Case Study: The Reputation of a Big Mac Explain how the time and financial requirements involved in obtaining a McDonald's franchise relate to the hidden-characteristics problem. Why would existing franchise owners have an interest in the maintenance of high application standards for new franchise owners?
Reference Case Study:
World of Business
Reputation of a Big Mac McDonald's has 32,000 restaurants in more than 120 countries and employs more than a million people. The secret to their success is that customers around the world can count on product consistency whether in Phoenix, Anchorage, Moscow, or Hong Kong. McDonald's has grown because it has attracted competent and reliable franchise owners and has provided them with appropriate incentives and constraints to offer a product of consistent quality.
To avoid adverse selection, McDonald's seldom advertises for franchisees yet still has plenty of applicants. Even to be granted an interview, an applicant must show substantial financial resources and good business experience. An applicant who passes the initial screening must come up with a security deposit and complete the nine-month full-time training program. A franchise costs anywhere from $950,000 to $1,800,000, depending on the size and location, plus an opening fee of $45,000. Of that amount, the new franchisee must have "non-borrowed personal resources," of at least $500,000 in cash; this money can't come from friends or relatives. In effect, the applicant must have saved this amount or own assets such as property or stock that could be sold to raise the cash. Those with more savings have an edge in the selection process. McDonald's uses personal wealth as a signal of the individual's business sense and ability to manage money. The rest can be borrowed from a bank but must be paid back in no more than seven years. McDonald's is using the bank's loan officers to screen the applicant's creditworthiness. During the training period, the applicant is paid nothing, not even expenses. Some who complete training are rejected for a franchise. Once the restaurant opens, a franchisee must work full time. McDonald's does not offer franchises to partnerships or to groups of investors.
Thus, the franchisee has a deep financial stake in the success of the operation. As a further incentive, successful owners may get additional restaurants. If all goes well, the franchise is valid for 20 years and renewable after that, but it can be canceled at any time if the restaurant fails the company's standards of quality, pricing, cleanliness, hours of operation, and so on. The franchisee is bound to the company by highly specific investments of money and human capital, such as the time invested learning McDonald's operating system. The loss of a franchise would represent a huge financial blow. Through its franchise policies, McDonald's is trying to protect its most valuable asset-its reputation for "quality, service, cleanliness, and value." The golden arches are the second most recognized corporate symbol in the world (the stylized lettering of Coca-Cola ranks first). In selecting and monitoring franchisees, McDonald's has successfully addressed problems stemming from hidden characteristics and hidden actions.