Abstract:

We propose and estimate a moral hazard model for contacts in business selling context, where manufacturers of industrial materials hire outside independent sales organizations as their representatives ("rep firms") to sell products to business customers. In return, rep firms receive commissions on realized sales. The question we address in this research is whether the observed commission rates are set at the optimal level, and if not, what are the economic consequences. This is different from most previous empirical contracting work which tests comparative statics predictions derived from theoretical models that impose optimality on manufacturers. A unique feature of the data is that we have a measure of salespeople's effort obtained from surveys. The effort data allow us to build a realistic model where salespeople have better information than the manufacturer about the opportunities in the field. Our empirical results show that optimal commission rates are twice as high as what are observed in the data, and that manufacturers could achieve greater profits by adopting the proposed rates.