Double Marginalization: A Final Integration Consideration

When a firm with market power (e.g., an input supplier) contemplates vertical integra- tion with another firm with market power (e.g., a manufacturer), it needs to consider one additional factor known as double marginalization. Recall from the Economics

Real-World Evidence • 145

EXAMPLE 4.3 VERTICAL INTEGRATION OFTHE SALES FORCEIN THE INSURANCE INDUSTRY

In the insurance industry, some products (e.g., whole life insurance) are usually sold through in-house sales forces, while other products (e.g., fire and casualty insurance) are mainly sold through independent brokers. The Grossman/ Hart/Moore (GHM) theory helps us understand this pattern. Relying on independent agents versus in-house sales employees is essentially a choice by the insurance firm for nonintegration versus forward integration into the selling function. This choice determines the ownership of an extremely important asset in the process of selling insurance: the list of clients. Under nonintegration, the agent controls this key asset; under forward integration, the insurance firm controls it.

If the agent owns the client list, the agent controls access to its clients; clients cannot be solicited without the agent’s permission. A key role of an insurance agent is to search out and deliver dependable clients to the insurance company, clients who are likely to renew their insurance policies in the future. To induce an agent to do this, the commission structure must be “backloaded,” for example, through a renewal commission that exceeds the costs of servicing and re-signing the client. When the insurance company owns the client list, however, this commission structure creates incentives for the company to hold up the agent. It could threaten to reduce the likelihood of renewal (e.g., by raising premiums or restricting coverage) unless the agent accepts a reduced renewal commis- sion. Faced with the possibility of this holdup problem, the agent would presumably underin- vest in searching out and selling insurance to repeat clients. By contrast, if the agent owned the client list, the potential for holdup by the insurance company would be much weaker. If the company did raise premiums or restrict coverage, the agent could invite its client to switch companies. Threats by the company to jeopardize the agent’s renewal premium would thus have considerably less force, and underin- vestment in the search for persistent clients

would not be a problem. In some circumstances, the holdup problem could work the other way. Suppose the insurance company can engage in list-building activities such as new product development. The agent could threaten not to offer the new product to the customer unless the insurance company paid the agent a higher commission. Faced with the prospect of this holdup, the company is likely to underinvest in developing new products. By contrast, if the insurance company owned the list, this type of holdup could not occur, and the insurance com- pany’s incentive to invest in new product devel- opment would be much stronger.

This suggests that there are trade-offs in alternative ownership structures that are similar to those discussed above. According to the GHM theory, the choice between an in-house sales force versus independent agents should turn on the relative importance of investments in developing persistent clients by the agent versus list-building activities by the insurance firm. Given the nature of the product, a pur- chaser of whole life insurance is much less likely to switch insurance companies than, say, a customer of fire and casualty insurance. Thus, the insurance agent’s effort in searching out persistent clients is less important for whole life insurance than it is for fire and casualty insurance. For whole life insurance, then, back- loading the commission structure is not critical, which diminishes the possibility of contractual holdup when the insurance company owns the client list.

The GHM theory prediction that whole life insurance would typically be sold through an insurance company’s in-house sales force is con- sistent with industry practice: most companies that offer whole life insurance have their own sales forces. By contrast, for term life or substan- dard insurance, the agent’s selling and renewal- generation efforts are relatively more important. Consistent with the GHM theory, many insur- ance companies rely on independent agents who own the client list to sell these products.

Primer that a firm with market power sets its price above marginal costs. Double mar- ginalization results when an upstream supplier exploits its power by marking up prices above marginal costs, and the downstream buyer exploits its own power by applying yet another markup to these already marked-up supply prices. This “double markup” causes the price of the finished good to exceed the price that maximizes the joint profits of the supplier and buyer. (As explained in the Economics Primer, a firm with market power can charge a price that is so high that its profits fall.) Through integration, the downstream firm can base its markup on the actual marginal costs of production, rather than the artificially inflated supply prices set by the independent supplier. In this way, the integrated firm uses just the right amount of market power and maximizes its profits. Although the concept of double marginalization receives considerable attention in microeconomics textbooks, very few mergers appeared to be undertaken to address this problem.

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There are a variety of alternatives between “make” and “buy.” In this section we consider four “hybrid” ways of organizing exchange: (1) tapered integration, in which the firm both makes and buys a given input; (2) franchising; (3) strategic alliances and joint ventures; and (4) close-knit semiformal relationships among buyers and suppli- ers, often based on long-term implicit contracts that are supported by reputations for honesty, cooperation, and trust. Each of these alternatives offers a different way to assign ownership and control of assets and creates distinct governance mechanisms. Thus, each offers a distinct resolution of the various trade-offs in the make-or-buy decision.