Incentive conflict between McDonalds and its Franchisees

The incentive conflict between franchisees and franchisors is well known.  Franchisors want to protect their brands, and want franchisees to invest in building a better retail experience.  However, because franchisees earn only a fraction of the returns from these brand-building investments, they are reluctant to to make them.

The conflict between McDonalds and its franchisees has come out into the open (2018 WSJ, 2019 Fortune, Twitter feed from a franchisee):

But traffic has waned in recent quarters, leading franchisees to voice concerns that the money they were being asked to invest in their stores for initiatives like remodels, self-serve kiosks, fresh beef, delivery, and all-day breakfast were not paying off.

“McDonald’s can set the direction of the brand, but you need the franchisees to buy into it,” says Senatore. “Franchisee alignment is so important to these systems.”

One way to manage this incentive conflicts is with:

1. Contracts to reward actions that are easily observable and contractible; and 
2. Vertical restraints, like exclusive territories, for actions that are not.  

Vertical restraints that restrict intra-brand competition among franchisees (e.g., with exclusive territories) give franchisees a profit stream that they are more eager to protect, i.e., with brand-building investments and higher-quality service.

Note that franchisees on freeways don't have much repeat business, so they can make more money by free riding on the brand reputation (e.g., by shirking on service or quality).  This incentive conflict is so costly to manage that McDonalds finds it easier to own and run their restaurants on the freeway.

HT:  Kaitlyn W.