designed by the incumbent and offered to potential franchisees. The contract consists of a franchise
fee, F, a wholesale price scheme, w (xt), and an exclusive territory, t. The contract obliges a
franchisee to sell the product to customers in its own market only, i.e. exporting the product to
another territory is either prohibited or associated with an additional fee, c. The contract also
specifies that violations of the contract are associated with damages, V.
The incumbent can then design a contract with the following terms; the wholesale price is
zero up to a quantity equal to one n:th of the incumbent’s global capacity and infinite thereafter,
the exclusive territory is a local market, t, and the franchise fee is the expected revenue for a
monopolist in that market, minus the assignment cost, i.e. F = υ (к/n, 0) — G.
Under this contract, the independent franchisee in each market has an incentive to produce and
sell its full capacity and entry is successfully deterred. The market assignment cost is identical to
the profit of the franchisee and it is determined by the relative bargaining power of the franchisee
and the incumbent. Hence, the profitability of franchising for the manufacturing firm is determined
by the outcome of the bargaining between the franchisor and the franchisees.
(ii) Strategic Investment and Multinational Production
Multinational production and strategic foreign direct investment constitute another natural appli-
cation of the model.12
Consider a modified version of the game. The incumbent firm has incurred the market-specific
fixed costs and meet demand for its product in all markets. In the first stage, the incumbent has
two options: either to concentrate production in a single plant, i.e. an export strategy, or to install
local plants, i.e. a multinational strategy. If it is choosing the former strategy, the incumbent must
choose a global pre-entry capacity, whereas, if it is choosing the latter strategy, the incumbent must
choose a global capacity and local capacities assigned to each of the plants. In the second stage, a
potential competitor considers entry in the local markets. If it enters, it must also decide whether
12In models with variable trade costs, Smith (1987) and Horstmann and Markusen (1987), show that an incumbent
has an incentive to make a foreign direct investment to deter entry. Multinational production reduces variable costs
and makes the incumbent more aggressive. A more aggressive play will reduce the revenues of potential entrants
and, thus, entry is deterred. If monopoly rents outweigh any costs associated with installing an additional plant, the
first-mover would choose this strategy.
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