We analyze two royalty structures in a two-tier industry in which a
franchisee makes a demand increasing investment. Suppose the franchisor can
propose either a margin-based royalty (MBR) or a sales-based royalty (SBR).
We show that the SBR has the advantage of providing a greater incentive for
the franchisee to invest, but has the disadvantage of inducing a greater
double-margin distortion. On the other hand, the MBR has the advantage of
influencing a smaller double-margin distortion, but has the disadvantage of
weakening the incentive for the franchisee to invest. Our main claims are two:
the first is that if the market is non-elastic, the franchisor enjoys a higher
pay-off from SBR than from MBR. The other is that the investment level
under SBR is always larger than that under MBR, regardless of market
elasticity.
Keywords: Double marginalization, downstream firm, franchisee’s
investment, franchisor, margin-based royalty, market elasticity, royalty
structures, sales-based royalty, successive monopoly, take-it-or-leave-it
contract, upstream firm.
