17 Jan 2014  Working Papers

Price Coherence and Adverse Intermediation

Executive Summary — In modern markets, buyers can often buy the same good or service directly from a seller, and through one or more intermediaries, all at the same exact price. Buyers respond by choosing whichever intermediary offers the greatest benefit - perhaps a rebate, some kind of "points," or superior service. Importantly, buyers ignore the fees that intermediaries charge to sellers. The resulting outcomes can be distortionary and welfare-reducing. In particular, as intermediaries compete to attract buyers, they can set benefit levels so high that no net value is created and, sometimes, that buyers and seller would be jointly better off without intermediaries. The study examines six markets in which intermediaries are prominent: travel booking networks, credit and debit cards, insurance brokers and financial advisors, malls and marketplaces (such as Amazon Marketplace), cashback and rebate services, and search engine advertising. In each instance, a law, norm, intermediary policy, or similar rigidity prevents sellers from passing an intermediary's fees to the specific buyers who choose to use that intermediary. Key concepts include:

  • Due to a market failure caused by the structure of the relationship between buyer, seller, and intermediary when buyers face a single price, intermediaries can thrive even when they offer little or no actual value.
  • By offering benefits to buyers, at no direct charge to buyers, intermediaries cause excessive usage of their services: usage which then lets intermediaries extract significant fees from sellers, indeed beyond even the normal monopoly fees.
  • Buyers ultimately pay for intermediaries' services via increased prices charged by sellers. But an individual buyer cannot escape the cost by declining the intermediary's service since he or she will pay the same price anyway.
  • Competition among multiple intermediaries does not necessarily improve welfare. When intermediaries compete by offering larger benefits to buyers, greater competition can actually exacerbate the distortions and make things worse.

 

Author Abstract

Suppose an intermediary provides a benefit to buyers when they purchase from sellers using the intermediary's technology. We develop a model to show that the intermediary will want to restrict sellers from charging buyers more for transactions it intermediates. We show that this restriction can reduce consumer surplus and welfare, indeed sometimes to such an extent that the existence of the intermediary can be harmful. Specifically, lower consumer surplus and welfare result from inflated retail prices, over-investment in providing benefits to buyers and excessive adoption of the intermediaries' services. Competition among intermediaries intensifies these problems, increasing the magnitude of their effects and also broadening the circumstances in which they arise. We discuss applications to travel reservation systems, payment card systems, marketplaces, rebate services, search engine advertising, and various types of brokers and agencies.

Paper Information