The Quality of Institutions and Organizational Form Decisions: Evidence from Within the Firm

• Date: 01 June 2017
• Author: Francine Lafontaine,Rozenn Perrigot,Nathan E. Wilson
• Published date: 01 June 2017
• DOI: http://doi.org/10.1111/jems.12185

The Quality of Institutions and Organizational Form

Decisions: Evidence from Within the Firm

FRANCINE LAFONTAINE

Ross School of Business

University of Michigan

Ann Arbor, MI 48109

laf@umich.edu

ROZENN PERRIGOT

IGR-IAE Rennes, CREM

University of Rennes 1

35000 Rennes, France

rozenn.perrigot@univ-rennes1.fr

NATHAN E. WILSON

Federal TradeCommission, Bureau of Economics

Washington, DC 20580

nwilson@ftc.gov

In many retail and service sectors, firms have to establish a physical presence in a geographic

market to access customers there. In countries where the quality of institutions is low, this can

put assets at risk. We use data on the operations of a multinational, multibrand hotel company

to show that in environments where local institutions are weaker—as proxied mainly by the

World Bank’s Checks index—the company eschews direct ownership. Rather than increasing its

reliance on franchising, as predicted by some models, the company relies more on another form of

organization commonly used in this industry, namely management contracts. We explain these

patterns by emphasizing how the quality of the institutional environment affects the cost of using

equity-based organizational forms, per arguments in the current literature, but also the cost of

enforcing the terms of franchise contracts.

1. Introduction

Economists and business scholars have devoted much attention to understanding how

institutions affect economic behavior.An important part of this literature has focused on

the effect of institutions, broadly defined, on economy-wide growth and performance

(see, e.g., Acemoglu et al., 2001; Levchenko, 2007; Dixit, 2009; Bruhn and Gallego, 2012;

see also Acemoglu et al., 2005 for a review of the economics literature). A smaller but

growing set of papers considers the effect of institutions at a more micro level, often

by examining how multinational corporations adapt to local market conditions. One

branch of this literature has explored how factors like the rule of law (Liu et al., 2011),

The opinions expressedhere are those of the authors and not necessarily those of the Federal Trade Commission

or any of its Commissioners. Weare very grateful to the Company for giving us access to the data and to Robert

Picard for his invaluable assistance. Wealso thank participants at the International Industrial Organization, the

Midwest Economics Association, and the International Society of Franchising conferences for their comments.

Finally, we thank the Ross School of Business and CIBER, University of Michigan, as well as the French

National Research Agency (grant number: ANR-12-BSH1-0011-01 – ANR FRANBLE), for their support.

C2016 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume26, Number 2, Summer 2017, 375–402

376 Journal of Economics & Management Strategy

regulatory credibility (Levy and Spiller,1994; Holburn and Zelner, 2010), property rights

protection (Javorcik, 2004), corruption (Cuervo-Cazuna, 2006; Javorcik and Wei, 2009),

the quality of the legal system (Laeven and Woodruff, 2007), and regulatory stability

(Henisz and Zelner, 2001; Delios and Henisz, 2003) affect the level of (often foreign)

investment. Another part of this literature has focused on how the type of investments

and the organization of firm activities—for example, ownership structures in foreign

ventures—are affected by similar factors (e.g., Oxley, 1999; Henisz, 2000; Asiedu and

Esfahani, 2001; Javorcik, 2004; Branstetter et al., 2006; Uhlenbruck et al., 2006; Chong

and Gradstein, 2011; Bloom et al., 2012; Feenstra et al., 2012).

One feature uniting the microlevel empirical literature on the effect of institutions

on economic behavior is that it has been concerned almost exclusively with high-tech and

manufacturing firms. Of course, institutional factors also affect firms in other sectors.

In fact, in some sectors, such as many retail and service industries, firms can access

customers in markets only by being present locally. Thus, contrary to what occurs in

manufacturing, firms in the retail and service sectors often must put assets at risk if they

are to do business in a country: they cannot simply locate in, and export from, countries

where both physical and intangible assets are better protected.

Among retail and service firms, lodging companies are particularly susceptible

to the types of expropriation and hold-up problems emphasized in the literature.1In

this paper, we develop a simple model to show how the existence of three modes

of organization in this industry—franchising, company ownership, and management

contracts—allows hotel firms to adjust to different local market conditions. We argue in

particular that management contracts, which combine aspects of company ownership

and franchising, give lodging firms the opportunity to protect themselves against expro-

priation risks while also protecting the value of their intangible assets, namely the value

of their brands. Wetest the predictions of the model using a unique, proprietary data set

with information on the organizational form under which all of the international hotels

affiliated with a specific major multinational, multibrand lodging company operate. A

confidentiality agreement prohibits us from disclosing the name of the company or char-

acteristics that might lead to its identification. We therefore refer to it as the Company,

and keep all references to its operations and brands oblique.

Our results imply that, consistent with evidence from the literature on high-tech

and manufacturing firms mentioned above, the Company eschews asset ownership in

markets where the quality of the institutional environment is low.However, rather than

minimizing its involvement by turning over operational control to local partners, as

would occur under franchising, the Company maintains control by relying instead on

management contracts in these environments. We interpret these findings as evidence

that in environments with lower quality institutions, the Company not only faces poten-

tial risks of expropriation, per arguments in the literature, but also major difficulties in

enforcing franchise contract terms. The latter, in turn, can lead to important free-riding

risks and potentially costly legal and other disputes under franchising, all of which

are much less severe under management contracts given the level of control that this

organizational form affords hotel firms.

We show that our results are robust to a variety of alternative specifications.

In particular, when we include separate variables designed to proxy for the risk of

1. See specific examples for hotels further below. However, these issues are not absent in other service

sectors. See James (2008) for example. Recent troubles experienced by McDonald’s in Russia provide yet

another example (see e.g., Gorst, 2014).