Cecil Bohanon and John Horowitz: Commissions are good incentives, but they come with trade-offs

The principal-agent problem is a powerful economic concept. One party, the principal, desires the other party, the agent, to engage in an activity for the principal’s benefit. But once the two sides reach an agreement, how does each party ensure the other keeps their side of the bargain?

Relying exclusively on the rectitude of the other party is probably naïve. Economists recognize that various rules and institutions typically emerge that establish incentives to deal with the problem. However, economists also note that those rules usually open the door to other problems that never completely resolve the tension nor “solve” the problem.

Consider rewarding employees by paying them commissions on sales. For example, real estate agents are typically compensated with 3% to 6% commissions. This creates an incentive to work harder and sell at higher prices. However, a $10,000 increase in the sales price of a house yields the agent an additional $300 to $600 but $9,700 to $9,400 to the client.

Several empirical studies find that real estate agents sell their own houses for about 3% to 5% more than they do for clients’ houses with similar attributes. They also take nine to 10 extra days to sell their houses with similar attributes. Working harder to sell their own homes doesn’t imply that real estate agents are dishonest or immoral. It simply means incentives matter. A 100% take of a higher sales price is greater than a 5% take.

Likewise, recruitment consultants typically earn 15% to 30% of the first-year salary of job candidates they place. Commissions incentivize recruiters to focus on rapid placements, reducing the cost of unfilled positions. Commissions also mean recruiters make more money if they focus on higher-income positions and mobile people whom they think they can quickly place in new positions. Typically, recruiters don’t earn a commission on internal promotions, motivating them to recommend external hires.

In addition, commissions can lead salespeople to focus on short-term and aggressive sales practices. Salespeople might oversell their products and resort to manipulative and deceptive sales practices. Sales might increase for such operators, but consumers learn not to trust salespeople and avoid them, to the detriment of honest salespeople. Firms might add quality metrics to determine their sales agents’ ultimate compensation.

Nevertheless, commissions are commonly used despite their flaws, suggesting they serve an essential market function. They might better align the incentives of the principals and agents than do other compensation mechanisms. As always, there are no “solutions” to the principal-agent problem, just trade-offs.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to [email protected].