Organizational design is an important determinant of firm transparency. In a recent study published in Management Science Anja Schöttner, together with Matthias Kräkel, modeled what happens when a firm gives its salespeople autonomy in setting the prices of its products. They study the optimal interaction between delegation, incentive pay, and the firm’s auditing technology using a contract-theoretic model, as Schöttner explains below.
Personal selling through sales forces is an important distribution channel for many firms. A long-standing question is whether and when firms should grant salespeople authority to set prices. Overall, salespeople are, or should, be better informed about the price customers are willing to pay for a service or product than managers. This would argue for giving salespeople the freedom to determine the pricing of their product. However, the fundamental problem is that, from the companies’ point of view, the pricing behavior between their salespeople and customers can therewith lack transparency. In particular, salespeople may collude with customers when setting the pricing, they may, for example, accept kickbacks, a form of negotiated bribery in which the sales agent receives a commission for giving a price discount. The firm can do two things to prevent collusion: it can either stipulate a fixed price to all customers, or it can implement performance-based pay that rewards the agent for selling at high prices, therewith reducing the incentive to accept kickbacks for selling at a low price. We studied the optimal arrangement and delegation of decision rights to the sales agent using a contract theory model.
We modeled the situation between a sales agent and a customer. In our model, the sales agent and customer have a sales talk, during which the agent is able to determine the value the costumer assigns the product: the price he is willing to pay. However, this information stays between the agent and customer, the firm does not learn about the customer’s valuation. In case the customer’s valuation is higher than the lowest price the agent is allowed to charge, customer and agent can collude. The agent can offer its lowest price, therewith offering the customer a price discount, and in return receives a kickback from the customer. In our basic model the agents do not have to take efforts to find prospective customers. The sales pitch could for example take place in a shop that is frequented by customers every day, or in a call center where the sales agent can be closely monitored. We also made an extended version of the model, here the sales agent has to actively search for customers; the model includes a so-called prospecting stage. As prospecting effort is usually hard to observe by the firm, it needs to motivate the agent to actively search for customers. This extended model therewith introduces what we call “moral hazard”.
Preventing collusion is costly
We show that the agent does receive some pricing authority but the respective contract that the firm offers the agent is typically collusion-proof, which requires limited pricing authority for the sales agent and a commission that rewards the agent for charging a high price if possible. In general, preventing collusion is costly for the firm for two reasons. First, the limited amount of pricing authority for the sales agents typically leads to losing those customers who were only willing to pay a low price. Second, the commission increases wage payments relative to the hypothetical situation where collusion is not an issue. Interestingly, however, our extended model shows that the latter problem is less severe when there is moral hazard. The reason is that the commission scheme now serves two purposes – it contributes to preventing collusion and at the same time motivates the agent to exert prospecting effort. As incentive contracting by means of a commission scheme becomes more effective from the firm’s perspective, it can now also grant more pricing authority to the sales agent. This leads to the surprising result that, the more intensive the moral hazard problem is, the more pricing authority the firm grants the agent in order to make him work hard and sell the product to customers with a low willingness to pay.
We also looked at the effect of auditing. A firm may implement an auditing system as part of its organizational design. It could for example interview customers and colleagues about the agent’s behavior or employ mystery shoppers. Intuitively, more effective auditing means the sales agent can be more easily caught in case of collusion. As such, the firm will delegate more pricing authority to the agent because the risk of collusion is reduced. However, our results show that in case of a severe moral hazard problem the results from auditing are not as useful, and therefore in these cases a less effective auditing technology suffices. Moreover, because moral hazard problems and their increasing severity imply more pricing authority for the agent and higher average compensation, our model predicts a negative relationship between those organizational variables and the effectiveness of the firm’s auditing technology.
In general, we show that a firm should offer more pricing authority to the agent the more severe the moral hazard problem is (i.e. the harder it is for the firm to incentivize the agent to exert prospecting effort). Nevertheless, typically an optimal measure to prevent collusion would be restricting the agent’s pricing authority such that he cannot sell to customers who are only willing to pay a low price. Moreover, we also identify circumstances where it is too costly for the firm to prevent solution, e.g., if incentive contracting leads to further administrative costs or the customer can offer certain types of nonmonetary benefits to bribe the agent.
The main take-away is that a firm can in principle prevent collusion between its sales agents and customers by carefully designing its organizational structure with respect to the delegation of pricing authority and performance pay. An increasingly non-transparent situation, e.g., moral hazard and a threat of collusion arising simultaneously, can lead to a counterintuitive adaption of the organizational design where the agent obtains more rather than less decision authority. Moreover, one needs to be aware of the fact the preventing collusion is costly to the firm and may even become prohibitively costly. Within the TRR 266 we will continue studying the interaction between non-transparent individual behavior and optimal organizational design.
Read the Publication “Delegating Pricing Authority to Sales Agents: The Impact of Kickbacks?” by Matthias Kräkel and Anja Schöttner in Management Science, published online in Articles in Advance: https://doi.org/10.1287/mnsc.2019.3293 .
We employ the principal-agent paradigm to develop a new model that allows us to study the impact of potential kickbacks on contracting with sales agents. We combine this model with a standard binary-effort moral hazard model featuring limited liability.