As we have discussed in
class, the principal-agent problem involves one party working for another party
in return for an incentive. The first party is the agent and the second is the
principal in this case. As the agent makes decisions on behalf of the principal,
certain costs or issues may arise. In particular, morally hazardous decisions
as well as potential conflicts of interest can lead to problems between the two
sides. Speaking to the prompt, the principal-agent problem often involves more
than just two sides. I want to examine the example of a salesman in a car
dealership and the moral hazards that are present.
Car dealerships are a
frustrating and difficult place to be more times than not, partially due to the
different motives that many individuals have there. Let’s first examine who is
the agent and principal in this case. For argument’s sake, there is a three
tier system: first, the owner of car dealership is in control (principal#1),
the car salesman (agent) is responsible for both the satisfaction of the owner
as well as the customer (principal #2). The salesman is obligated to both. In
terms of obligation to the owner, the salesman must sell a certain amount of
cars in order to maintain his job. There may not be a minimum amount of cars he
must sell, but if low performance is the salesman’s norm then he will more than
likely be replaced. Similarly, the
salesman’s goal is to sell the car for as close to list price as possible. Not
only will the dealership make more money, but the salesman will make higher
commission as well.
In terms of serving the
customer, the car dealer will go to extreme lengths to ensure the sale of the
vehicle. However, the customer is seeking the lowest possible price so the
salesman must tailor his sales pitch to that fact. So, in order to make
commission, the salesman may be willing to sacrifice a higher sale price of the
vehicle for a lower one. This may compromise the owner of the dealership’s
desire to earn the highest revenue possible. In other words, the contracts
between the owner, salesman, and customer are misaligned.
For example, if the list
price of the vehicle is $30,000 but the salesman and the customer have
negotiated the price down to $27,000 an interesting dilemma arises. Let’s also assume
the commission rate is 10% for simplicity’s sake. Ultimately, the difference
between commission ($300) is much less for the salesman than it is between the
owner ($3000). Therefore, the salesman probably will not go to such extreme
measures as to make sure that he reaches the firm’s set price. Similarly, the
car salesman has the opportunity to make up the difference in commission by
increasing the rate at which he sells cars.
In terms of resolving
this dual obligation, I feel there are few solutions to offer. One that may be
viable, however, is meeting halfway between the dealership’s and the customer’s
price. As previously discussed, the incentive for the salesman to do so is not
exceedingly high. More times than not, the agent will fail in fully satisfying
the two principles but the main objective is achieved. To clarify, the salesman
both sold a car (satisfying principal #1) and the customer received a car
(principal #2). The difference in price is a smaller issue than if the salesman
were not selling cars on a consistent basis.
I believe that the internet has changed this particular moral hazard. Buyers can get better information about what a dealer would be willing to sell the vehicle for. Also, in an urban area (or even in central Illinois) a buyer can visit too different dealerships a price the same model car, buying from the place where there is a lower price.
ReplyDeleteOne of the ways moral hazard might manifest here, is with the value of the trade in, if there is one. That might not be negotiated at the same time the price of the new car is considered. A different issue that might impact the moral hazard is whether the buyer is selecting a car already on the lot, a car that is at a neighboring dealer and gets delivered to the local deal, or a car that is made to order because it has features the buyer wants but none of the current inventory matches that. The buyer has the least market power with the last option and that is where the seller moral hazard is greatest.
You also might consider the triangle not so much with the buyer as the second principle as with the parent company. Dealers hold inventory but the parent company is also on the hook for some of that cost. The parent company wants to see movement of inventory into sales, because that sort of data impacts its stock market price. So, as I understand things, there are monthly quotas. Here's a bit about that.
Way back when as a buyer you could get a deal on a car if the new model year had already started and you were buying a new car but from the previous year. Now there is something similar on a month by month basis. If near the end of the month the dealer hasn't yet reached quota, the dealer is willing to sell for less. Not so if the dealer had a good month. The buyer doesn't know where the dealer is on the quota, but that is something that might be explored. I learned about this only recently, having bought a car over the Internet without seeing it first. I thought I made a good offer. I learned after the fact that I left a few buck on the table based on when I purchased the vehicle.
I agree that the internet has greatly altered the manner in which people purchase cars. If a buyer does not like the price of a certain model, they can easily travel to a different dealership that has a lower price for the same car. Thus, the pricing in the market will become relatively normalized as the high price and low price fluctuate to some semblance of equilibrium.
DeleteIn the case of car dealerships, I believe that buyers have the least power in this problem. Buyers drive the dealership as there would be no dealership without the customers' income and propensity to spend it. However, they have very little control over the price they pay. Dealerships set the price so while there may be some collective bargaining between customer and salesman, the customer can do little to alter the price. This may bring rise to moral hazard in which the dealer takes advantage of the customer. The dealership may try to exploit the buyer by setting the price so that even with a reduction, they make a higher profit than if the car were priced normally.
As Professor Arvan mentioned, the parent company is an interesting variable that needs to be considered in this situation. At the beginning of this semester my mother was looking for a new car to lease, there isn't anything too much different when negotiating a lease price vs selling a car aside from what you are paying monthly and not overall. Anyways, she had X type of car and wanted to lease a new X type of car, but her lease was not up. The dealer wanted to take her lease in early and give her the new car at a higher cost per month, however, the parent company denied their request and thus the sale fell apart. In this situation the company itself was the blockade and not management from the dealership. Do you think there can be any type of moral hazard in a situation like this?
ReplyDeletei really liked your example of the principal agent model, as it just so happens my brother was a salesman at a car dealership in a small town in Pennsylvania. it is one of those towns where everyone knows each other and everyone has grown up together. this led to be a huge moral hazard for my brother because he cared about everyone in his town and wanted them to get a fair price on their cars but he also had to do his job. i feel that most small towns are faced with this issue and deal with it in different ways.
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