This chapter analyzes royalty modes in the franchise arrangements of
convenience stores under double-sided moral hazard. In Japan, the majority of
franchisors charge margin-based royalties based on gross margin rather than sales-based
royalties based on sales. We show that the franchisor can attain the first-best outcome
by adopting margin-based royalties under double-sided moral hazard. We consider a
case where a franchisee sells two kinds of goods; one is shipped from its franchisor and
the other is purchased from another (independent) manufacturer. In this case, the
franchisor is completely unable to control the wholesale price of the goods bought from
the manufacturer. Therefore, the franchisor cannot achieve the first-best outcome via
sales-based royalties under double-sided moral hazard.
Keywords: Double-sided moral hazard, franchise arrangement, franchise
contract, franchise fee, joint profits, margin-based royalty, risk neutral, royalty
rate, royalty structure, sales-based royalty.
