Imagine you are at a major electronics chain store, finally ready to purchase that plasma television that would be just perfect for your recreation room. But when you tell the salesperson which model you want to take home, she asks you a few questions about your television room and viewing habits. She then says, “Let me show you another TV that might be even better for you.” She takes you across the store to a newer unit that looks a lot like the one you came for—except the price tag is $500 higher. The saleswoman points out several of the new television’s superior features, and then leaves you alone to “think about it.”
Now the confidence with which you entered the store has turned to confusion, not only about which television to buy, but also about how much you should trust the saleswoman. After all, you remind yourself, she probably earns a larger commission if she sells a more expensive product. In short, it is hard to tell whose interests the saleswoman has at heart—yours or her own. Now imagine your interaction had been related to a much larger financial commitment—such as a mortgage—and the mortgage salesperson had initiated contact with you through an unsolicited phone call. How much should you trust the salesperson’s advice?
This type of conundrum inspired Marco Ottaviani, a management and strategy professor at the Kellogg School, and co-author Roman Inderst to research conflicts of interest that arise when seller-employed individuals responsible for finding new customers are also the ones advising prospective customers on a product’s suitability for their needs. In “Misselling through Agents,” a paper forthcoming in the American Economic Review, Ottaviani and Inderst investigate ways to incentivize sales agents to sell—but not “missell”—through internal organization of the sales process, commission transparency, and an expanded role of self-regulation and policy intervention.
The Phenomenon of Misselling
Ottaviani and Inderst point out that when consumers purchase unfamiliar products, they often rely on information and advice provided by representatives of the seller. This creates the possibility of “misselling”—the ethically dubious practice of a salesperson selling a product that does not match a customer’s needs. The researchers note that misselling frequently occurs in markets for complex products including electronics, auto repairs, medical care, and retail financial services such as securities, pensions, insurance, and mortgages.
As more and more financial decisions end up in the hands of consumers, the scope and ramifications of misselling increase—as exemplified by factors that contributed to today’s economic challenges including the large number of home buyers holding mortgages that ultimately did not match their ability to repay. It is too early to know the size of misselling’s impact in these and other domains (e.g., the shift from defined pension plans to 401(k)s in the United States), but the benefits of keeping this practice to a minimum for consumers, businesses, and the global economy alike are becoming clearer.
Misselling through Agents
Ottaviani and Inderst examine misselling “through the lens of the agency relationship between the selling firm and its salesforce.” The incentives that sellers provide their agents to search for customers may induce the agents to advise customers to purchase indiscriminately, thereby making the problem of misselling “particularly acute.” To understand this, note that there are two reasons why a direct marketing agent may be unable to sell to a customer: either the agent failed to prospect for a customer in the first place (which sends a bad signal about the agent’s search effort), or the agent found a customer and correctly advised against purchase (indicating proper search and advice).
“Misselling”—the ethically dubious practice of a salesperson selling a product that does not match a customer’s needs.This attribution problem creates a conflict between the tasks of searching and advising. For example, an investment advisor may recommend that a 70-year-old customer buy a financial product that guarantees full repayment of principal only after ten years. Firms may be held liable or risk damaged reputations due to such misselling, but ensuring that agents comply with specific standards requires costly measures such as regular internal reviews. Inderst and Ottaviani analyze how the likelihood of misselling depends on several factors including an agent’s expected cost of prospecting for customers, the seller firm’s internal organization of its sales process, and the commission structure’s transparency to consumers.
The model demonstrates a complex relationship between selling (or misselling) and compensation structures. A higher commission for a sale lowers the suitability standard by inducing agents to advise purchase to more customers. However, a higher base salary increases the suitability standard because agents receive payment regardless of the number of purchases they recommend, and they even stand to lose their jobs—and incomes—if they provide poor advice to customers. However, the higher the ratio of salary to commission, the less incentive agents have to search for new customers in the first place.
The researchers find that making a firm’s compensation scheme transparent reliably results in a higher internal suitability standard. When the seller’s compensation scheme is not disclosed to customers—as in most unregulated industries—the seller may be tempted to reduce the suitability standard by jacking up the commission rate, thereby increasing the chance of a sale. Being unable to observe directly the commission rate, customers should come to expect the firm to set it at a high level, and therefore the resulting suitability standard and their willingness to pay for the product would be low. If instead the seller commits to disclose the compensation paid to the agent, as is imposed by regulations for financial product sales in some European countries, the seller finds it optimal to enforce a more stringent standard so as to reassure customers of the product’s quality—thereby increasing their willingness to pay and allowing the seller to charge a higher price.
Ottaviani and Inderst also propose that a higher suitability standard will emerge when sellers make one agent responsible for prospecting and a separate, independent agent responsible for advising. Interestingly, the model reveals that sellers who are more likely to resell contracts are more likely to maintain lower suitability standards as well. This is especially relevant to the U.S. mortgage market, where banks are less likely to resell the loans they originate and other financial firms are more likely to resell.
Ottaviani and Inderst also analyze the impact of increased competition among firms for customers. When competitive forces make it more costly for firms to find customers, the firms must step up sales-force incentives. Ensuring compliance with a given standard becomes more costly for the firm. Faced with a higher marginal cost of compliance, firms gradually become more permissive toward potential misselling. Beyond the strength of competition, Ottaviani and Inderst outline several variables that affect suitability standards and, in turn, the rate of misselling. Among these are the commission structure’s transparency and the organization of the sales process (e.g., separate agents for prospecting and advising). Policymakers must take these variables into account when addressing misselling problems and may even need to consider different policy standards for different firms within a given industry.
Understanding the factors that influence misselling can help regulators and others determine the scope and nature of policy intervention. For example, firms may be less willing to tolerate misselling based on the policies and actions of self-regulatory organizations such as the Financial Industry Regulatory Authority, which oversees U.S. securities firms. But Ottaviani and Inderst show that self-regulation is often not enough and that external regulators can reduce misselling further through measures such as penalties and required disclosure of agent commissions. This latter stipulation not only diminishes the likelihood of misselling, but also reassures customers that agents are advising in their best interests, which increases their willingness to purchase.
Ottaviani and Inderst suggest that future work could adapt their framework and model to specific industries, potentially shedding light on cross-country regulatory and industry organization issues such as degree of competition and level of vertical integration. Such information may help policymakers develop even more effective measures to identify and curtail misselling.
Inderst, Roman and Marco Ottaviani (2009). “Misselling through Agents,” American Economic Review, 99(3): 883–908.