International Journal of Industrial Organization 43 (2015) 137–141

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International Journal of Industrial Organization

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Regulating commissions in markets with advice☆

Roman InderstGoethe University Frankfurt/Main

☆ Fundingwas provided by FIRM, an ERC Advanced Graand by DFG (Leibniz). I am thankful to the editor, Heskiearlier draft and, in particular, for inviting this presentatio

E-mail address: inderst@finance.uni-frankfurt.de.1 The case ended with a settlment under which Mar

Cummins and Doherty (2006) provide a detailed discussiokerage intermediation in the US insurance market.

2 In this paper, given its theoretical focus, I do not disting(financial) advisers or brokers, as definedby law indifferenciary duties and legal requirements imposed on particulasubstantially, so that, for instance, broker-dealersmay be etheir offer of advice is “solely incidental”. See, for instancesion of legal definitions, at least in the context of the US, asceive the different roles.

3 Cf. Financial Stability Board (2011).

http://dx.doi.org/10.1016/j.ijindorg.2015.05.0050167-7187/© 2015 Elsevier B.V. All rights reserved.

a b s t r a c t

a r t i c l e i n f o

Available online 2 June 2015

JEL classification:L51 (Economics of regulation)M52 (Compensation and compensationmethods and their effects)

Keywords:CommissionsAdvice

The paper explores the implications of regulating commissions in markets with advice. It provides a review ofrecent contributions dealing with policies that mandate disclosure, impose caps on commissions, restrict thesteepness of commissions, or require the deferral of commissions.

© 2015 Elsevier B.V. All rights reserved.

1. Introduction

Commissions for sales are common in many industries, both whencustomers are final consumers and when they are corporations. In par-ticular when these commissions are paid as undisclosed “kickbacks”,this practice has become heavily criticized in recent years, notably inthe financial and insurance industries.

As amotivation, take the recent lawsuit against the largest insurancebrokerage firm in the US, Marsh & McLennan Companies, which alleg-edly steered businesses towards insurers with which it had lucrative“contingent commission” (or “placement service”) agreements.1 Morerecently, the focus has been on cases of commissions paid to financialbrokers, such as mortgage brokers but also investment advisers.2 At aglobal level, the G20 leaders have put financial consumer protectionon the agenda, and the EU's Financial Stability Board has subsequentlymade a series of proposals, some of which have already beenimplemented.3

nt (“Regulating Retail Finance”),Bar-Isaac, for comments on ann for the EARIE 2014 meeting.

sh agreed to pay $850 million.n and empirical analysis of bro-

uish between different types oft jurisdictions. Clearly, thefidu-r financial intermediaries differxcluded from regulationswhen, Hung et al. (2008) for a discus-well as on how consumers per-

Another area of regulatory interest is that of health care. Medical ad-vice can be compromised by gifts or other inducements that physiciansreceive from pharmaceutical companies, for instance.4

An immediate way to rectify possible problems could be to increaseliability. To the extent that this requires a larger capital base (or, say, theposting of a “surety bond” to cover liability), this may, however, lead tothe exit of intermediaries, thereby increasing the market power of theremaining firms. Requiring a minimum qualification for advisers mayhave the same unintended consequences, and a higher qualificationwill clearly not prevent intentional mis-selling. Still another approachcould be the regulation of contracts with final consumers, e.g., throughgranting them a minimum statutory right of cancellation. This couldprotect consumers directly and it could have, in addition, an indirecteffect as firms have less incentive to mis-sell.5

In this paper, I focus exclusively on another regulatory instrumentthat is widely adopted: the regulation of commissions. Commissionsare regulated in various ways, and this paper does not encompass allpossibilities. Policies that the literature and ongoing work look atinclude the following:

1. A cap on commissions or the complete prohibition of commissions.2. The mandatory disclosure of commissions.3. Restrictions on the steepness of commissions.4. The mandatory deferral of commissions.

4 Commissions are also regulated in other sectors of the economy such as in the residen-tial rental market. There, brokers' function tomatch properties with potential tenantsmaybe also analyzed through the lenses of the subsequently presented analysiswhere advisersmake recommendations. See, for instance, Bar-Isaac and Gavazza (2014) for a recent em-pirical analysis of brokers' contractual arrangements.

5 Inderst and Ottaviani (2013) consider refund provisions in a model of advice.

138 R. Inderst / International Journal of Industrial Organization 43 (2015) 137–141

In the following sections, I consider policies 1–4 in turn.My focus lieson theoretical contributions, rather than on the (scarce) empirical evi-dence. Before proceeding with the discussion of the aforementionedpolicies, it should be noted that these policies clearly do not exhaustall (theoretical and practical) possibilities and that this paper does notintend to provide a comprehensive review.6 In the concluding remarksI also offer some thoughts on possible future research avenues.

2. Capping or prohibiting commissions

As of January 1st, 2013, the new rules of the UK's financial regulatordo not allow financial advisers to receive commissions from productproviders.7 That is, in terms of the presently considered policy 1, thisessentially imposes a cap of zero on commissions. Alternatively, onecould imagine also strictly positive caps on commissions.

2.1. Inefficient bias

Commissions have the potential to bias advisers towards a particularproduct that is, however, not in the best interest of consumers. In themost simple model, an adviser trades off the benefits from receivingcommissions with the benefits that he receives when providing advicethat is in the interest of consumers. The latter benefits can be intrinsic,e.g., due to altruism or the wish to adhere to a professional code ofethics, or they can arise more extrinsically from liability or the fear tolose reputation and future business.8

I provide a formal illustration of this within a toy model. This is usedalso subsequently. I consider two choice options, n = A, B, which pres-ently shall describe two different products. There are also two statesthat describe the needs of a particular consumer, θ = A, B. Theconsumer's gross utility from purchasing a product is denoted byvA,A = vB,B = vh when the product matches his state and by vA,B =vB,A = vl when this is not the case. I let Δv = vh − vl N 0. Ex-ante an in-dividual consumer is uncertain about the likelihood qwithwhich eitherof the two products is more suitable and I denote the respective distri-bution function by G(q). Instead, an adviser can observe the realizationof q and make a corresponding recommendation. To be specific, I sup-pose that q is uniformly distributed over [0,1].

The adviser receives a commission fn. The adviser's additional benefitsfrom making a recommendation are captured by two values uh N ul thatare realized when the purchased product turns out to be suitable or not.I suppose that a consumer follows the adviser's recommendation,whichwill hold in equilibrium (given the respective prices and consumerbeliefs about the quality of advice). DenoteΔu=uh−ul. This represents ameasure of howmuch the adviser cares about the suitability of his advice.

When observing a particular consumer's realization of q, theadviser's expected benefits from recommending product A are thusfA + ul + qΔu, while those from recommending product B arefB + ul + (1 − q)Δu. When there is an interior cutoff, this is thusgiven by

q� ¼ 12−

f A− f B2Δu

; ð1Þ

so that the adviser recommends A when q ≥ q⁎ and B otherwise. Thus,from the perspective of a consumer's expected (gross) utility alone,advice is biased whenever fA ≠ fB and thus q⁎ ≠ 1/2.

6 In the spirit of Bolton et al. (2007) one could imagine, for instance, a policy that wouldforce advisers to carry a broad portfolio of products, whichmay limit their incentives to bi-as advice so as to induce a purchase in the first place.

7 More precisely, this restriction applies to the sale of investment products such as pen-sions, annuities, and unit trusts. Notably credit products, such asmortgages, but also insur-ance policies are not affected.

8 The role of such extrinsic factors is clearly much more limited when the adviser is anemployee, given that then the firm would become the primary target (cf. Inderst andOttaviani (2009) for such a model).

Biased advice need however not always arisewhen commissions arepaid. In fact, when firms are symmetric, they will charge symmetriccommissions in equilibrium, so that the level of commissions does notaffect which of the products the adviser recommends. In expression(1) this is the case when commissions take on the same value fA =fB = f. With asymmetry, differences in commissions arise and affect ad-vice. A binding cap limits the scope for such asymmetry, which wouldthen lead to less biased advice from consumers' perspective, albeit –as is argued next – efficiency may decline.9

2.2. Efficient steering

Efficiency may be lower with a binding cap when commissions alsoserve to steer demand to the most efficient product. When higher mar-gins are earned by firms because of lower costs, then it is efficient to“bias” recommendations more towards these firms, which is the out-come when commissions are not constrained by regulation. When reg-ulation constrains commissions, the market share of a less efficient firmmay increase, thereby reducing efficiency. This is explored next.

When consumers are sufficiently wary, their willingness to pay for arecommendedproduct depends on the anticipated behavior of the advi-sor, that is on the cutoff q⁎ that consumers expect the advisor to apply. Isuppose now instead that consumers are naive: they expect the adviserto provide unbiased advice, e.g., as commissions are not disclosed and asthe possibility that the adviser receives commissions is simply not sa-lient at the time of purchase. When this is the case, product providerscan choose prices pn so as to extract the full expected consumer surplusconditional on an expected cutoff q̂� ¼ 1=2.10When G(q) is the uniformdistribution, I have

p� ¼ pA ¼ pB

¼Z q̂�¼1=2

0vl þ 1−qð ÞΔvð Þ dG qð Þ

G q̂� ¼ 1=2� �

¼Z 1

q̂�¼1=2vl þ qΔvð Þ dG qð Þ

1−G q̂� ¼ 1=2� �

¼ vl þ34Δv:

ð2Þ

A product provider's profit from a sale is then p∗ − cn − fn, wherecA ≤ cB represent constant unit costs. The respective expected profitswith a single consumer are then

πA ¼ p�−cA− f Að Þ 1−G q�ð Þ½ �;πB ¼ p�−cB− f Bð ÞG q�ð Þ: ð3Þ

With a uniform distribution I can solve for the respective bestresponses in commissions, fn, explicitly. I have11

f n ¼ p−cn−Δu þ f n0

2: ð4Þ

I obtain, after substitution of the equilibrium fees, for an interiorequilibrium

q� ¼ 12þ cA−cB

6Δu: ð5Þ

Suppose that the respective payoffs ul and uh for the adviser repre-sent mere transfers, e.g., arising from liability or penalties. Aggregateefficiency is then maximized when a cutoff qFB is applied at whichthe expected total payoff from producing and selling product A,

9 These results follow from Inderst and Ottaviani (2012a), which is reviewed below.10 This assumes that consumers have no other alternative to purchase the consideredproducts, so that the advisor is a gatekeeper for these products.11 Precisely, I have for A the first-order condition p− cA− fA=2Δu[1− G(q∗)]/f(q∗) andcan then substitute q⁎ from (1).

15 Inderst and Ottaviani (2012b) show aswell, however, that a binding cap can decreaseefficiency when consumers have rational expectations. Interestingly, even then commis-sions (albeit often combined with lump-sum payments) will arise in equilibrium, as theyserve to induce information acquisition by advisers.16 Some of the recently introduced regulation in the US mortgage industry may be in-spired by these considerations. In September 2010 an amendment of Regulation Z (Loan

139R. Inderst / International Journal of Industrial Organization 43 (2015) 137–141

vl + qΔv − cA, equals that from producing and selling product B,vl + (1− q)Δv − cB:

qFB ¼ 12þ cA−cB

2Δv: ð6Þ

From a comparison of q⁎ in (5) and qFB in (6) we can determinewhen the outcome is efficient and when not. When Δu = Δv, sothat the adviser's preferences regarding the products' “fit” perfectlymatch those of consumers, there is underprovision of the more effi-cient product: cA b cB implies qFB b q∗ b 1/2. There is overprovision ofproduct A, for which the respective product provider pays highercommissions, only when Δu b 3Δv.

The rationale for these results is as follows. Steering the agenttowards a firm's product is costly. Moreover, a marginal increase inthe commission involves higher expected costs for a firm when the re-spective product ismore likely to be sold, i.e., for thefirm sellingproductA when q⁎ b 1/2. The firm benefits “at the margin”, i.e., when q = q⁎ isrealized, as then the shift in q⁎ increases the likelihood with which theproduct is ultimately sold. But for all “inframarginal” values q N q⁎ the in-crease in the commission represents only additional rent for the advis-ing agent. The resulting trade-off that each firm faces resembles thatof a firm considering reducing prices so as to increase sales.12

I turn now to the possibility of an overprovision of product A. Thisfollows from the fact that when commissions are not observable, thenconsumers will not react to a change in commissions: the price that afirm can then charge remains the same. As the margin that firm Aearnswill be larger than that offirm B, the incentives offirmA to expandsales are thus higher. The two described forces, leading potentially tounder- or overprovision of the more efficient product, exactly balancewhen Δu = 3Δv.

This preceding argument emphasizes a more general and importantprinciple: in markets where intermediaries play a role in directing con-sumers to different products, e.g., through the provision of advice,asymmetric commissions across different products can have the effi-ciency enhancing role of steering demand towards more efficientproducts.

2.3. Naivité

When consumers naively fail to adequately perceive either the valueof firms' offerings or the possibility of potentially biased advice, it seemshowever more likely that a cap on commissions can be beneficial.Inderst and Ottaviani (2012b) consider a model where advisers can bepaid by a combination of commissions and a lump-sum fee fromconsumers.13When consumers are naive about the effects that commis-sions have on advisers' recommendations, then only commissions, butnot lump-sum fees, will arise in equilibrium.14 The reason for this isthat while consumers correctly assess the costs of (higher) lump-sumfees, they underestimate the costs related to higher commissions, asthese are associated with higher product prices.

In the previously introduced model, consumers may thus naivelybelieve that the adviser applies the threshold q̂� ¼ 1=2, though thetrue threshold q⁎ is different. Even when consumers do not observecommissions, these beliefs may still be described as being naivewhen consumers should infer that, given a higher price for one ofthe products, the respective provider should also pay a highercommission. Suppose that product A was more expensive and that,

12 In anoligopolistic setting,when demand is symmetric it is also typically found that themarket share of the more (cost) efficient product is inefficiently low in equilibrium.13 In Gravelle (1994) the choice between up-front payment and commission trades offtwo monopoly pricing problems. In Stoughton et al. (2011) kickbacks paid to portfoliomanagers enable price discrimination across investors with more or less wealth.14 Misperceptions about incentives and their impact on the recommendations of a self-interest adviser may also explain why some consumers take sales talk at face value. Suchcredulity has been assumed in Ottaviani and Squintani (2006) or Kartik et al. (2007).

through a higher commission, advice was tilted towards A asq⁎ b 1/2. With a uniform distribution, consumers would thus expectto be advised to purchase product A with probability 1/2, while thetrue probability was higher by the difference q⁎ − 1/2 N 0. Whenthe price difference between the two products was Δ N 0, consumerswould thus underestimate their expected payment by Δ(q∗ − 1/2).Such an underestimation of the expected “costs” of advice does notoccur with a lump-sum payment for advice. This generates forfirms an incentive to reduce direct payments for advice and increaseproduct prices, instead. In equilibrium, consumers would only payfor advice through higher product prices and advisers would receivecommissions instead of lump-sum fees.

Under the described circumstances, a cap on commissions wouldsteer the industry towards direct payments for advice, which enhancesefficiency when consumers are naive about advisers' incentives.15

Another case of naivité is that where consumers misperceive the valueof products. Then, firms with products whose value consumers overes-timate more will have greater incentives to pay commissions, so thatrecommendations become biased towards more deceptive products(Murooka, 2013).16

3. Mandatory disclosure of commissions

Turning to policy 2, a disclosure requirement represents a morelight-touch form of regulation, notably as the size of commissions isthereby not restricted. For instance, in the European Union, since Janu-ary 2008 the disclosure of commissions on retail financial products hasbecome mandatory.17 When consumers are aware of firms' incentives,including those of advisers, disclosure limits product providers' incen-tives to steer advice, as consumers will then discount the value of arecommended product accordingly. Inderst and Ottaviani (2012a)show that such a dampening of commissions can have both beneficialand detrimental implications for welfare. The intuition for this isprovided below.

To the extent that consumers are, however, naive aboutfirms' incen-tives unless commissions are disclosed (“eye opener”), there should bean immediate positive effect of disclosure.18 To illustrate this, take theprevious model and suppose that, in equilibrium, firms set differentcommissions, e.g., fA N fB as cA b cB. Then, naive consumers may holdthe beliefs that advice is unbiased with q̂� ¼ 1=2, while in fact the truecutoff is q⁎ b 1/2. In the presently analyzed setting, product providersand the adviser jointly extract all of consumers' anticipated surplus. Tosee this precisely, note that the true expected surplus (gross of prices)is given by

Z q�

0vl þ 1−qð ÞΔvð ÞdG qð Þ þ

Z 1

q�vl þ 1−qð ÞΔvð ÞdG qð Þ;

while firms set prices p⁎ so as to extract the conditional surplus thatnaive consumers expect under unbiased advice (cf. (2)). Taken togeth-er, with a uniform distribution this yields for naive consumers an ex-pected detriment (negative utility) of [(q∗)2 − q∗ + 1/4]Δv. This is

Originator Compensation and Steering 12 CFR 226) was published that prohibits variouscompensation practices. Notably, compensation for mortgage brokers should not be con-ditioned on the terms and conditions (other than size) of a loan.17 Markets in Financial Instruments Directive (MiFID). In the US, in November 2008 theUS Department of Housing and Urban Development imposed stricter disclosure require-ments for third-party brokers in the mortgage market.18 Notably in face-to-face situations, however, even disclosed commissions may not be-come a salient factor in consumers' decisions (cf. the experimental and survey evidence inChater et al., 2010).

140 R. Inderst / International Journal of Industrial Organization 43 (2015) 137–141

clearly equal to zero only when the true cutoff was indeed q⁎ = 1/2.Consumer detriment is instead highest and equal to Δv/4 when q⁎ = 0or q⁎ = 1.

When consumers are, in principle, aware that advisers are self-interested and that product providers have incentives to pay commis-sions, the potential negative implications of disclosure are, however,more subtle and analogous to those of a binding cap on commissions(cf. above).19 Disclosure reduces product providers' incentives to paycommissions, as consumers will lower their willingness to pay for aproductwhen they observe a higher commission and anticipate a great-er bias in advice. Thiswill affectmore negativelymore efficient productswith a larger market share, as the resulting discounted price is appliedto a larger number of units (or, in the present model, to a larger likeli-hood of a sale, e.g., 1−G(q∗)=1− q∗ for productA). Disclosure of com-missions would then always reduce the market share of the moreefficient product. This decreases, rather than increases, efficiency unlessthe more efficient product was overprovided when commissions arenot disclosed. Recall from above that such overprovision only resultswhen the adviser's and consumers' incentives are not sufficientlyaligned (that is, when Δu b 3Δv).

4. Restricting the steepness of commissions

Incentive contracts that prescribe a discontinuity, e.g., through thepayment of a fixed bonus when a certain sales threshold has beenreached, are ubiquitous in practice. They have received a theoreticalfoundation in the literature that studies contract design with unobserv-able actions (moral hazard; cf. notably Innes, 1990). The literature hasalso documented, however, that such contracts can have negative impli-cations for firms, notably in a dynamic environment, given that agentsmay then take unwanted actions towards the end of the prescribed pe-riod, so as to thereby (just) fulfill the qualifying requirement for a bonus(Holmstrom and Milgrom, 1987).20

Given the perspective of this paper, I ammore interested in the non-internalized consequences that such nonlinear incentives may have onconsumers and efficiency. These may then generate scope forregulation.21 To analyze the potential implications of non-linear incen-tive contracts, I now extend the preceding framework and considerthe case where two different customers, instead of just one, receive arecommendation. Consequently, the respective incentive scheme canpay a different overall commission depending on whether none, one,or two units of the respective product were sold. I suppose that the ad-viser must apply the same cutoff rule q⁎ to both customers. One justifi-cation of this could be that the two customers receive recommendationsfrom two different advisers that are, however, employed by the samefirm. The analyzed compensation schemewould then apply to the advi-sory firm as a whole. To streamline the exposition, I now assume thatonly product A is incentivized, e.g., as product B represents the optionof not purchasing at all.

I suppose first that incentives have to be linear. That is, when I de-note by nA the number of units of product A that are sold, then the re-spective incentive scheme of firm A is given by nAfA, for some fA ≥ 0.Then, the number of advised consumers, that is now two instead ofone, just scales up the respective profits and it is intuitive that the out-come is the same irrespective of whether one or two consumers are ad-vised. In particular, what is independent of the number of advised

19 In the literature, also other potential drawbacks of disclosure have been discussed, no-tably that this may lead to consumer information overload (e.g., Lacko and Pappalardo,2004) or a greater bias as it provides “moral licensing” to advisers (Cain et al., 2005).20 For two notable empirical studies documenting such “gaming” see Oyer (1998) andTzioumis and Gee (2013).21 It seems that such regulation is imposed more informally in practice, e.g., throughchecks on whether firms exert due diligence in complying with imposed general stan-dards of good behavior. This seems, for instance, to be the present policy of the UK'snew watchdog for financial consumer protection. Cf. the guidance given in http://www.fca.org.uk/static/documents/thematic-reviews/tr14-04.pdf.

consumers is the product provider's (marginal) cost to induce theagent to choose a given cutoff q⁎. Instead, when the product provideris allowed to use nonlinear incentives, not only the overall cost of com-pensation cost is lower, but also the marginal cost of compensation.22 Imake this now more formal.

For this denote the cost of product provider A to induce a cutoffq⁎ b 1/2 by KR (q⁎) when compensation is regulated to be linear andby KNR (q⁎) when compensation can be nonlinear. The respective costsKR (q⁎) with regulation follow immediately from the first-order condi-tion (1) for q⁎. Precisely, using that now fB=0, the required commissionfA is given by fA=Δu(1− 2q∗), so that the expected compensationwhenthere are two consumers, 2fA[1− G(q∗)], becomes

KR q�ð Þ ¼ 2Δu 1−2q�ð Þ 1−q�ð Þ: ð7Þ

Turn now to the optimal compensation when there are no regulato-ry restrictions. The optimal incentives then prescribe a positive com-pensation only when two units of product A are sold (i.e., to bothconsumers). The intuition is straightforward. For this note first thatwhile the adviser is by definition indifferent at q⁎, for all q N q⁎ he strictlyprefers to recommend product A. In standard terminology, the adviserthus obtains an agency rent for all q N q⁎.23 The optimal compensationscheme thus reduces, for given q⁎, this agency rent.

Denote now the bonus that is paid under the non-linear incentivescheme by FA. When the adviser applies the threshold q⁎, he earns thebonus with probability [1− G(q∗)]2, so that overall his expected utilityis

U ¼ ½1−Gðq�Þ�2 FA þ 2ul þ 2Δu

Z q�

01−qð ÞdG qð Þ þ

Z 1

q�qdG qð Þ

" #:

From the first-order condition I obtain, with a uniform distribution,

q� ¼ 12−

FA2Δu

1−G q�ð Þ½ �: ð8Þ

As the expected compensation is now KNR(q∗) = FA[1 − G(q∗)]2,solving (8) for FA yields

KNR q�ð Þ ¼ Δu 1−2q�ð Þ 1−q�ð Þ: ð9Þ

Comparing finally the two costs of compensation, (7) and (9), I thushave that KR(q∗)= 2KNR(q∗), so that also themarginal cost of pushing q⁎further down when compensation is regulated is twice that when it isnot regulated. The upshot of this is that this again dampens the productprovider's incentives to steer advice. As previously noted, this increasesconsumer surplus and welfare when the adviser's bias is too high, but itcan reduce efficiency when it inefficiently stifles the sales of product A.

5. Mandatory deferral of commissions

Whether a purchase or signing a contract was a good decision for aconsumer is oftenonly revealed over time. This applies tomany physicalconsumer good, but also to many retail financial and insurance con-tracts. For instance, a consumer will only find out over time whetherhe can indeed afford the installments of a loan or the arranged monthlyinvestments into a capital life insurance. One way to protect consumersis to prescribe a minimum cancellation period, provided it is reasonableto assume that themarket outcomewill not lead to the efficient contrac-tual terms in thefirst place.24 Also firms can grant consumers protection

22 This is taken from Inderst (2014).23 In fact, recall that this agency rent was also the reason for why, in our discussionabove, a more efficient firm may end up with an inefficiently low share of the market.24 Inderst and Ottaviani (2013) consider such regulation in a model of advice. Hoffmanet al. (2014) consider the optimal joint regulation of refund level and refund period in amarket environment, albeit there is no role for advice in their model.

141R. Inderst / International Journal of Industrial Organization 43 (2015) 137–141

through generous terms of return and refund as well as warranties. Inwhat follows, I do not discuss how an optimal policy that could combinethese elements with compensation regulation would look like, whichseems to be still an open question (cf. also below).

In terms of compensation regulation alone, to better align aconsumer's interest with those of the respective intermediaries, com-pensation for the intermediaries could be deferred, so that it is paidonly when, for instance, a contract was not cancelled or a consumerdid not complain within some specified time (policy 4).

Hoffman et al. (2013) consider the contracting problem between afirm and an agent when the agent has both to exert effort to acquire acustomer and to exert diligence to ensure that ultimately no “bad out-come” is realized in the future. While their model is tailored more toregulation in banking, where the “bad outcome” generates a (potential-ly “systemic”) externality on third parties, the results can be appliedmore widely, notably also to the case where such an externality is im-posed on the customer (e.g., through personal bankruptcy). The keyfinding in their paper is that a bindingmandatory deferral of compensa-tionmay not always lead to higher equilibrium diligence but that it mayinstead backfire by making it profitable for a firm to induce a strictlylower level of diligence.25 The rationale for this is that such amandatorydeferral may increase the marginal costs of implementing a higher dili-gence level, given that the higher compensation that then needs to bepaid must now be delayed longer, which is costly when the agent isless patient than the firm. Their results suggest that regulation is morelikely to be beneficial, however, when the same agent undertakes boththe task of customer acquisition and that of exerting diligence(e.g., through advice and product selection), when the task of customeracquisition is more important, when there is more competition for cus-tomers, or when the firm itself has relatively low (self-)interest in dili-gence (e.g., because of low liability standards).

6. Concluding remarks

In this article I have reviewed some recent contributions that consid-er the regulation of commissions in markets with advice. Various poli-cies can limit the use of commissions or dampen the impact that theycan have on advisers' recommendations, such as a cap or an outrightprohibition, mandatory disclosure, restrictions on the steepness of in-centives, or their mandatory deferral. One of the key insights is thatthis may however not always increase welfare. In fact, when commis-sions serve a welfare enhancing role, such as to steer recommendationsto more efficient products, such policies may generate or aggravate aproblem of underprovision of incentives. The positive role of commis-sions is frequently overlooked notably in policy debate.

To my knowledge, the academic literature has so far however failedto provide a more comprehensive account of the various regulationsthat constrain advisers and their incentives and that affect also the de-sign of products. Under which circumstances should regulation imposea mandatory deferral of compensation in addition to a statutory mini-mum contract cancellation period for consumers? Alternatively, whenshould only the structure of commissions be regulated, rather thantheir absolute size? Should regulators care at all about “micromanaging”commissions and therefore restricting contractual freedom, rather thanimposing stricter liability to better align incentives of consumers andfirms?

Further, I have focussed on one particular role of the intermediarywho receives inducements,26 namely to provide advice. Generally,an intermediary may perform very different roles that make it opti-mal for a firm to pay commissions. Notably the theory of Industrial

25 Suchmandatory deferral of compensation for intermediaries is not uncommon, for in-stance, in the insurance industry, where regulation may limit the size of the initial com-mission, while the rest of the compensation must be deferred (“trail commission”).26 I do not consider alternative ways, other than through payments, how product pro-viders could influence advice, e.g., through strategic information provision as in Li (2010).

Organization has largely ignored the role of these intermediaries inits models, focusing on prices and advertising as firms' strategic var-iables, rather than also on the compensation of the firm's sales force.In many industries, both for consumer as well as for industrial goods,salespeople and advisers play however an important role and firmsmake inducements so that they adequately perform these roles,such as to inform consumers about the existence of certain productsor to lower their transaction costs.27 One possible avenue for furtherresearch could thus be to incorporate both prices as well as salesforce incentives as strategic variables in an oligopolistic model ofcompetition.

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27 There are some notable contributions in the marketing literature that consider com-pensation for sales agents. However, this literature has traditionally focused on the classictrade-off between risk-sharing and incentives (e.g. Basu et al., 1985). A notable exceptionthat is close to the theme of this paper is Kalra et al. (2003), where the credibly disclosedchoice of commissions is used to signal a product's quality.