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In-house and arm’s length: Productivity heterogeneity and variation in organisational form

A burgeoning literature documents the emergence of ‘superstar firms’ across an array of industries and countries.  To understand the concentration of economic activity in these firms requires beginning with a fundamental question in economics: why do so many transactions take place within firms rather than between independent agents via markets? In other words, why do firms exist to begin with? Originating in Nobel Prize winner Ronald Coase’s 1937 paper, economists have developed a number of theories to answer this question and explain how the boundaries of firms are drawn.  

In a new paper (Kalnins et al. 2020), we attempt to shed new light on this question by analysing the relative importance of within-firm and between-firm activity in the US hotel industry. We focus on how the balance between the two depends on property-level productivity. Specifically, we analyse hotel chains’ decisions about whether to employ managers to run their hotel properties or outsource management to independent franchisees instead.  

Canonical theories of the firm observe that it is often prohibitively expensive for economic agents to write complete and fully enforceable contracts governing their relationships and transactions. As a result, all parties’ incentives are compromised, giving rise to economic distortions. The choice of whether to undertake an activity within the firm or to outsource can rebalance bargaining power and economic incentives among the transacting parties, partly mitigating the incomplete contracting problem and the associated economic inefficiencies.  

There are several reasons why the hotel industry is fertile ground for an empirical investigation of these theories. To start with, complete contracting appears infeasible in this industry. Managing a hotel day to day involves responding to unforeseen contingencies, adapting to local circumstances, and doing many other activities that are hard to formally delineate and evaluate. These requirements cannot be fully specified in a contract or job description, and yet are vital to the successful operation of the hotel. Moreover, the value of a hotel property is also likely increasing in the non-contractible attention it receives from the chain itself, in the form of marketing and sales efforts for example.

Another key reason for studying the hotel industry is that many chains have properties under both organisational forms, many towns have numerous hotel properties belonging to different hotel chains, and some establishments change organisational form over time. Controlling for brand and city fixed effects – or even establishment fixed effects – substantially mitigates potential endogeneity issues and permits focus on the determinants of organisational form. The third reason is that establishment-level productivity varies substantially even within firms, as hotel properties differ in potential value, and our results suggest that productivity plays a key role in determining firm boundaries in the industry.

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We develop a theoretical model of hotel property-level organisational form choice. The model assumes that each hotel’s profitability is determined by property productivity, the inputs that the hotel chain provides to the relationship, as well as the inputs that the manager provides, where the manager could be either a franchisee or an employee salaried by the chain. Productivity can reflect amenities and characteristics that enhance value, such as the property’s location and whether it has conference centres, swimming pools, or restaurants. The hotel chain assesses whether franchising or managing a property gives it the highest payoffs conditional on property productivity. 

Franchising hotel management can increase the value of the property through several investment incentive mechanisms. First, a franchisee may face stronger direct incentives to invest in the establishment and the relationship compared to a manager employed by the chain because the franchising contract typically leaves the franchisee with all residual profits after paying expenses (including royalty payments to the franchisor). Second, the franchisee also faces indirect incentives to work harder to make the hotel a success because she retains control over the property if the relationship breaks down. Because she is less concerned that she will lose all the value of her investment (the ‘holdup problem’), she will invest more.  Third, and unrelated to incentives, franchising incurs lower fixed costs than headquarters management of the property. 

However, franchising a property may also reduce the value of the property from the chain’s perspective, and hence its value to the chain, through several mechanisms. Because the franchisee retains relationship control, the chain headquarters tends to invest less in its own property-level activities than it would if it managed the hotel itself. For example, it may choose to promote other properties on the company website, or offer less high-quality training to the staff. In addition, if it does opt to share relationship surplus to incentivise the franchisee, the chain will retain less of the surplus itself. 

For each establishment, the chain weighs these tradeoffs and decides accordingly whether to franchise.  The terms of the tradeoff vary across establishments; for those properties that have higher productivity and therefore potentially high values, investment from either party is more valuable, and the efficiency costs of misaligned incentives are greater. The incentive mechanisms in the model combine elements of two models of outsourcing developed in the international economics literature. Grossman and Helpman (2004) allow firms to embody performance incentives in outsourcing contracts in a setting of relationship productivity heterogeneity. Antras and Helpman (2004) describe how productivity heterogeneity shapes the costs of the underinvestment due to hold up concerns from each party in the relationship. Our model demonstrates that these different incentive mechanisms interact for a firm headquarters when deciding whether or not to outsource a given production relationship. 

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Data from the US hotel industry suggest franchising contracts vary investment incentives as anticipated by the theory, and that this variation determines organisational form choices. The hospitality market research firm Smith Travel Research (STR) provided data on over 9,300 hotels between 2004 and 2009 that were used to find the monthly average occupancy rate for each property – the share of available rooms that were occupied on any given night. Across all these hotels, the average monthly occupancy rate was 65%. The occupancy rate can be viewed as either a measure of property-level productivity or output. In either case, it can be taken as positively correlated with the value of the relationship. 

We report a new empirical finding: within a hotel brand, hotel properties with either a low or high occupancy rate are more likely to be franchisee-managed, while properties with intermediate occupancy rates are more likely to be managed by chain company employees. Figure 1 controls for hotel chain and property location and shows the share of hotel properties that are chain-managed in each decile of the occupancy rate distribution. The share of chain-managed hotels is increasing with occupancy decile up to the seventh decile, in which just under 40% of properties are chain-managed. The share of chain-managed hotels falls in each successive higher-occupancy decile.

Figure 1 The hotel properties most likely to be managed by the hotel chain are those with intermediate occupancy rates

This relationship is robust to including controls for property age and remains when focusing only on a subset of locations with a large number of hotel properties. For hotels that changed organisational form in the time period studied, the months with the lowest and highest occupancy rates were relatively more likely to be months in which the hotels were operated as franchises rather than chain-managed, controlling for the average occupancy rate of each hotel over the whole time period. 

The model can explain why such a pattern emerges and the findings suggest that franchising relationships fall into two different categories in this industry. When the hotel property does not have a lot of potential value, the chain prefers franchising – choosing to reduce its own investment incentives in order to keep fixed costs low. For high-potential properties, the chain prefers franchising for different reasons. It is willing to reduce its own investment incentives and then also share relationship surplus with the franchisee in order to use all the mechanisms at its disposal to encourage franchisee investment. 

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This matters because organisational form choices determine how well the industry as a whole deals with the challenges that are inherent when production requires inputs from parties with misaligned incentives while contracts are incomplete. By shaping investment incentives, organisational form governs how much value is created in this industry, as well as how value is shared between firms and managers.

The findings are likely to generalise to other supplier-buyer relationships where the firm chooses whether to ‘make or buy’ an input, that is, either to produce it in-house or to outsource production to a third party. Franchising hotel management is analogous to contracting with a supplier and chain management is analogous to vertical integration. The evidence from US hotels is that arm’s-length contracts can create varied and interacting mechanisms for supplier investment in relationships where valuable activities remain non-contractible. Firm boundaries and the size of the firm in this context hence reflect a compromise between incentives mechanisms at each stage of the production process. 

Authors’ note: All errors and omissions are our own responsibility. The views expressed in this column are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of anyone else associated with the Federal Reserve System. Prior to his employment at the Federal Reserve Board, Stephen Lin worked on this project during his Ph.D. candidacy at Harvard University; in that capacity, he received financial support from Harvard and from the Bradley Foundation. Smith Travel Research data were obtained by Arturs Kalnins under the purview of the Center for Hospitality Research at the Cornell School of Hotel Administration.  Stephen Lin and Catherine Thomas did not have any unauthorized access to this data while working on this paper/project.  

References

Antras, P and E Helpman (2004), “Global sourcing”, Journal of Political Economy 112(3): 552-580.

Coase, R H (1937), “The nature of the firm”, Economica 4(16): 386-405.

Grossman, G M and E Helpman (2004), “Managerial incentives and the international organization of production”, Journal of International Economics 63(2): 237-262.

Kalnins, A, S Lin and C Thomas (2020), “In-House and Arm’s Length: Productivity Heterogeneity and Variation in Organizational Form”, Journal of Law, Economics and Organization, forthcoming.