001) for further discussion of the potential
benefits franchisees can derive from owning multiple units in a market.
24. Operations manuals are usually very detailed, to the point of including,
for example, pictures of what plates should look like when served in a
restaurant chain, including the position of each item on the plate.
25. Siegel et al.v. Chicken Delight, Inc., 448 F. 2d43 (9th circuit, 1971)
established that input purchase requirements were a form of tying for
business format franchisors as long as the inputs were a separate
product from the brand. As a result, business-format franchisors in the
United States rely on approved suppliers rather than input purchase
requirements to control input quality.
26. Resale price maintenance is per se illegal under US antitrust laws.
However, a 1997 Supreme Court decision has made maximum resale
prices for all intents and purposes legal. (See Blair and Lafontaine 1999
for more on this.)
27. On average, US franchisors operate about 20 percent of all their units,
despite about 25 percent of franchisors operating none. Similarly, in
France, about 78 percent of all franchised systems include both
franchised and corporate units. See Lafontaine (1992) and Lafontaine
and Shaw (2001) for US data, and Allam and Le Gall (1999) for French
data. One finds a number of theories in the literature as to why
franchisors might want to combine company owned and franchised
outlets within a given chain. It is beyond the scope of the present chapter
to review this fairlyextensive literature, but see Lafontaine and Slade
(2001) for a review of the empirical literature on this topic.
28. For instance, "poulets de Lou©" and "volailles de Challans" where Lou©
and Challans are different geographical regions.
29. See also Atheyand Stern (1998) on this. Ichniowski, Shaw and Prennushi
(1997) and Cockburn, Henderson and Stern (2000) provide evidence of
complementarities in incentive mechanisms in steel production and the
pharmaceutical laboratory context, respectively. Finally, Brickley(1999)
considers complementarities between a few specific contract clauses in
franchising.
The Quasi-Judicial Role of Large
Chapter 19:

Retailers”An Efficiency Hypothesis of their
Relation with Suppliers
Benito Arru±ada
1 Introduction
1.1 The problem

In recent years, public discussion concerning large retailers and their suppliers has been
growing in intensity. It is often claimed that large retailers are endowed with
overwhelming bargaining power and that they abuse this power in their relations with
suppliers. New regulations have already been introduced and new regulatory initiatives
[1]
are often proposed. This work formulates and tests an alternative hypothesis,
according to which large retailers efficiently perform a function similar to that of a court of
first instance, that is, they act as second-party enforcers in their relationships with
suppliers.

The empirical analysis is consistent with the argument that, in order to perform this
function, large retailers exercise a set of implicit and explicit rights to "complete" or fill the
gaps in the contract, to evaluate their own and the other party's performance and to
impose due sanctions. Safeguards against opportunistic behavior in the performance of
these quasi-judicial functions follow directly from the retailers' own interest in maintaining
their reputation and the relationship with the suppliers, and in continuing to perform the
double role of judge and interested party. It is rarely optimal, however, to eliminate
opportunism completely. In retailing, failures in safeguards arise especially when the
retailer's time horizon is unexpectedly shortened or his decentralized decisions are
imperfectly controlled. Regarding these residual and potentially efficient distortions, it is
claimed that regulation could hardly provide better incentives than market competition.

The chapter pays special attention to the most problematical aspects of the relationship
between suppliers and retailers: the duration of the payment period, payment delays,
and the revision of the clauses before the end of the contract term. Quantitative empirical
evidence aiming to explain these phenomena in terms of efficiency is presented. On the
one hand, payment periods vary according to an industry-wide pattern that is coherent
with an incentive-based logic. On the other hand, statistical analysis of the average
payment period and payment delay per country shows that administrative difficulties of
the firms are the cause of both the longer payment period and the delay. This is coherent
with the view of these two phenomena, payment period and payment delay, as being
efficient contractual instruments. Finally, some empirical data concerning revisions
before the end of the contract term are analyzed. It seems, first, that these revisions are
related to phenomena that increase the total surplus of the relationship. Secondly, the
possibility of suppliers being exploited is rejected on several grounds, such as the lack of
specific investments because of the nature of the activity, the low concentration of the
retail sector in Spain, the use of short-term contracts and, above all, the annual
renovation of contracts.
The rest of the chapter has the following structure. The logic of the contracting process is
examined in the second part of this introduction, where the theoretical background of the
analysis is presented. Both the explicit (section 2) and the implicit (section 3) contracting
between the two economic agents are studied, including the initial contracts, their
revision, and the form and contents of the contracts. Special attention is paid to the
payment period and payment conditions. The main sources of conflict are studied at
length (section 4), and possible discipline mechanisms used by the retailer in his
parajudicial role are analyzed (section 5). Finally, the safeguards assuring that these
discipline mechanisms would not be abused are presented (section 6). The article ends
with a summary of its basic conclusions.

1.2 Asymmetric contracting
Three main branches have been distinguished in the analysis of contracts (Masten 2000).
First, in the economic theory of contracts, parties reach agreements on the content of the
exchange and an external judge enforces these agreements perfectly. Secondly, law and
economics comes closer to reality, by supposing that the judge also completes the
contract, contributing to defining the terms of exchange. Different approaches within this
perspective use more or less restrictive concepts. Sometimes the judge is believed to
behave efficiently, trying to discover the hypothetical will of the parties. Alternatively,
judges are assumed to take into account other considerations, such as equity, and
sometimes their decisions are viewed as affected by the rent-seeking activities of the
parties. Finally, the theories that consider contracts as relationships offer a more
complex perspective, considering also the possibility that judicial intervention can be
relatively inefficient. As a consequence, the main function of contracts is not to define the
terms of exchange, but to frame the process by which these terms are decided
(Macaulay 1963, 1985). Thus contracts define a variety of organs and decision rules,
helping to create a framework, constitution, or governance structure for the
corresponding economic relationship.
From this latter point of view, a basic option in contractual design consists of choosing
whether to facilitate or to avoid the use of self-completion and self-enforcement
mechanisms. "Self-completion" consists of the parties defining by themselves the
conditions or contents of exchange, that is, the set of duties that the parties are obliged
to perform for each other in any possible contingency. In general, these obligations can
be specified through mechanisms that are internal or external to the parties. Internal
solutions are implemented through organs and decision rules, but also through
asymmetric authority, as in the case in hand. Alternatively, external institutional solutions
may be used, consisting mainly of the law, for achieving ex ante completion, and of
litigation and arbitration, for ex post completion. There is also a wide range of
possibilities for enforcing the obligations resulting from the contractual relationship. They
are also either internal to the parties, based on repetition and reputation, or external,
using mainly the coercive power of the state.
Participants in economic transactions enjoy considerable information advantages with
respect to third parties, including judges. For this reason, if one of the parties reaches a
position of impartiality (either because of his reputation or because he contracts in a
repetitive way), it is in the interest of all contracting parties to agree that this party
possessing better information and incentives should be in charge of completing and
enforcing the contract. This party thus performs tasks of a judicial nature. These include
defining ex post any obligations that have not been agreed on ex ante, by adjusting the
terms of trade to the latest changes and distributing unexpected gains or losses;
evaluating whether each party has fulfilled its obligations or not; and imposing sanctions
for poor performance.[2] In order to facilitate the exercise of these functions, it is
necessary for the parties to choose contract solutions which strengthen the enforcing
capacity of the internal judge (or which prevent opportunistic recourse to an external
judge, as analyzed in Masten and Snyder 1993). The clearest of the examples studied in
this chapter is the payment period between retailers and suppliers, which plays a much
more important role than just exploiting comparative advantages of a strictly financial
nature.
The resulting organizational structure therefore constitutes a hybrid between the two
extremes that, following Williamson's typology (1975, 1985), represents the ideal types
of market and hierarchy. Williamson views these hybrids as corresponding to
neoclassical contract law subject to the "excuse doctrine," which is also an intermediate
form between classical contract law and the principle of forbearance that governs the
legal treatment of hierarchical relations (Williamson 1991, 1996, pp. 93“119).
The degree of judicial intervention places these intermediate solutions closer to one of
the two extremes. In this case and with respect to the dimensions analyzed, we will see
that the solution adopted in practice will be closer to the forbearance that is typical of the
judicial treatment of hierarchical organization. This closeness, however, is not a
consequence of active judicial abstention. In fact, judges are not given the opportunity of
passing judgment on these matters because they are not litigated. Furthermore, if judges
were given such an opportunity, precedents in other fields suggest that they would be
likely to act in a way that would obstruct the performance of quasi-judicial functions by
the retailer. This judicial inclination would motivate opportunistic litigation by suppliers.
For this reason, this solution could work only when the relationship provides a large self-
enforcement range or when this range can be enlarged by contractual means (Klein
1992, 1996; Masten and Snyder 1993; Klein and Murphy 1997).

These contractual mechanisms designed to avoid judicial intervention seem to be
unnecessary between suppliers and retailers. Suppliers do not usually object to retailers'
decisions, mostly because of the repetitive nature of the transactions. Interestingly, this
happens even in cases of statutory rules which, because of their mandatory nature, can
not be overruled contractually and which aim to establish a legal basis for litigation. An
example of such a rule is the one giving creditors an irrevocable right to be paid interest
and a penalty in the case of late payment by a retailer.

[1]
See, for example, the French 1996 "Galland" Act (Loi 96“588), modifying the 1986
Ordonnance (86“1243) on freedom of pricing and competition, and the Spanish Retailing Act
of 1996 (Ley 7/1996). More recent examples of this regulatory trend are the proposal for the
EU Directive on late payments (OJEC, December 3, 1998), even if the text finally adopted
was less strict (Directive 2000/35/CE, OJEC, August, 8, 2000); the failed project for a Code of
Good Commercial Practice prepared by the Spanish Ministry of Finance in 1998; the
extension of the concept of unfair competition to include the exploitation of economic
dependence, the termination of a commercial relationship without a six-month notice period
and the attainment of discounts under threat of termination introduced in the Spanish Unfair
Competition Act by Ley 52/1999; and the initiative taken by the French Government in
January 2000 to modify the Galland Act (Les Echos, January 14“15, 2000; p. 24).

[2]
For an empirical test of this theory in the car distribution sector see Arru±ada, Garicano and
Vázquez (2001).
2 Explicit contracting
Typically, explicit contracting between suppliers and large retailers begins with the
retailer making a thorough examination of the potential supplier. When the supplier
passes the examination, a written contract is signed defining the terms of exchange,
even if they remain open to systematic renegotiation and annual revisions.[3]

2.1 Contractual conditions
2.1.1 First negotiation
Large retailers usually examine their suppliers before signing the first contract to ensure
that the quality of the product corresponds to the retailer's market position, thus
effectively performing their quality assurance role. They usually inspect the supplier's
financial solvency, probably with the intention of estimating the potential duration of the
relationship, and its incentives to maintain quality. Finally, they also evaluate the
administrative organization of the supplier, as this is often a source of future conflicts.

Selling through a large retailer is valuable for small suppliers. If the retailer is an industry
leader, suppliers even use this fact as a signaling device in their relations with other
clients. The existence of an initial examination and this use of the condition of supplier as
an informative signal indicates that large retailers effectively provide quality assurance
services, which for many years has been one of their main objectives.[4]
2.1.2 Contract terms
At the beginning of every business year, the relations between suppliers and retailers are
subject to exhaustive renegotiation. The process starts with the setting of objectives and
follows with the signature of a new framework contract stipulating the price and other
conditions. In the majority of relationships, a tariff and series of discounts related to
specific variables (such as volume) are agreed. In this way, the retailer bears the risk of,
for example, unexpectedly low sales which would prevent it from benefitting from any
such discounts. In other contracts, these risks are borne by the supplier because annual
"guaranteed prices" are agreed. In this second case if, at the end of the business year,
after computing all the sales and promotions the resulting average price exceeds the
guaranteed price, the supplier should pay the difference to the retailer. A small number
of retailers try to go further, negotiating a "net price" plus a detailed schedule of all the
promotions planned for the whole year. In this way, both parties have incentives to
achieve common goals.
2.1.3 Payment period
Payment conditions such as the term and the instruments to be used are a central
element of the contract. The established patterns show remarkable regularities, which
can be seen most clearly in the duration of the payment periods. (a) Purchases of
perishable goods are generally paid for within thirty and forty-five days, or on the spot.
The only spot payments that are really immediate, however, are those for purchases of
fresh fish, the rest having a payment period of about ten days. Payment periods are
shorter for those products where a longer payment period would not facilitate supervision
of the supplier by the retailer (short product life and no-return policy for perishables) or
where such supervision would generate more trouble than good (fresh fish). The
argument can be extended to other attributes of the transactions and products that
influence the parties' capacity to observe any possible defect in product quantity or
quality. In this case, the problem is solved by the intervention of a third party, usually an
independent transport company, that gives information about the quantity of the
merchandise delivered and the date of delivery. (b) Consumer products such as
packaged food and drugstore items are paid for within a period of sixty“ninety days,
while household goods are generally paid for in ninety days. (c) Textile products, which
have the longest trade cycle and whose quality is thus known with the greatest delay, are
paid for in 120“180 days. (d) Finally, any merchandise that is distributed with a right to
return unsold items is paid for in periods longer than the return period, thus the payment
period avoids possible opportunism associated with credit balances.[5]
There is also some variation among suppliers within the same industry that is sometimes
explained by differences in the suppliers' bargaining power. However, it is not clear how
the retailer benefits if he exploits his hypothetically greater bargaining power over a
longer payment period rather than over the buying price. In fact, international data
confirm the existence of a positive correlation between the price paid by purchasers and
the payment period, both in general for all kinds of purchasers, and in particular for
retailers (see table 19.1, in which the purchase price is proxied by the commercial
margins, assuming that the selling price is unaffected). Explanation of the variety
observed would therefore consider the payment period as an implicit modification of the
product's price. The discount implied in a longer payment period is less evident both for
the negotiator himself and for an employee who negotiates for his superiors. Differences
among retailers with respect to their average payment period are also difficult to explain
on the basis of bargaining power. They are neither related to the respective market share,
nor do these shares reach a sufficiently high level, at least in Spain, in order to exert an
influence. Given that there are also considerable variations in other dimensions of the
retailers' strategies, such differences could be interpreted as an integral part of their
strategic variety. In particular, retailers with longer average payment periods can be
understood as developing comparative advantages in financial management.


Table 19.1: Average profit margin as a function of credit and payment periods in
EU countries
[a]
Average net margin Average
gross
margin[b]


Constant 38.203 40.592 1.037
[c]
(5.906***) (5.375***) (15.199***)
6.796
Ln (Contractual ” ”
credit period granted
to clients)
( 3.758***)
6.838
Ln (Actual average ” ”
payment period)
( 3.532***)
0.222
Ln (Actual average ” ”
payment period)
( 3.222**)
R2adj 0.467 0.433 0.652
F 14.123** 12.473** 10.379**
N 16 16 6
[a]
Regressions based on country averages for the net commercial margin, obtained
through a survey of manufacturers (Intrum Justitia, 1997). This survey, carried out in
1996 by NOP Corporate for Intrum Justitia, covered 3,000 European companies and
was part of a research into payment patterns supported by the European
Commission.

[b]
Regression based on country averages for the gross margin of large retailers, given
by Strambio, González and Contreras (1995, p. 53).

[c]
Two-tail t-statistics are in brackets, with *** = significant at the 99% confidence
level; ** = significant at the 95% confidence level.
In conclusion, the patterns in payment periods are coherent with the argument that the
payment period serves not only to achieve comparative advantage of a financial nature,
but also to lessen the intensity of conflict in contractual relationships. Bargaining power
explanations are not satisfactory because they are unable to account for sectorial and
product patterns. It is difficult to believe that bargaining power varies according to sectors
and products, especially considering that sectorial and product patterns are not
correlated with concentration of supply.
2.1.4 Legal formalization
The first agreement and successive annually revised ones are formalized in writing.
Considering that litigation is very rare, these written contracts are mostly used to help the
parties during the progress of their relationship. In this sense, the written form
rationalizes the parties' behavior in at least three dimensions. First, it facilitates annual
revision of the contract, which starts out on a sounder and less controversial basis,
reducing the cost of bargaining. Secondly, it facilitates completion, as the danger of
forgetting or distorting previous mutual agreements is avoided. Finally, it provides a
precise reference when judging performance, whether this judgment is made by one of
the parties or by a third independent one.

2.2 Annual revision of contracts
The relationship between the large retailers and their suppliers usually lasts for a long
time, although its conditions are revised by writing new contracts annually. (This is
separate from the revision of the contract before the end of the contract term, which will
be analyzed in section 3.) This revision of the annual contract lasts from three to six
months. The time and resources spent in these annual negotiations is understandable
when considering that failure, which happens sporadically, would interrupt the
relationship, causing substantial costs to both parties.
The duration of the negotiations is justified because it is necessary to know how the
relationship functioned the previous year. In addition, retailers are overloaded with work
at the end and the beginning of each year and therefore force the negotiations to start
long after the beginning of the year during which the parties bargain. Furthermore, it is
believed to be a disadvantage to be the first supplier to reach an agreement with a
retailer, and this helps to delay the agreement further. However, signing a contract with a
retailer should strengthen, rather than weaken, the bargaining position of a supplier in his
negotiations with other retailers. Maybe transaction costs within both firms are also
relevant, with both negotiating agents wanting to demonstrate to their superiors the effort
they have made.

Apart from the direct costs, the long duration of the annual negotiations on revising the
contracts is in itself a source of conflict and misunderstanding. During the months of
negotiating, the conditions from the previous business year are still in force. However,
once a new agreement is reached, the new terms are applied to all transactions during
the year, including those already carried out before the agreement. Outside observers
frequently misinterpret this retroactive effect of the annual price agreement, considering
[6]
it as a forced discount over the previously agreed price.

[3]
Unless stated otherwise (mainly with respect to the econometric tests in sections 2 and 4,
which are run over aggregate European data), the evidence on the structure and functioning
of contractual relations comes from case studies and interviews conducted with a sample of
representatives from all the parties in the sector in Spain. This sample contained large and
small, multinational and Spanish retailers and manufacturers. While special care was taken to
cover a variety of operators, it was not possible to assess the statistical significance of the
sample.

[4]
It should be expected that suppliers sell at a lower price and accept worse conditions from
retailers that give them more additional services of this nature. For this reason, the
comparisons of selling prices which are often employed in discussions on competitive
conditions may lose much of their relevance, because it is possible to observe only the net
price (the nominal price less the implicit discount that the supplier accepts in exchange for
services that are not explicitly paid). This net price is no longer comparable across retailers of
different reputation and size, because the value of the reputation services they provide to
suppliers is not the same.

[5]
Payment periods have been discussed in more detail in Arru±ada (1999a, 1999b).

[6]
For example, Expansión (June 1, 1998, p. 8).
2 Explicit contracting
Typically, explicit contracting between suppliers and large retailers begins with the
retailer making a thorough examination of the potential supplier. When the supplier
passes the examination, a written contract is signed defining the terms of exchange,
even if they remain open to systematic renegotiation and annual revisions.[3]

2.1 Contractual conditions
2.1.1 First negotiation
Large retailers usually examine their suppliers before signing the first contract to ensure
that the quality of the product corresponds to the retailer's market position, thus
effectively performing their quality assurance role. They usually inspect the supplier's
financial solvency, probably with the intention of estimating the potential duration of the
relationship, and its incentives to maintain quality. Finally, they also evaluate the
administrative organization of the supplier, as this is often a source of future conflicts.

Selling through a large retailer is valuable for small suppliers. If the retailer is an industry
leader, suppliers even use this fact as a signaling device in their relations with other
clients. The existence of an initial examination and this use of the condition of supplier as
an informative signal indicates that large retailers effectively provide quality assurance
services, which for many years has been one of their main objectives.[4]
2.1.2 Contract terms
At the beginning of every business year, the relations between suppliers and retailers are
subject to exhaustive renegotiation. The process starts with the setting of objectives and
follows with the signature of a new framework contract stipulating the price and other
conditions. In the majority of relationships, a tariff and series of discounts related to
specific variables (such as volume) are agreed. In this way, the retailer bears the risk of,
for example, unexpectedly low sales which would prevent it from benefitting from any
such discounts. In other contracts, these risks are borne by the supplier because annual
"guaranteed prices" are agreed. In this second case if, at the end of the business year,
after computing all the sales and promotions the resulting average price exceeds the
guaranteed price, the supplier should pay the difference to the retailer. A small number
of retailers try to go further, negotiating a "net price" plus a detailed schedule of all the
promotions planned for the whole year. In this way, both parties have incentives to
achieve common goals.
2.1.3 Payment period
Payment conditions such as the term and the instruments to be used are a central
element of the contract. The established patterns show remarkable regularities, which
can be seen most clearly in the duration of the payment periods. (a) Purchases of
perishable goods are generally paid for within thirty and forty-five days, or on the spot.
The only spot payments that are really immediate, however, are those for purchases of
fresh fish, the rest having a payment period of about ten days. Payment periods are
shorter for those products where a longer payment period would not facilitate supervision
of the supplier by the retailer (short product life and no-return policy for perishables) or
where such supervision would generate more trouble than good (fresh fish). The
argument can be extended to other attributes of the transactions and products that
influence the parties' capacity to observe any possible defect in product quantity or
quality. In this case, the problem is solved by the intervention of a third party, usually an
independent transport company, that gives information about the quantity of the
merchandise delivered and the date of delivery. (b) Consumer products such as
packaged food and drugstore items are paid for within a period of sixty“ninety days,
while household goods are generally paid for in ninety days. (c) Textile products, which
have the longest trade cycle and whose quality is thus known with the greatest delay, are
paid for in 120“180 days. (d) Finally, any merchandise that is distributed with a right to
return unsold items is paid for in periods longer than the return period, thus the payment
period avoids possible opportunism associated with credit balances.[5]
There is also some variation among suppliers within the same industry that is sometimes
explained by differences in the suppliers' bargaining power. However, it is not clear how
the retailer benefits if he exploits his hypothetically greater bargaining power over a
longer payment period rather than over the buying price. In fact, international data
confirm the existence of a positive correlation between the price paid by purchasers and
the payment period, both in general for all kinds of purchasers, and in particular for
retailers (see table 19.1, in which the purchase price is proxied by the commercial
margins, assuming that the selling price is unaffected). Explanation of the variety
observed would therefore consider the payment period as an implicit modification of the
product's price. The discount implied in a longer payment period is less evident both for
the negotiator himself and for an employee who negotiates for his superiors. Differences
among retailers with respect to their average payment period are also difficult to explain
on the basis of bargaining power. They are neither related to the respective market share,
nor do these shares reach a sufficiently high level, at least in Spain, in order to exert an
influence. Given that there are also considerable variations in other dimensions of the
retailers' strategies, such differences could be interpreted as an integral part of their
strategic variety. In particular, retailers with longer average payment periods can be
understood as developing comparative advantages in financial management.


Table 19.1: Average profit margin as a function of credit and payment periods in
EU countries
[a]
Average net margin Average
gross
margin[b]


Constant 38.203 40.592 1.037
[c]
(5.906***) (5.375***) (15.199***)
6.796
Ln (Contractual ” ”
credit period granted
to clients)
( 3.758***)
6.838
Ln (Actual average ” ”
payment period)
( 3.532***)
0.222
Ln (Actual average ” ”
payment period)
( 3.222**)
R2adj 0.467 0.433 0.652
F 14.123** 12.473** 10.379**
N 16 16 6
[a]
Regressions based on country averages for the net commercial margin, obtained
through a survey of manufacturers (Intrum Justitia, 1997). This survey, carried out in
1996 by NOP Corporate for Intrum Justitia, covered 3,000 European companies and
was part of a research into payment patterns supported by the European
Commission.

[b]
Regression based on country averages for the gross margin of large retailers, given
by Strambio, González and Contreras (1995, p. 53).

[c]
Two-tail t-statistics are in brackets, with *** = significant at the 99% confidence
level; ** = significant at the 95% confidence level.
In conclusion, the patterns in payment periods are coherent with the argument that the
payment period serves not only to achieve comparative advantage of a financial nature,
but also to lessen the intensity of conflict in contractual relationships. Bargaining power
explanations are not satisfactory because they are unable to account for sectorial and
product patterns. It is difficult to believe that bargaining power varies according to sectors
and products, especially considering that sectorial and product patterns are not
correlated with concentration of supply.
2.1.4 Legal formalization
The first agreement and successive annually revised ones are formalized in writing.
Considering that litigation is very rare, these written contracts are mostly used to help the
parties during the progress of their relationship. In this sense, the written form
rationalizes the parties' behavior in at least three dimensions. First, it facilitates annual
revision of the contract, which starts out on a sounder and less controversial basis,
reducing the cost of bargaining. Secondly, it facilitates completion, as the danger of
forgetting or distorting previous mutual agreements is avoided. Finally, it provides a
precise reference when judging performance, whether this judgment is made by one of
the parties or by a third independent one.

2.2 Annual revision of contracts
The relationship between the large retailers and their suppliers usually lasts for a long
time, although its conditions are revised by writing new contracts annually. (This is
separate from the revision of the contract before the end of the contract term, which will
be analyzed in section 3.) This revision of the annual contract lasts from three to six
months. The time and resources spent in these annual negotiations is understandable
when considering that failure, which happens sporadically, would interrupt the
relationship, causing substantial costs to both parties.
The duration of the negotiations is justified because it is necessary to know how the
relationship functioned the previous year. In addition, retailers are overloaded with work
at the end and the beginning of each year and therefore force the negotiations to start
long after the beginning of the year during which the parties bargain. Furthermore, it is
believed to be a disadvantage to be the first supplier to reach an agreement with a
retailer, and this helps to delay the agreement further. However, signing a contract with a
retailer should strengthen, rather than weaken, the bargaining position of a supplier in his
negotiations with other retailers. Maybe transaction costs within both firms are also
relevant, with both negotiating agents wanting to demonstrate to their superiors the effort
they have made.

Apart from the direct costs, the long duration of the annual negotiations on revising the
contracts is in itself a source of conflict and misunderstanding. During the months of
negotiating, the conditions from the previous business year are still in force. However,
once a new agreement is reached, the new terms are applied to all transactions during
the year, including those already carried out before the agreement. Outside observers
frequently misinterpret this retroactive effect of the annual price agreement, considering
[6]
it as a forced discount over the previously agreed price.

[3]
Unless stated otherwise (mainly with respect to the econometric tests in sections 2 and 4,
which are run over aggregate European data), the evidence on the structure and functioning
of contractual relations comes from case studies and interviews conducted with a sample of
representatives from all the parties in the sector in Spain. This sample contained large and
small, multinational and Spanish retailers and manufacturers. While special care was taken to
cover a variety of operators, it was not possible to assess the statistical significance of the
sample.

[4]
It should be expected that suppliers sell at a lower price and accept worse conditions from
retailers that give them more additional services of this nature. For this reason, the
comparisons of selling prices which are often employed in discussions on competitive
conditions may lose much of their relevance, because it is possible to observe only the net
price (the nominal price less the implicit discount that the supplier accepts in exchange for
services that are not explicitly paid). This net price is no longer comparable across retailers of
different reputation and size, because the value of the reputation services they provide to
suppliers is not the same.

[5]
Payment periods have been discussed in more detail in Arru±ada (1999a, 1999b).

[6]
For example, Expansión (June 1, 1998, p. 8).
4 Sources of conflict
Like all complex relationships, those established between suppliers and retailers suffer
from substantial conflicts. Claims of faulty performance, either intentional or unintentional,
are the main source. Other common discrepancies concern prices and deliveries.
Discussion frequently arises about whether the invoiced prices are or are not in
accordance with the previously agreed levels. There are also delivery delays that are
punished by the retailer when they cause stockouts and losses of sales. Clarification of
these arguments is difficult. Price schedules are intricate and it is hard to evaluate the
cost caused by imperfect performance. Opportunism is possible on both sides. For
instance, it is possible for a return of merchandise with the allegation of late delivery to
be due to opportunistic behavior on the part of the retailer because sales did not go as
well as planned when ordering the goods.

Errors in the administration circuits are also a main source of conflict. Examples of these
are differences in the quantities and prices between the time of ordering and delivery of
the merchandise, or accounting errors, where the quantity in the invoice and the
delivered quantity do not correspond. Retailers claim that administrative problems are
common because the administrative systems of small-size suppliers are under-
developed. There are cases when the supplier issues the invoice and the delivery note at
the same time so, if the delivery suffers from some defect, this is discovered only when
the whole invoicing process has started. This makes fixing the problem cumbersome and
slow. In other cases the transportation agent may fail to return the delivery notes to the
supplier, causing administrative chaos. The importance of the supplier's administration is
supported by the fact that some retailers refuse to work with suppliers that lack reliable
administrative systems.
How important contractual and administrative factors are becomes clear when we
observe the empirical relation that exists between the average duration of the payment
periods in each country and the importance attributed to the different kinds of
phenomena that cause payment delays. It has been observed that the average payment
period is positively correlated with the importance of debtors' financial difficulties
resulting in delays and negatively correlated with the importance of both disagreements
between creditor and debtor and administrative errors. In other words, in countries with
longer payment periods, debtor insolvency is more important while disagreements and
administrative errors are less important, arguably because there is more time to solve
both problems before the end of the contractual credit period (table 19.2). This can mean
that a longer payment period worsens problems with a financial origin, while it lessens
those related to contractual and administrative issues.


Table 19.2: Correlation coefficients between country averages of credit and
payment periods and causes of late payment in domestic transactions
Contractual Actual Days
credit average overdue
period (%) payment (%)
period
(%)

Causes of late 54.75** 58.72** 39.98
payment Debtor in
financial difficulties
55.78** 50.02** 15.94
Disputes
52.00** 64.31*** 59.56**
Administrative
inefficiency
Note:***,** = Correlation is statistically significant at a confidence level of 99 and
95 percent, respectively.
Source of data: Intrum Justitia (1997), see notes to table 19.1 for details.
The macroeconomic data are also coherent with the argument that improved
administration tends to reduce payment periods and payment delays. As shown in table
19.3, in the most developed countries in which companies are supposedly better
organized, both average payment period and payment delay are lower. In fact, the
administrative competence of the supplier is probably as important as that of the client.
On the one hand, the best-organized suppliers are the ones that meet their obligations
best.


Table 19.3: Average payment periods, average delays, and economic
development
Contractual Actual Delay
payment payment
period period


Constant 390.877 564.142 173.265
(4.369)*** (6.186)*** (3.424)***
35.201 51.065 15.863
Ln (GDP per head)
( 3.936)*** ( 5.602)*** ( 3.136)***
R2adj 0.509 0.685 0.387
F 15.494*** 31.385*** 9.837***
N 15 15 15
Notes: Two-tail t-statistics are in brackets. *** = Significant at the 99% confidence
level.
Source of data: Intrum Justitia (1997, p. 5) and national accounting data.


On the other hand, the best-organized clients are the ones that are most capable of
verifying the supplier's performance in a short time.
5 Disciplinary mechanisms
In relationships between the large retailers and their suppliers, the parties themselves
undertake the tasks of completing the contract and sanctioning the most usual non-
fulfillments. Even when the default is claimable, the parties are unlikely to go to court,
because repeated contracting provides them with a cheaper solution. The parties even
find it efficient to divide the supervision and control rights “ including the rights to
complete the contract and to punish defaults “ in an asymmetric form, assigning both
rights to a greater extent to the retailer. In this quasi-judicial role, it is common for the
retailer to evaluate the level of performance and to take disciplinary actions. Let us
analyze now what these actions are and how they work.

5.1 Payment delay as safeguard and sanction
Payment postponement strengthens the retailer's position as a judge, enabling it to take
precautionary and punitive measures for possible nonfulfillment on the part of the
supplier. In this function, it can either delay the payment until the defects are rectified or
discount compensation if the defects are not corrected. Obviously, on the negative side,
the retailer can abuse this authority, using delay or other instruments in an opportunistic
manner, extracting benefits from his suppliers. However, if this opportunistic behavior is
controlled (there is more on this in section 6), this quasi-judicial role can be a helpful and
efficient mechanism in the contracting process. This efficiency is based on the fact that
both parties have an important information advantage in their role as judges, because
they know the particularities of the trade and can observe the defaults and conflicts at a
very low cost, as a by-product of being in the business and trading.[11]

This interpretation provides a simple explanation for a common practice found in many
countries, where no supplier pretends to be paid interest in instances of payment
[12]
delay. It is thought that such interest is not requested because of the high litigation
costs. This factor may be of importance in cases of insolvency, but not in the case of
delay, especially in countries in which the party that is found guilty pays the other's party
litigation expenses. The persistent remission of this interest can be better explained by
the continuous nature of the relationship, which easily survives episodes of late payment.
Furthermore, this continuity is coherent with the possibility that apparent late payments
may not be real or may have efficient causes, stemming from previous defaults by the
creditor or being related to the provision of financial slack to the debtor in times of
hardship.

5.2 Explicit sanctions: discounts for inexact debits

It is also common for retailers to apply discounts for "inexact debits," usually on the basis
of differences between the prices agreed and those invoiced.[13] The existence of
administrative costs, allegedly burdensome for suppliers, helps to explain why it is the
retailer that resolves this issue. The retailer is the one who writes the framework contract
which is equivalent in its consequences to a contract of adhesion, while most suppliers
sign a different contract for each of their distributors.[14] This variety, compounded by
decentralization, means that suppliers with standard organizational capabilities do not
have complete and current knowledge of the terms under which they are trading.

5.3 Quasi-judicial taxes

Most disagreements between retailers and suppliers are discussed by suppliers and
"settled" through negotiation. This fact hints that retailers exercise self-restraint and do
not use their self-enforcement role opportunistically. Furthermore, a process is
constituted which is very similar in its characteristics to court litigation: the unsatisfied
supplier "appeals" before the decision-maker or frequently before a superior within the
hierarchical structure of the retailer. This negotiation process is subject to problems
similar to those affecting court litigation, including frivolous litigation. To avoid this
phenomenon, some retailers have introduced a penalty payment for ungrounded claims.
In a well-known case, suppliers of a chain of supermarkets who made ungrounded
payment claims had to pay 3 percent of the sum claimed as well as a fixed fee for
[15]
administrative expenses. These payments raise a question similar to that of charging
fees to the parties for court proceedings. Not imposing fees may motivate parties to
present trivial or opportunistic claims, while imposing them may prevent parties from
making justified claims. If, in our case, the retailer does not impose claim fees, treats
everybody equally in its initial decisions and these decisions are subject to errors, the
suppliers have an incentive to claim even in cases when it would be efficient not to claim,
because of the small stakes involved or doubtful grounds. In such circumstances, a
system of fees for ungrounded claims could probably help to prevent excessive claiming.

5.4 Merchandise returns

If we ignore the wholesale phase, the most simple trading cycle is the one starting with a
retailer's purchase and ending, after a storage period, with a sale to a final consumer.
However, in modern economies many sales are accompanied by an explicit or implicit
right to return. This prolongs the cycle by one or two phases and makes it even more
unstable, because the duration of these additional phases depends on the return period
the supplier and the retailer may want to introduce in their relationship, which is generally
shorter than the return period for the consumer. This extension of the trade cycle may
induce a corresponding extension of the payment period in order to facilitate the
enforcement of the right to return. If the consumer buys with a right to return, his return
decisions function as a disciplinary mechanism which helps to assure product quality. It
seems logical that the retailer and the supplier should share the cost of returns to the
extent to which their decisions affect the quality in question. Likewise, it seems
reasonable for the retailer to be assigned an explicit or implicit right to return. An
arrangement that assigns to the retailer the right to return unsold merchandise intensifies
the suppliers' incentives to produce relevant information and to adjust their product to the
final demand, while at the same time it reduces the retailer's incentives in these
connections. For this reason, such an arrangement is more likely when suppliers are in a
better position to organize productive resources according to final demand, either in the
information producing activity or in the coherent adaptation of product design and the
corresponding change of the production system. This conjecture is coherent with the
observation that the arrangement discussed is most commonly used with products for
which sales vary seasonally, and for which retailers are in a relatively worse position to
produce information about demand.[16]

5.5 Breaking off and cooling of relations

The long-term relationships of retailers with their suppliers may be interrupted in two
ways. Final termination, which is relatively rare, is motivated by deficiency in product
quality or in the services provided. A cooling-off of relations during short periods (a
duration of several months, although there are cases of up to two years) may also take
place as a consequence of irreconcilable disagreements over buying prices. This,
however, is not common. Most retailers do not put a definite stop to their purchases,
especially of branded products. Instead, they keep buying the product, although they sell
it at a higher price, either because its buying price is higher or because the product in
question is not included in the retailer's promotion activities, which results in a substantial
decrease in the product sales.

[11]
There is more on this in Arru±ada (2001 and 2002, chapter 3, generally; see also 1999c,
2000, for an application to financial auditing).

[12]
For information about the situation in different European countries, see CCE (1997, p. 7).

[13]
In some cases the impact of these discounts is substantial. For example, in the relationship
between one of the biggest retailers and one of the biggest consumer good suppliers, both
multinational firms, these discounts were evaluated in 1998 at 1.67 percent of the turnover,
according to the supplier. In the same year and with the same retailer the supplier recovered
13 percent of the total value of the discounts (0.2171 percent of his turnover with the retailer).
[14]
The fact that retailers have a greater capacity for control does not mean that they have
either perfect or homogeneous control. This issue is highlighted by the policy of some
retailers who contracted specialists to detect irregularities in the contracting and accounting of
their purchases. Operations over the previous five years were investigated and the specialist
received half of the amount recovered. The mere existence of this practice highlights the high
degree of error that exists in the administrative processing of transactions.

[15]
Expansión (1 June, 1998, p. 8).

[16]
Obviously there are more factors that influence the efficiency of contracting with or without
right of return. (See Kandel 1996.)
6 Safeguards and regulation
It can be deduced from the above that the retailer is in a situation to behave
opportunistically with his suppliers. Moreover, some observers interpret as opportunistic
many of the practices that we have rationalized by efficiency arguments. To understand
some of the conflicts subsisting in these relationships, it is useful to analyze how the
safeguards against opportunistic behavior function and why they occasionally fail, giving
rise to conflicts.

6.1 The efficient safeguard is imperfect

The basic safeguards are the repetitive character of the exchange and the contractual
[17]
reputation of the retailer. The reputation affects in particular the possibility of further
contracting under the asymmetry conditions that have just been described. Reputation
also inspires enough confidence to convince suppliers to invest in assets which are
specific to the retailer. This is becoming increasingly important with the growth in sales of
products under retailers' own labels.

Given that these safeguards are costly, it would not be optimal to have perfect
safeguards, freeing the relationship of all opportunism. In particular, incentives to
perform well lessen when the decision-makers' time horizon shortens. This is especially
true for firms whose survival is in question. Some retailers that acquired other financially
troubled retailers realized the importance of this issue, when observing that the acquired
firm had followed dubious practices with their suppliers, usually in the form of late
payments.

Similarly, on a more general level and irrespective of the type of firm, problems also
appear with decentralized decision-making, because of misalignment between the
optimal behavior of the decision-makers and the behavior that is optimal for the company
as a whole. In large retailers this situation arises because of substantial delegation of
decision-making to store and product-line managers at store level, whose time horizon is
shorter than that of the company. When these division managers are subject to high-
powered incentives and there are no mechanisms to control long-term effects, these
managers are tempted to take decisions that boost their apparent performance at the
cost of cheating the suppliers, no matter how much such cheating of suppliers damages
the reputation of the retailer company.

When discussing the importance of these cases of opportunistic behavior, the long-term
incentives of the parties and the inescapable nature of transaction costs have to be
considered. First, given that the retailer suffers a net loss, he has an interest in resolving
the conflict. Otherwise, he will be subject to worse contract conditions. Second, because
of the existence of contractual costs in the relationship with the divisional managers and
while decentralized decisions are needed, it is not optimal to avoid these agency costs
completely. Today, even in the presence of strong differentiation among retailers, there
is a powerful tendency towards centralization, which reduces the importance of these
dysfunctional phenomena. In some retailers, store managers no longer have the
authority to influence the payment process. These retailers have centralized the
decisions that affect the whole market, with respect not only to product range and prices,
but also to the physical location of products on the shelves and, for the majority of
products, the selling price and promotions. The task of store managers is therefore to
implement these decisions at minimum cost, and the role of in-store product-line
managers is limited to incorporating specific local information and controlling, confirming,
or correcting the ordering decisions. Such decisions are automatically generated by the
management information system (MIS), which controls the stock level and sales flows.
Similar consequences result from the development of logistics platforms and centralized
storehouses, which increase the distance, even physically, between suppliers and the
points of sale, and also separate shop managers from the contracting process with
suppliers. Obviously, the possibilities for centralization vary according to the type of
product and it can be expected that decentralized decisions will be still needed for
perishable products.
6.2 No clear scope for regulation

In view of all the possible failures in the system of private safeguards, a relevant
question concerns the role of regulation. As is usual with regulatory matters, the answer
depends on the assumptions. In this case, the important assumptions to consider are, on
the one hand, the capacity of the private agents to anticipate (and also penalize through
their pricing decisions) possible non-fulfillment and, on the other hand, the regulatory
capacity to prevent them. As for insolvency and the deterioration of incentives that
precede it, the predictive capacity of the parties is probably not very high. But regulation
similar to bank regulation, like that discussed in Spain at the beginning of the 1990s,
would not be effective either. Moreover, it would be costly. This is why, in the absence of
systemic risk, which might justify such bank regulation, it would not be reasonable. As for
payment delays, the repetitive character of the transactions inclines us to think that
creditors, to a great extent, are able to anticipate delays and the problems arising from
them. When delays occur, suppliers penalize the retailers that behave worst and, in
consequence, the latter will strive to improve their internal control. Empirical evidence
regarding the existence of these penalties is the differences in retailers' reputations
concerning their internal organization capacity and their inclination to engage in this kind
of conflict.

In view of the above, the analysis indicates that regulation in this field will most likely
result in a reduction and distortion of competition, among both retailers and suppliers,
rather than a balance of suppliers' bargaining powers with respect to retailers. To the
extent that regulation in fact would oblige retailers to perform better, the ones that have
been complying worst would be at a disadvantage, because they would have to include
this additional cost of change in their policy, and this would lead to less decentralization
and a tighter control of decentralized decisions. Obviously, these retailers would obtain a
benefit because of lower prices in the agreements given the higher rate of compliance,
but probably this benefit would not compensate for the cost in question, because if it had,
they would have followed this policy before the change in regulation. Moreover, since
regulation would oblige some retailers to adopt a policy that is not beneficial for them, it
would indirectly benefit those for which the new policy was already beneficial. The same
argument can be applied to the differences that exist among suppliers, either in their
capacity to foresee insolvency or in their capacity to accumulate information on the rate
of compliance of their clients. As a result, regulation would probably favor suppliers with
a smaller capacity for prediction.

[17]
See Klein and Leffler (1981) and Shapiro (1983) for the basic formulation of the role of
reputation in contracting.
7 Summary
Contractual practices that are typical of the relationships between large retailers and
their suppliers may respond to efficiency considerations. This efficiency explanation
contradicts the hypothesis of systematic abuse on the part of retailers but does not imply
perfect functioning of the safeguarding mechanisms. The recurrent nature of the
relationships generates incentives for compliance and makes it possible for most
conflicts to be solved through negotiation between the parties without third-party
enforcement. The retailer is assigned and performs quasi-judicial tasks possibly because
of its advantageous position regarding availability of information, which is needed to
evaluate suppliers' performance. Thus, retailers act as courts of first instance, exercising
a right that is implicitly assigned at the beginning of the relationship and with each annual
renovation of the contract.

The main ways by which this quasi-judicial role is exercised is by delaying payments
associated with defective purchases and invoices, as well as debiting discounts for
inaccurate debits or incorrect invoices. Coherent with this analysis is the variability in
standard payment periods across different groups of products. Payment periods vary
systematically according to the types of product and the differences observed seem to
correspond to the ultimate objective of reducing conflicts in the parties' financial and
commercial relations rather than to their relative bargaining power. This conclusion is
also supported by the fact that there are no relevant differences in payment periods,
even in the special cases of exclusive suppliers and suppliers delivering products sold
under the retailer's own labels.
This quasi-judicial role of retailers permits them not only to motivate suppliers'
performance but also to adjust the distribution of the additional surplus produced by the
efforts of each party which are too costly to contract explicitly ex ante. The mechanism
used is that retailers request bonuses and discounts below the contracted buying price,
these requests being made, and mostly accepted, throughout the life of the contract. The
fact these requests are triggered by retailers' initiatives “ retailer mergers, openings of
new stores and logistics platforms, special promotions “ that benefit their suppliers
supports an interpretation of these contractual revisions as being efficient. According to
this interpretation, the possibility of modifying the contracted conditions allows for
modification of the distribution of any gains from trade resulting in both changes in the
environment and efforts and investment by the parties.

The long-term behavior of suppliers also refutes the hypothesis that delays and the
revision of contract conditions constitute an abuse on the part of retailers. In the short
run, suppliers might accept these delays and contract modifications because they have
no other option. However, in the long run, they keep contracting repeatedly with the
same retailers, in spite of such practices. This persistence would not be reasonable if
such delays and adjustments were expropriatory.

A final word of caution is in order, however. The qualitative and casuistic nature of much
of the evidence in this study recommends a prudent conclusion. It is hoped, however,
that the arguments in the chapter will hold relatively well if a similar level of
circumspection is applied to alternative explanations.[18]

[18]
In fact, the studies that currently guide European legislative proposals in this field do not
seem more reliable. See, in particular, the study that provided the basis for the Directive on
late payments (CCE 1997) and, for a criticism, Arru±ada (1999b).
Notes
Chapter 19 was originally published as "The Quasi-Judicial Role of Large Retailers: An
Efficiency Hypothesis of their Relation with Suppliers," in Revue d'Economie Industrielle
(92, 2000).

The author acknowledges the cooperation received from IDELCO and its personnel and
the assistance of the managers and experts interviewed who provided most of the
information on which this study is based. The author also expresses his thanks for the
comments made by Luis Garicano, Fernando Gómez-Pomar, Manuel González, Luis
Vázquez, Pedro Schwartz, Decio Zylbersztajn, numerous workshop participants, and two
anonymous referees, and the help of Demián Castillo and Veneta Andonova as research
assistants. Usual disclaimers apply.
1. See, for example, the French 1996 "Galland" Act (Loi 96-588), modifying
the 1986 Ordonnance (86-1243) on freedom of pricing and competition,
and the Spanish Retailing Act of 1996 (Ley 7/1996). More recent
examples of this regulatory trend are the proposal for the EU Directive on
late payments (OJEC, December 3, 1998), even if the text finally adopted

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