Mitigating Agency Problems by Advertising, with Special Reference to Managed Health Care

Abstract

An agency conflict arises when consumers rely on middlemen for product recommendations. Although consumers want the middlemen to recommend the most suitable product, the middlemen may earn a higher profit if the consumer buys another product. One setting where this conflict arises is the managed health care market. Managed health care providers have an incentive to spend too little on prescription drugs. We investigate whether pharmaceutical manufacturers can use advertising to mitigate this agency conflict. Although advertising may induce health care providers to offer socially efficient medications, drug companies may not choose the socially efficient level of advertising. It will also pay for drug companies to inform consumers if they will not benefit from some drug, as this will increase the price that those who will benefit will be willing to pay. Manufacturers often sell their products to middlemen, who in turn resell the manufacturers' goods to consumers. Middlemen may serve as the agents of the manufacturers, the consumers, or possibly both of these groups. When they are agents of the manufacturers, middlemen typically promote, sell, and service the manufacturers' products. When they are agents of the consumers, middlemen supply product-related information and help consumers decide which product to buy. In this paper we study the conflict that arises in the agency relationship between consumers and middlemen. The source of the agency problem that we study lies in the information asymmetry between consumers (the principals) and middlemen (the agents). Our formal assumption is that consumers do not initially possess the information that they need in order to choose the best or most suitable products. Therefore, they must rely on their agents, the middlemen, for recommendations. But the middlemen wish to maximize their own profits, and this goal may conflict with their obligation to recommend the product that is optimal for consumers. If a conflict exists, the middlemen may try to influence consumers to use the most profitable product, rather than the product that the consumers would prefer. The parties involved in an agency relationship often find it profitable to take actions that mitigate the effect of the conflict of interests that inheres in their relationship. For example, the