Distribution Systems and Operating Leverage

Abstract

This paper presents a model in which firms compete in a Cournot-Nash game. Firms can choose an exclusive agency (EA) or an independent agency (IA) distribution system. Firms can enter and exit the market and switch distribution systems with no cost. The only difference between an EA system and an IA system is the operating leverage or cost structure. An EA firm incurs low (per unit) variable cost but high fixed cost. An IA firm incurs high variable cost but low fixed cost. Under the different operating leverages, we investigate the equilibrium outcome in which no entry, no exit, and no switching occur. We find that coexistence is possible when IA firms are less efficient than EA firms. IA firms can dominate in the market even if IA firms are inefficient. An EA firm produces more than an IA firm. IA firms tend to dominate more in high risk lines than in low risk lines. We provide numerical examples showing how an inefficient system can survive and even dominate in the market.