Moral hazard, asset specificity, implicit bonding, and compensation: The case of franchising

In franchising, many of the elements of moral hazard models merge. Issues of two-sided moral hazard, bonding, and asset specificity all play a role. We extend the literature by considering how asset specificity creates an implicit bond and affects incentive pay. This approach implies that if one party posts a larger bond, this improves their incentives and allows enhancement of the other party's incentives through a larger residual income claim. Our empirical work supports this approach. For example, reductions in the specificity of the franchisee's investment due to leasing lowers the royalty rate and raises the franchise fee.