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franchise. The main item purchased is the trademark of the franchise. This is valuable because consumers have a good deal of information about price and quality sold by establishments with a given trademark. Consumers have this information precisely because the franchisor polices franchises and makes certain that quality standards are maintained. What is involved is a classic externality problem. If any one franchisee allows quality to deteriorate, he will generate revenue because consumers perceive him as being of the same quality as other stores with the same trademark. Thus, if one franchisee allows the quality of his establishment to deteriorate, he benefits by the full amount of the savings from reduced quality maintenance; he loses only part of the costs, for part is borne by other franchisees. All franchises would lose something as a result of this deterioration in one franchise: consumers would have less faith in the quality promised by the trademark.
There are several aspects to this policing. First, the franchisor must be careful to grant franchises to those who are likely to be competent in running them. Some screening of potential franchisees is important. Second, the franchisor must control the quality of products offered by the franchisees. We argued above that the franchisee could best run the day-to-day operations of the business; this is true in the sense that he can produce the desired good (including quality) at least cost. However, it is relatively inexpensive for the franchisor to monitor the quality of the good produced, as opposed to the method of production. This is the sort of monitoring which franchisors undertake. Third, errors will sometimes be made, and some franchises will not be profitable. Such businesses will operate in the short run if they are covering variable costs and will shut down in the long run, when capital has been sufficiently depreciated. But it is precisely this depreciation of capital that the franchisor wants to avoid. The franchisor wants to eliminate any operations not maintaining the quality of the franchise. Con-tracts calling for easy termination of franchises makes it possible to avoid the period of quality deterioration.
Because of the externality problem, all franchisees have an interest in having quality policed. Assume now that the franchisor sold the entire value of the profits to franchisees-that is, the franchisor obtained no royalty from current sales. If quality deteriorates, this would reduce his income because renewal fees would decrease, as would fees from sales of new franchises. In addition, profits of existing franchises would also be reduced, but this reduction would have no effect on the franchisor. He would bear only part of the cost of reduced quality, and thus would have an incentive to underinvest in resources used in policing franchisees. Thus, giving the franchisee a large share of the profits of the operation creates an incentive for him to be efficient in that part of the operation he can most efficiently control; giving the franchisor a share of the profits of all