21 September 2010

Commission Sales And Economic Waste

As our economy enters the "Information Age," an growing share of the economy is devoted to selling goods and services, as opposed to providing them. We have few factory workers and more merchants.

While this can create value, by making sure that the price signals sent to producers insure that what is made is what the economy actually needs, a lot of the growth of the marketing workforce is economically wasteful sales force bloat driven by "rent seeking" behavior. More people are fighting over a share of productive value created mostly upstream economically where goods and services are produced.

What Is Rent Seeking?

I've noted many times before that most of the weird real life economic phenomena that exist can be explained by "price discrimination." A large share of the dramatic power struggles that grace the business pages involve "rent seeking" and it isn't always obvious whether the people trying to deprive other firms of economic rents, or the ones trying to hold onto them are the good guys.

Rent seeking "generally implies the extraction of uncompensated value from others without making any contribution to productivity." Typically, "[s]tudies of rent seeking focus on efforts to capture special monopoly privileges such as government regulation of free enterprise competition." Lobbying, for example, is a classic example of rent seeking. But, the term is broader.

"Economic rents" as the term is used in economics, are distinguished from "profits" which involve situations when someone who creates value receives a share of the value created. Another way of thinking about "economic rent" is as the excess over the return someone receives from economic activity above the perfectly competitive price necessary to produce the amount of something that the market needs.

Rent seeking is an important concept in political economy, even apart from ordinary government regulation, because it involves an economically important class of activies, analytically distict from externalities, where an unregulated market is less efficient than a regulated market. Usually, competition makes the economy more eficient and productive, but competition to gain economic rents is often inefficient and wasteful.

How Does Rent Seeking Emerge In The Marketing Industry?

Lots of marketing activity in the economy is mostly rent seeking, and when you see rent seeking in the world of marketing, it is often the little guy, and not the monopolist who is struggling to protect an economic rent. Productivity and efficiency oriented economists generally consider economic rents to be a bad thing, when they can be avoided.

The underlying product being sold, perhaps cars or life insurance or houses or jewelry, adds value to the economy, so it is efficient to devote considerable resources to cause the economy to buy all of the product that it needs. The demand for any particular good or service doesn't change much based upon how many people are selling it. But, if there is a good profit to be made from selling the product, lots of people will devote their efforts to selling it, even if nearly as much of the product could be sold with far lower sales expenses.

When marketing is set up on a commission basis, the ultimate supplier of the good or service doesn't have much of an incentive to limit the sales force. The ultimate seller makes the same profit whether it is earned by one big seller with a very small sales force, or lots of little sellers with a very little sales force, and since additional sellers usually produce at least a few more sales, even if the increase in aggregate sales revenue created by a new seller is less than the increase in aggregate sales expenses created by a new seller, the ultimate supplier of the good or service still makes more profits if more of the good or service is sold.

Rent Busting

In Economic 101 models of perfect competition, competition should drive down sales commissions until they are so small that only the most efficient sellers can stay open. Big Box stores (like Home Depot and Wal-Mart), and Internet mega stores like Amazon, for example, are designed to produce that effect.

Indeed, as a general rule, as a result of economies of scale, for a whole host of goods and services, big businesses are firms that are more efficient at marketing than many small ones. One of the main factors that had resisted economics of scale in marketing had been the ability of smaller firms to manage information relevant to sales better, but advancing information technology is rapidly eroding this edge.

For example, computerized inventory control systems at firms like Home Depot and Wal-Mart are one important reasons that these large firms can operate efficiently despite having relatively unsophisticated, poorly paid sales forces to the general managers and owners of small hardware stores and consuemr retailers. As I learned this weekend, shopping for a renovation project, a store like Home Depot can save a sale it would otherwise lose to the competition by making it possible for a retail clerk with a PDA to tell you in an instant precisely how many units of each product it has run out of remain on the shelves of precisely which other stores in the chain. Both chains get a good share of their edge from being able to consistently and quickly connect a consumer with the product that the consumer wants to buy, rather than having to push a substitute that is less likely to produce a closed sale.

Rent Seeking Emerges When Sale Compensation And Retail Prices Are Decoupled

But, often sales commissions and consumer prices are not linked the way that they are in a simple system where the manufacturer sells something in an open auction to wholesalers who in turn sell those things in an open auction to retailers who in turn sell them to consumers, with no one exerting any influence over the producer-marketing firm system as a whole.

Life insurance sales commissions are often fixed by the life insurance company for a particular product. Real estate commissions tend to be sticky at a certain percentage of the sales price. Manufacturers suggested retail prices for products as diverse as cars and books and compact discs encourage retailers to compete over volume, rather than price.

Eventually, in a market with more sellers than the market needs for a particular good or service, a glut of sellers will make entering the business of selling that good or service unattractive, and ultimate suppliers will decide that they can sell almost as much with a reduced commission. One of the most striking recent examples of this happening is the slashed commissions paid to travel agents in recent years that has put large numbers of travel agents out of business and shifted most routine airline ticket sales to the Internet.

Why Are Sales Commissions Sticky?

There are many reasons that sales commissions tend to be sticky, and that sales forces in commission sales industries tend to bloat:

* Initial sales commissions are often set when neither the ultimate seller nor the sales force knows what sales commission will actually be optimal, and it is often hard to correct an initial sales commission that is too high.

* Commissions set on a percentage basis don't have to be constantly renegotiated based on inflation and sales volume with nearly the same urgency as fixed dollar commissions. If a 7% commission on the sale of a home becomes customary, that commission is likely to be more economically robust than a flat $20,000 commission on the sale of a home, even if the amount of sales work that goes into selling a home doesn't actually have much to do with the price of the home.

* When sales commissions are too fat and there are exclusive dealerships of some kind, it is hard to know if the sales force is highly compensated because the jobs requires well compensated sales people, or if less highly compensated sales people could sell just as much. In practice, this often comes down to whether the good or service should be sold with haggled prices, that require a more skilled sales force, or prices that sales people can't negotiate that permits a less skilled sales force.

* Commission sales costs are invisible costs to the ultimate seller. They are always accompanied by revenues that make them seem worthwhile. Often the ultimate seller doesn't have any idea what the sales force cost structure looks like.

* Cutting the sales force almost always reduces aggregate sales, even if the cuts are very modest, but it is not always easy to determine by how much sales will be reduced. So, it is often impossible for the ultimate seller to know if a smaller sales force will reduce aggregate sales by less than aggregate sales expenses, despite the fact that this is what matters in arriving at an economically efficient outcome.

* Cutting the sales force by reducing commissions can create a chicken and egg problem. Even if it would be more efficient to have a small number of high volume dealers who with lower sales costs, if most current sales firms are small and the ultimate seller doesn't supervise the process, far too many sellers could go out of business, hurting sales, before a "Big Box" economic model with lower sales costs per sale can emerge.

* Cutting prices almost always increases aggregate sales, but if the ultimate supplier and the sales force are in different firms and the sales force sets the prices, it isn't always easy to know how much reducing the size of the sales force will allow it to reduce prices.

* There are many firms in the sales force all with an interest in maintaining existing sales commissions, and there is usually only one ultimate supplier of a good or service with an interest in reducing sales commissions. Consumers have an interest in reducing prices, but generally don't know how much of the price they are paying goes towards sales commissions and generally have a personal relationship and hence some allegiance to the retail sales person that they do business with regularly. The opportunity costs of having too large a sales force are invisible. Governments tend to care more about how many firms are hurt and how many jobs are lost, than about profits for the ultimate seller or a modest reduction in consumer prices.

* It is also hard to tease apart the value created by the sales force itself from the value created by the ultimate supplier of the good or service.

Financial advisors, for example, often earn commissions on the insurance products that their clients purchase and based upon the value of the assets that they manage for their clients, despite doing nothing to make the insurance products provide a greater benefit to the client, or make the assets managed secure a higher return than they would without the financial advisor.

But, the financial advisor often does create, "free of charge" considerable value by getting clients to think about their needs rationally, organizing their finances, imparting to them conventional wisdom about matters like diversification, mediating financial firm bureacracy, and pushing them to obtain financial products that it is actually in the client's interest to obtain.

What share of the value of the total financial planning package comes from the products themselves, and what share of the total value of the total financial planning package comes from the advise that the financial planner provides?

How do you properly consider the value created by having an economy full of small Main Street shop owners, and an economy full of Big Box stores and franchises? In the days of Internet marketing, how can you be fair in a situation where consumers shop in their neighborhood store, but buy over the Internet?

Should Government Intervene To Reduce Rent Seeking By Marketers?

Any time a lassiez-faire approach to the economy produces economically inefficient results, the natural question is whether the government should step in to regulate the economy to prevent that from happening.

In the case of externalities, where the harm created by economic activity is imposed on someone other than the person who creates it, the answer is almost always yes. Tort law and many forms of government regulation exist to prevent firms from imposing externalities on others.

But, in the case of rent seeking behavior, the response is not so clear.

In political contests over economic rents, the political system is often prone to favor the wrong side to improve productivity and efficiency. Government may have even less access to accurate information than direct participants in struggles over economic rents who are in the messes that they are precisely because even they don't have the information that they need to act rationally.

The misallocation of wealth caused by rent seeking often plays out in a context where none of the participants are critically hurt by it, except during an economic crisis. Rent seeking is most common in industries that are generally very profitable as a form of friction in the economy, that isn't sufficient to undermine that generally economic value creating nature of the industry as a whole. The most stable cases are those where the waste associated with rent seeking hasn't gotten totally out of hand.

And, many of the inefficiencies that result from rent seeking do resolve themselves without direct government intervention sooner or later, often when key firms in an industry are hit by bankruptcies and have no other places to look to control costs so that they can continue to provide a useful product or service at an economically workable price, or when technological change makes the imbalances more clear.

Travel agencies saw their commissions cut, for example, only after airlines had endured wave after wave of bankruptcies, and after Internet ticket booking had reached a point where the cost of providing the service that travel agencies used to provide had fallen dramatically.

Travel agents may be the harbringer of similar squeezing of middle man commissions in areas like insurance sales and real estate sales where computers and the Internet can do a lot of the selling that used to be done by individual sales people.

The Big Three in the automobile industry decided to cut the ranks of their bloated dealership networks, relative to their "foreign" competition, only when two of the three went bankrupt. Internet marketing of new cars is also cutting into the value created by dealership based sales people, not only by undercutting them on price, but by benefitting from their sales efforts without sharing commissions with them.

On the other hand, collectively, rent seeking behavior by marketing firms is a huge drain on the economy. The immense amount of waste that goes into devoting more people than necessary to efficiently market goods and services was one of the key forces that Communism seem like an attractive alternative until the Soviet Union collapsed and China abandoned strict ideological commitments to a non-market based economic system.

Finding systemic ways to squeezing inefficiencies out of the economy in marketing may also be a more attractive option to improve economic growth via legislative action at a time when the alternatives no longer looks as attractive.

For much of the history of the United States, technology has driven economic growth. But, now that the United States has a technologically mature economy that can only become more technologically efficient with innovation, while our competitors can still simply adopt technologies invented elsewhere at a much lower cost, this is a hard way for the United States to grow.

Agriculture and manufacturing have become so much more dramatically efficient that even major gains in efficency still only modestly reduce the share of the economy devoted to creating the outputs that these industries generate. It is hard for efficiencies in the construction industry to make much of a difference when you have a glut of buildings for the medium term future. Better quality products of all kinds have reduced the need for people to fix things and maintain them.

Ultimately, part of the problem of political intervention is that the politicians leading the public debate on economics need to enrich the framework they use to talk about it. A debate framed as being between a "do nothing" position and a "government runs everything" position is doomed to failure. Both are bad choices.

We need to be able to recognize problems in the economy that call for government action, and problems in the economy that do not, and we need to develop a set of approaches that work to correcting problems that do require action. Legislating on economic issues is like gardening. Weeds keep cropping up, but if kept under control, the garden will thrive. But, the economy, like a garden, will no function to our advantage in the long term if left to its own devices.

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