Delegating Pricing Decisions

Abstract

An outstanding problem in marketing is why some firms in a competitive market delegate pricing decisions to agents and other firms do not. This paper analyzes the impact of competition on the delegation decision and, in turn, the impact of delegation on prices and incentives. The theory builds on the simplest framework of competition in two dimensions: prices and (sales agents') effort. Specifically, we are interested in answering the following questions: (1) Does competition affect the price-delegation decision and, if yes, why? (2) How do prices vary under price-delegation and no-price-delegation scenarios? (3) Do the incentives to the sales representatives vary under the delegation and no-delegation scenarios? To address these issues, we build a game-theoretic model that consists of two firms selling through their sales representatives. These representatives are company employees. Sales are a function of prices and selling efforts. The risk-neutral firms decide whether or not to delegate the pricing decision to risk-averse sales representatives. The wages to the sales representatives consist of salary plus a commission on gross margins. The commission on gross margins can be adjusted, either through communicated marginal cost of production, which we call “virtual” marginal cost, or directly. The firm and the sales representative are assumed to have the same information about the market, that is, there is no information asymmetry. With competition in two dimensions, the strategic nature of decision variable price depends on the relative intensity of competition. With unobservable contracts and risk-averse sales representatives, firms delegate the pricing decision when price competition is intense. Part of the uncertainty in demand is absorbed by the firm by keeping “virtual” marginal cost greater than the marginal cost of production. The competing firm infers this through the risk aversion of the sales representatives. Under price delegation the sales representatives' wages are higher, and they set a price that is higher than what the firms would have set themselves. This leads to softening of price competition that is to the advantage of both firms. When the effort competition is dominant, however, the firms prefer to make the pricing decision themselves, because this reduces the intensity of effort competition among agents. A single-instrument commission structure in which the firms adjust the “virtual” marginal cost is compared to a two-instrument commission structure in which the firms can adjust the commission rate, as well the “virtual” marginal cost. Under no price delegation, the two incentive schemes are the same. However, under price delegation the risk premium with the two-instrument scheme is lower. However, the prices and efforts are higher with the single-instrument scheme. When price competition is intense, the increase in risk premium with the single instrument scheme is more than compensated for by the increase in profits. This is the benefit of softening price competition through higher prices.