The Role of Relational Contracts in Interfirm Relationships: Theory and Evidence on Multiunit Franchising

Abstract: We analyze the interaction between formal governance and relational contracts in two-sided collaborations. Our theoretical model shows that when embedded in a relational contract, a formal governance structure that incentivizes cooperation by party A also increases cooperation by party B, as it reduces the relational bonus B must pay to elicit A’s cooperation, and hence B’s overall temptation to break the relationship by reneging on both the bonus due to A and its own cooperative action. We test our prediction using data on franchisee-franchisor litigation outcomes, and we find that consistent with the model, the adoption of multiunit franchising not only reduces franchisees’ freeriding on the brand, but also encroachment and other abuses by the franchisor. We suggest implications of our results for inter-organizational relationships more generally, including buyer-supplier relations, alliances, and the like.