Journal of Economics and Business 57 (2005) 139–149 Externality and organizational choice in franchising Antony Dnes a,1 , Nuno Garoupa b,∗ a The University of Hull Business School, Kingston-upon-Hull, HU6 7RX, UK b Faculdade de Economia, Universidade Nova de Lisboa, Campus de Campolide, P-1099-032 Lisboa, Portugal Received 10 September 2001; received in revised form 2 June 2004; accepted 30 September 2004 Abstract In this paper, we examine some implications of externality for the organization of firms. The need to control externality explains the selection, at the level of the chain, of full integration, dealerships or franchising systems, or systems of dual distribution where company and franchised outlets operate simultaneously, in preference to unrestricted retailing. We show that there could be a trade-off between managerial motivation and effective controlling of externality. This trade-off can explain the selection of particular organizational structures within franchising. In particular, non-separable externality, where the value of the externality depends upon characteristics of both the generating and affected unit, is costly to control contractually and could encourage integration. © 2005 Elsevier Inc. All rights reserved. JEL classification: L14; L22; M21 Keywords: Externality; Franchising; Dual distribution 1. Introduction In this paper, we examine some implications of externality for the organization of firms. In particular, we offer an explanation of franchising characteristics including the practice of dual distribution, where a franchise chain simultaneously uses both franchised and company- operated outlets. The need to control externality is cited as an explanation of the selection ∗ Corresponding author. Tel.: +351 21 3801600; fax: +351 21 3870933. E-mail addresses: a.dnes@hull.ac.uk (A. Dnes), ngaroupa@fe.unl.pt (N. Garoupa). 1 Tel.: +44 1482 465875; fax: +44 1482 466216. 0148-6195/$ – see front matter © 2005 Elsevier Inc. All rights reserved. doi:10.1016/j.jeconbus.2004.09.005