The retail industry is characterised by a mixture of stores directly owned by parent companies ("vertically integrated") and franchise outlets.  This paper examines the motivation for decisions to use these different forms of contracting,  This paper suggests that the mix of contracts observed reflects a "separating equilibrium", in which the form of contract is chosen reflects uncertainty about the state of demand in the market and asymmetric information. 

Using new firm- and outlet-level survey data to develop a discrete choice model, the study shows that contract choices are an attempt to secure the best outcomes for the brand owner (principal) in the trade-off between incentives and risk sharing, overcoming moral hazard and adverse selection problems by getting agents to self-select.  This self selection mechanism is also optimal for outlet owners/managers, who are able to maximise their utility by picking the form of contract to which they are best suited.

A revised version of this paper was published in Applied Economics Volume 34 Number 8, May 2002. A more detailed description of the analysis can be found on the website of the  Econometric Society: www.econometricsociety.org meetings page

This paper looks at intra-firm contractual practices in retailing. It examines existing explanations, illustrates some limitations, and proposes a new hypothesis to explain the adoption of both vertical integration and delegation within firms. This focuses on the human capital of potential retailers i.e., on the existence of a ‘workers’ selection mechanism’ to determine the (upstream and downstream) contract choice. This hypothesis is supported by evidence from a survey of UK companies conducted for the purpose of this study. Further hypotheses are tested by means of econometric analysis.