Fourth factor of production

Since the time of Marshall, the concept of entrepreneurship has continued to undergo theoretical evolution. For example, whereas Marshall believed entrepreneurship was simply the driving force behind organisation, many economists today, but certainly not all, believe that entrepreneurship is by itself the fourth factor of production that coordinates the other three (Arnold, 1996). Unfortunately, although many economists agree that entrepreneurship is necessary for economic growth, they continue to debate over the actual role that entrepreneurs play in generating economic growth.

Bearing risk

One school of thought on entrepreneurship suggests that the role of the entrepreneur is that of a risk-bearer in the face of uncertainty and imperfect information. Knight claims that an entrepreneur will be willing to bear the risk of a new venture if he believes that there is a significant chance for profit (Swoboda, 1983). Although many current theories on entrepreneurship agree that there is an inherent component of risk, the risk-bearer theory alone cannot explain why some individuals become entrepreneurs while others do not. For example, following from Knight, Mises claims any person who bears the risk of losses or any type of uncertainty could be called an entrepreneur under this narrow-definition of the entrepreneur as the risk-bearer (Swoboda, 1983). Thus, in order to build a development model of entrepreneurship it is necessary to look at some of the other characteristics that help explain why some people are entrepreneurs; risk may be a factor, but it is not the only one.

Innovator

Another modern school of thought claims that the role of the entrepreneur is that of an innovator; however, the definition of innovation is still widely debatable. Kirzner suggests that the process of innovation is actually that of spontaneous "undeliberate learning" (Kirzner, 1985, 10).

The creative destruction is obvious in examining the so clod “shutting technologies”, when a new technology leads to the closure of old sectors.

Thus, the necessary characteristic of the entrepreneur is alertness, and no intrinsic skills- other than that of recognizing opportunities- are necessary.

Other economists in the innovation school side more with Mill and Marshall than with Kirzner; they claim that entrepreneurs have special skills that enable them to participate in the process of innovation. Along this line, Leibenstein claims that the dominant, necessary characteristic of entrepreneurs is that they are gap-fillers: they have the ability to perceive where the market fails and to develop new goods or processes that the market demands but which are not currently being supplied. Thus, Leibenstein posits that entrepreneurs have the special ability to connect different markets and make up for market failures and deficiencies. Additionally, drawing from the early theories of Say and Cantillon, Leibenstein suggests that entrepreneurs have the ability to combine various inputs into new innovations in order to satisfy unfulfilled market demand (Leibenstein, 1995).

If creativity is thinking up new things, it’s innovation that is doing new things[43].

Although many economists accept the idea that entrepreneurs are innovators, it can be difficult to apply this theory of entrepreneurship to less developed countries (LDCs). Often in LDCs, entrepreneurs are not truly innovators in the traditional sense of the word. For example, entrepreneurs in LDCs rarely produce brand new products; rather, they imitate the products and production processes that have been invented elsewhere in the world (typically in developed countries). This process, which occurs in developed countries as well, is called "creative imitation" (Drucker, 1985) The term appears initially paradoxical; however, it is quite descriptive of the process of innovation that actually occurs in LDCs. Creative imitation takes place when the imitators better understand how an innovation can be applied, used, or sold in their particular market niche (namely their own countries) than do the people who actually created or discovered the original innovation. Thus, the innovation process in LDCs is often that of imitating and adapting, instead of the traditional notion of new product or process discovery and development.

As the above discussion demonstrates, throughout the evolution of entrepreneurship theory, different scholars have posited different characteristics that they believe are common among most entrepreneurs. By combining the above disparate theories, a generalized set of entrepreneurship qualities can be developed. In general, entrepreneurs are risk-bearers, coordinators and organisers, gap-fillers, leaders, and innovators or creative imitators. Although this list of characteristics is by no means fully comprehensive, it can help explain why some people become entrepreneurs while others do not. Thus, by encouraging these qualities and abilities, governments can theoretically alter their country's supply of domestic entrepreneurship.

Although economists have posed many theoretical interpretations of entrepreneurship, there has been very little empirical research conducted on this phenomenon, especially compared to the amount of research conducted on the other three factors of production. In particular, growth and development economics has "suffered rather seriously from the neglect of the entrepreneurial role" (Kirzner, 1985, 69). This neglect has occurred for two main reasons. First, entrepreneurship is difficult to measure empirically. Since few economists can even agree about how to define entrepreneurship, developing the tools to measure it has been especially problematic. Second, as explained in the theories above, entrepreneurship is characterized by uncertainty and typically occurs in the presence of imperfect information, unknown production functions, and market failure. As Leibenstein claims, entrepreneurship arises "to make up for a market deficiency" (1995). However, the majority of mainstream economic models assume perfect information and clearly defined production functions. Thus, entrepreneurs typically fall outside of these models (Leibenstein, 1995).

Like Leibenstein, Kilby (1983)suggests that entrepreneurship has been largely overlooked in economics. Kilby claims that entrepreneurship exists "only in the lower realms, where imperfect knowledge and market failure are granted an untidy presence;" as a result, many economists disregard this phenomenon, particularly in economic models dealing with developed countries. However, many models that focus on the underdeveloped economies of LDCs relax their assumptions about perfect information. This more realistic view of economic markets allows entrepreneurship to stand out as one of the leading sources of market transformation and economic growth and development.

Leibenstein maintains that there are two simultaneous steps in the process of economic development for LDCs: economic growth and market transformation. In order for a country to increase its per capita income, it must have a "shift from less productive to more productive techniques per worker". This shift is the process of market transformation, and it can be manifested in the creation of new goods, new skills, and new markets. Entrepreneurship is the driving force behind both growth and transformation. Without entrepreneurs there would be no new innovation or creative imitation in the marketplace; hence, the transformation to new production methods and goods in the country would not take place. As entrepreneurs transform the market, not only do they provide new goods and services to the domestic market, they also provide a new source of employment to the economy. As a result, entrepreneurship is a necessary ingredient in the process of economic development; it both serves as the catalyst for market transformation and provides new opportunities for economic growth, employment, and increased per capita income.

Although entrepreneurship can directly affect the rate of an economy's transformation and development, few countries have actively pursued entrepreneurship encouragement programs. Additionally, many LDCs have focused more on encouraging entrepreneurship in the form of multi-national corporations (MNCs) rather than domestic and indigenous entrepreneurship. MNCs can certainly increase a country's income, provide market innovations, and serve as the catalyst for market transformations; thus, MNCs can be used as a source of entrepreneurship-led development. However, Saeed suggests that it is preferred for governments to promote domestic and indigenous entrepreneurship because domestic entrepreneurs are more aware of the market gaps that need to be filled domestically (Saeed, 1998). Thus, instead of producing goods that might not be consumed within the country, domestic market forces encourage domestic entrepreneurs to create innovations and creative imitations that fulfill a real market deficiency domestically. Hence, MNCs can be used for entrepreneurship-led development, but domestic entrepreneurship is thought to be more effective.

Theorists disagree, however, about whether or not informal sector self-employment is beneficial for entrepreneurship-led development. Saeed suggests that many of the small family enterprises and shop-houses that make up the informal sector are indeed entrepreneurial ventures. He asserts that the close-knit structure of the small-family enterprise is conducive for the incubation of ideas that are tested in the informal sector and later used to transform market products and processes. Additionally, Saeed claims that women and young people are traditionally excluded from the formal sector; thus, their entrepreneurial ideas are locked out of the formal market. However, since small-family enterprises in the informal sector typically involve women and youth participation, the informal sector can often serve as the outlet for their entrepreneurial ideas (Saeed, 1998).

Unlike Saeed, Carree et. al. suggest that self-employment in the informal sector can actually thwart entrepreneurship-led growth. They assert that an economy will suffer from lower growth rates both when it has too little and too much domestic business ownership. Since many enterprises in the informal sector sell goods or services that are already available in the formal sector market, informal sector enterprises are often redundant and fail to provide market transformations. According to Carree et. al., business ownership in the informal sector rarely transforms the structure of the economy or produces new market innovations or creative imitations. Thus the presence of business ownership in the informal sector of a country does not ensure entrepreneurship-led growth because simple business ownership is not necessarily market transforming. Hence, business ownership is not synonymous with entrepreneurship (Carree, 2000).

Since entrepreneurship can serve as a positive source of economic growth and development, governments should attempt to increase their supplies of market-transforming entrepreneurship. Although it is debatable as to whether the informal sector is truly a source of entrepreneurs, governments can insulate themselves from this debate by focusing on the encouragement of market-transforming entrepreneurship, and not simply business ownership in both the formal and informal sectors.

Agency theory

In economics, the principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, the agent posting a bond, or fear of firing. The principal-agent problem is found in most employer/employee relationships, for example, when stockholders hire top executives of corporations.

Agency theory is directed at the ubiquitous agency relationship, in which one party (the principal) delegates work to another (the agent), who performs that work. Agency theory is concerned with resolving two problems that can occur in agency relationships. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principle to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately. The second is the problem of risk sharing that arises when the principal and agent have different attitudes towards risk. The problem here is that the principle and the agent may prefer different actions because of the different risk preferences.

description of theory in more detail

Agency theory explains how to best organise relationships in which one party (the principal) determines the work, which another party (the agent) undertakes (Eisenhardt, 1985). The theory argues that under conditions of incomplete information and uncertainty, which characterize most business settings, two agency problems arise: adverse selection and moral hazard. Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid. Moral hazard is the condition under which the principal cannot be sure if the agent has put forth maximal effort (Eisenhardt, 1989).

The problems of adverse selection and moral hazard mean that fixed wage contracts are not always the optimal way to organise relationships between principals and agents (Jensen and Meckling, 1976). A fixed wage might create an incentive for the agent to shirk since his compensation will be the same regardless of the quality of his work or his effort level (Eisenhardt, 1985). When agents have incentive to shirk, it is often more efficient to replace fixed wages with compensation based on residual claimancy on the profits of the firm (Alchian and Demsetz, 1972). The provision of ownership rights reduces the incentive for agents' adverse selection and moral hazard since it makes their compensation dependent on their performance (Jensen, 1983).

A number of scholars have shown that the problems of adverse selection and moral hazard exist in the management of retail outlets (Rubin, 1978; Mathewson and Winter, 1985; Brickley and Dark, 1987). Outlet managers have an incentive to shirk and to misrepresent their abilities since the owner of the firm cannot easily differentiate the effect of manager behaviour on outlet performance from the effect of exogenous factors (Carney and Gedajlovic, 1991). Franchising scholars have found that one way that performance of retail outlets can be enhanced is through the provision of residual claimancy that comes from franchising (LaFontaine and Kauffman, 1994).

However, the establishment of a hybrid organisational form does not eliminate all agency costs. Rather, the sale of residual claimancies on the profits of retail outlets creates a number of new agency costs, which come from the management of hybrid organisational arrangements. This paper argues that the survival of new franchise systems depends on the ability of the franchiser to economize on these agency costs. In the paragraphs below, I examine these agency problems and generate specific hypotheses to predict the effect of specific agency economizing activities on franchise system survival.

Ensuring Ownership Incentives

The argument made above suggests that the provision of residual claimancy on the profits of a retail outlet provides a strong incentive for agents not to engage in moral hazard or adverse selection and so enhances the performance of a retail distribution system (Brickley and Dark, 1987). By turning individuals into residual claimants on the profits of retail outlets that they have purchased, franchising reduces the incentive to shirk (Alchian and Demsetz, 1972).

However, the argument that franchising provides a superior incentive to fixed wage employment (Williamson, 1991) assumes that the franchised outlets are run by owner-operators. If the franchised outlet is run by a passive owner who hires a manager to run the outlet, then the beneficial effects of franchising on adverse selection and moral hazard are lost. Passive ownership simply recreates the agency problems that franchising is designed to overcome (Bradach, forthcoming).

Moreover, passive ownership increases agency costs over those which exist when the owner hires outlet managers. In place of the cost of managing the agency relationship between the owner and the outlet manager, passive ownership imposes the cost of managing the agency relationship between the franchiser and the passive owner and the cost of managing the agency relationship between the passive owner and the outlet manager. Since the survival of new franchise systems depends on the franchisers' ability to economize on agency costs, those new franchise systems which allow passive ownership should be less likely to survive. This argument leads to the first hypothesis:

H1: New franchise systems which permit passive ownership of franchised outlets are less likely to survive than are other new franchise systems.

Monitoring Efficiency

The performance of a franchise system depends on the ability of the franchiser to ensure that all members of the system work to develop and maintain its brand name. The brand name is a signal to customers of the quality of the retail outlet (Norton, 1988b). As such, it is the major strategic asset that differentiates outlets in the franchise system from outlets in other franchise systems or independent businesses in the same industry.

However, the development and maintenance of the brand name is an externality problem. Each franchisee has an incentive to free ride off of the efforts of other franchisees to develop and maintain the brand name. Each franchisee can internalize the entire value of the savings from shirking on quality maintenance or on advertising and promotion, but can externalize the cost of that shirking.

For example, if a franchisee degrades quality, he will still be perceived as having the same quality as the rest of the franchise chain and will receive the same amount of benefit from the brand name (Rubin, 1978). However, he will reap the entire savings of the unexpended cost of maintaining quality (Brickley and Dark, 1987; Carney and Gedajlovic, 1991).

Given the existence of a free rider problem, the survival of a new franchise system depends on the franchiserís ability to minimize the agency cost of free riding. Research has shown that information about agent behaviour minimizes agent free riding (Brickley and Dark, 1987). Information raises the risk of detection and therefore the likelihood that the franchisee will be terminated. Even if the information does not allow the principal to detect all free riding, it deters agents as long as the agents are risk averse (Eisenhardt, 1989). In addition, the information allows the principal to better differentiate suboptimal performance that is due to the agent's shirking from exogenous environmental shifts; and any information that improves this differentiation reduces the agent's incentive to shirk (Holstrom, 1979).

Obtaining information about franchisee behaviour is a costly undertaking. Information on franchisee behaviour is often gained through direct monitoring of franchisees. This activity includes verification that the franchisee is adhering to the contractual terms of the franchise agreement (Lal, 1990) through activities such as inspections of franchisee outlets by management personnel (Michael, forthcoming).

Efficiencies in outlet monitoring can reduce these monitoring costs in two ways. First, by increasing the ratio of outlets to monitoring personnel, per outlet monitoring costs are reduced. The primary mechanism for verifying franchisee compliance with franchiser terms is the unannounced audit. Since franchiser representatives can audit multiple outlets during a given work week, the cost per outlet of hiring a franchise consultant is lower if the franchiser has multiple outlets for each monitor on its payroll. Second, monitoring accuracy is improved by a high ratio of outlets per monitor. "Franchise systems with numerous units typically develop efficient routines for monitoring and measuring performance to assure profitability and uniform delivery of the franchise product or service. Such routines are enhanced by volume comparisons across units. The sheer volume of these comparisons can produce more educated routines for identifying and then managing the shirker (Huszagh et al, 1992: 8)." One would expect that the more monitoring efficiency a franchiser has, the more able the firm would be to monitor franchisees and so economize on agency costs. This argument leads to the second hypothesis:

H2: The greater the franchiser’s monitoring efficiency, the more likely the franchise system is to survive.

Geographic Dispersion

Monitoring costs increase with the distance between the principal and the agent (Norton, 1988b). The cost of monitoring franchised outlets is a function of the amount of time that monitors can spend on monitoring relative to other activities. The greater the distance between the monitor and the agent, the more travel costs must be added to the cost of monitoring (Rubin, 1978). Moreover, when distances are greater, monitors must spend a greater amount of time away from agents, increasing the latter's opportunity to free ride and raising monitoring costs (Martin, 1988). For these reasons, monitoring costs are lower when agents are geographically concentrated (Carney and Gedajlovic, 1991). Therefore, one would expect that the more geographically concentrated a franchise system's expansion is, the more the firm is able to economize on agency costs. This argument leads to the third hypothesis:

H3: The more geographically concentrated the expansion of the franchise system, the more likely it is to survive.

Franchiser Free Riding

Although much of the literature on franchising has focused on establishing franchisee incentives, franchisers must also be given incentives to motivate them to monitor franchisees against free riding (LaFontaine and Kauffman, 1994). As was described above, franchisees have an incentive to degrade the brand name and, in the absence of monitoring, will do so. The franchiser prevents franchisees from doing this by auditing the quality of franchised units, and by establishing and enforcing contractual provisions for advertising, training and outlet operations (Brickley and Dark, 1987).

However, these monitoring activities impose a cost on the franchiser. In the absence of a countervailing benefit, the franchiser has an incentive not to follow through on this monitoring obligation. Rubin (1978) has shown that if the franchiser were compensated entirely through these up-front franchise fees, he would have no incentive to monitor the system against agent shirking since he would receive no benefit from maintaining a high quality system.

The royalty that the franchiser receives provides an incentive to monitor franchisees against shirking (LaFontaine and Kauffman, 1994). To the extent that the franchiser receives ongoing royalties, he has an incentive not to default on his monitoring obligations. Defaulting on these obligations would lower the franchiserís return from establishing the franchise system since an unmonitored system would have greater franchisee free riding and lower sales.

Potential franchisees see the size of the royalty rate in the franchise contract as a measure of the franchiserís incentive to develop and uphold the brand name and the reputation of the franchise system. This reassures potential franchisees that the franchise system is organised in a way that will minimize agency problems (Lal, 1990). Therefore, one would expect that the higher the royalty rate in the franchise system, the more the firm is able to economize on agency costs. This argument leads to the fourth hypothesis:

H4: The higher the royalty rate, the more likely the new franchise system is to survive.

Master-Franchise Agreements

The use of master franchise agreements complicates the agency problems of managing a franchise system. Master franchise agreements are agreements "to grant the rights of development to an individual, who has no intention of operating an establishment himself or herself. Instead the intention is to recruit, train, and oversee the operations of individual franchisees in the area (Dandridge and Falbe, 1994: 41)."

One of the roles of the master franchisee is to enforce franchise agreements. The use of contractually employed monitors, as occurs with the use of master franchise agreements, increases agency costs. The introduction of a master franchise agreement requires that the franchiser be able to specify in the contract how master franchisees should enforce the franchise agreement. Given uncertainty and incomplete information about the ways in which franchisees could potentially shirk, it is difficult to identify the necessary enforcement behaviour ex-ante. Without master franchise agreements, the codification of enforcement behaviour is unnecessary. The franchiser can simply adopt appropriate monitoring routines as the situation dictates. However, with master franchise agreements, enforcement behaviour must either be specified at the time of contracting or be foregone. Given the inability of franchisers to foresee all possible mechanisms for franchisee shirking, this requirement will reduce the ability to monitor franchisees and raise the opportunity for franchisee shirking. Therefore, the use of master franchise agreements should increase agency costs. This argument leads to the fifth hypothesis:

H5: Franchise systems which use master franchise agreements are less likely to survive.

Quasi-rent Appropriation

Business format franchisers often require franchisees to pay for franchiser-specific investments such as materials, signs or building designs through an up-front franchise fee (Fladmoe-Lindquist, 1991). These franchise fees might have a positive effect on franchise system survival because they generate cash for the franchiser, which could mitigate cash flow constraints on survival.

However, agency theory suggests a stronger, countervailing effect of up-front franchise fees. Since franchiser-specific investments are worth more if the franchisee remains part of the franchise system than if he does not, these assets generate quasi-rents (Brickley and Dark, 1987; Carney and Gedajlovic, 1991). Mathewson and Winter (1985) explain that a franchiser can appropriate the value of these quasi-rents by precluding the franchisee from using these assets before the end of their useful lives. Moreover, the quasi-rents create an incentive for the franchiser to claim that the franchisee has violated the franchise agreement so as to permit the franchiser to appropriate these rents (Klein et al, 1978).

Quasi-rents place limits on the size of the up-front franchise fee that franchisees are willing to pay. Franchisees want to minimize these fees so as to recoup the cost of the up-front franchise fee during the life of the franchise contract and preclude the possibility of franchiser appropriation (Combs and Castrogiovanni, 1994). The greater the amount of the up-front franchise fee, the greater the divergence between the franchiser and franchisee over the required return on the outlet's assets during the period of the initial franchise agreement. For this reason, high franchise fees raise ex-ante bargaining costs (LaFontaine, 1992). Therefore, franchise fees should be positively associated with agency costs. This argument leads to the sixth hypothesis:

H6: The higher the initial franchise fee, the less likely the franchise system is to survive.

Length of the Agreement

Increasing the term of an agreement between the principal and agent reduces agency problems (Levinthal, 1988). Longer term agreements reduce agent shirking for three reasons. First, long time horizons provide an incentive for principals to invest in gathering information about agents' behaviour (Eisenhardt, 1989). Increased information about the agent enhances the likelihood that the principal will detect shirking and reduces the incentive for the agent to shirk. It also helps to disclose the agent's type and thereby reduces the adverse selection problem. Second, Holstrom (1979:90) explains that over time the patterns of environmental effects on performance become clear, allowing the principal to more precisely separate exogenous environmental effects on performance from the agent's shirking behaviour, making agent moral hazard more difficult. Third, the longer the time horizon of the agreement, the lower the agent's incentive to shirk or engage in perquisite-taking (Jensen and Meckling, 1976). Long time horizons increase the amount that the agent has to gain by proper behaviour relative to the amount he has to gain from shirking (Williamson, 1991). Because agents will not shirk if the net present value of future earnings from not shirking exceeds any gains from shirking, long-term agreements reduce franchisee shirking (Klein et al, 1978). Therefore, longer term franchise agreements should reduce agency costs. This argument leads to the seventh hypothesis:

H7: The longer the initial term of the franchise contract, the more likely the franchise system is to survive.

Complexity

Information transfer in a non-hierarchical setting is problematic because of the agency problem of moral hazard. If the principal has imperfect information about the agent's ability to perform the task that is demanded of the agent, the principal will have difficulty ensuring that the agent has performed that task (Barzel, 1989). This lack of measurement ability will provide the agent with an incentive to shirk on the proper performance of that task (Chi, 1994). In the context of franchising, this means that if the franchiser cannot be sure that the franchisee is performing the job of managing a local retail outlet, the franchisee will have an incentive to shirk on his efforts to manage the outlet. Michael (forthcoming) explains that the decisions that the franchisee makes about local demand, real estate, prices, and labour markets are important to the success of franchising; and it is difficult for the franchiser to ascertain whether a potential franchisee has made the right decisions about these things.

"Explicit long-term contracts can, in principle, solve [these] problems, but... they are often very costly solutions . . . since every contingency cannot be cheaply specified in a contract or even known and because legal redress is expensive (Klein et al, 1978: 303)." The cost of writing long-term contracts depends on the complexity of the franchise concept. Complex franchise concepts are ones that require both franchisers and franchisees to undertake a large number of different activities. The more complex the franchise concept, the more difficult and costly it is for the principal to specify he agent's required behaviour under all contingencies (Eisenhardt, 1989). Moreover, the more complex the concept, the more costly it is for the principal to ensure that the agent is properly undertaking the appropriate activities (Anderson, 1985; Eisenhardt, 1985). Therefore, the more complex the franchise concept, the higher the agency cost of operating the business through a hybrid structure (Klein et al, 1978). This argument leads to the eighth hypothesis:

H8: The more complex the franchise concept, the less likely the franchise system is to survive.

Date: 2016-03-03; view: 855