| Abstract: | ABSTRACT National advertising is an important ongoing marketing activity in a franchise arrangement. A majority of franchisors require franchisees to pay an advertising royalty as a percentage of gross revenues while some require franchisees to pay a fixed advertising fee. These payments are earmarked for national advertising. We investigate the relationship between the franchisor's profits and the different types of advertising payments in franchise contracts. Our model incorporates the idea that the franchisor and franchisee are in an ongoing relationship where there is demand uncertainty. We show that specification of an advertising payment in the form of a fixed fee or a royalty is better than no specification since it commits the franchisor to invest the payments in advertising. We demonstrate that the advertising royalty specification is more flexible since it permits the advertising expenditure to be adjusted based on information that is not available at the time the contract is written. |
