CONCLUSION
Like the tension between creating and distributing value, our second tension between empathy and assertiveness must be managed. The most skilled negotiators have a broad repertoire of interpersonal skills. They can both listen well and speak persuasively. These basic communication skills lay the best foundation for problem-solving.
3
The Tension between Principals and Agents
Sam Walsh is about to sell his house and move to Arizona to retire. He bought the house eight years ago when the real estate market was in a slump. The market is booming now, and some of his friends have recommended that he sell his home without a real estate agent. Sam has seen books that describe how to advertise a house, how to conduct a successful open house, and how to negotiate with a potential buyer through the process of offer and acceptance, purchase and sale, and closing. And of course the Internet now offers new possibilities for listing one’s home. Given all these resources and a booming market, Sam thinks perhaps he could sell his house fairly quickly and for a good price by himself, without paying an agent’s 6 percent commission.
But Sam isn’t so sure that the savings are worth all that effort and anxiety. Granted, real estate agents are expensive, but what if selling independently doesn’t go well? And it seems like an awful hassle. Wouldn’t it be easier to let an agent handle all the details? And more comfortable not to have to do all that negotiating with the buyer?
Sam calls a family friend who recently bought property in the neighborhood and asks her whether she liked her real estate agent. “Sure,” the friend says. “She’s a great agent—her name is Betty Ortiz. Give her a call. She’ll help you out.”
THE GOAL: REAPING THE FULL BENEFITS OF HIRING AN AGENT
Sam wonders whether hiring a real estate agent will provide a net benefit in the sale of his home. On the one hand, maybe an agent will sell his home more quickly and for more money than he could otherwise get. If he doesn’t use an agent, maybe his home will sit unsold for months. But on the other hand, maybe the agent won’t earn her commission and will end up costing Sam money. How should Sam decide what to do? How will his decision about hiring an agent affect the sale of his home? Moreover, if he hires an agent, how should he negotiate the terms of that relationship?
Agency relationships are everywhere. We constantly delegate authority to others so that they may act in our place. We ask lawyers to represent us; we give money managers authority to make our investments; we ask doctors to take responsibility for our medical care; we depend on employees to do the work we assign; and we elect public officials to legislate on our behalf. Indeed, it is hard to imagine how society could function at all without agents acting on behalf of principals—diplomats on behalf of nations; labor leaders on behalf of unions; sports agents on behalf of players; literary agents on behalf of authors.
When a principal hires an agent to act on his behalf in negotiations across the table with another party, he may expect—naively—that the agent will be motivated solely to serve the principal’s interests. This is how principal-agent relations would work ideally. But in the real world, agents always have interests of their own. As a result, the principal-agent relationship is rife with potential conflicts that demand skillful management behind the table.
For example, a client and his lawyer may need to negotiate how the lawyer will be paid; how the other side will be approached; what information will be sought from or disclosed to the other side; at what point to accept the other side’s offer, and so on. If these issues are left unacknowledged and unaddressed, they can adversely affect the negotiation across the table. For all of these reasons, effective negotiation requires a good understanding of the benefits and risks of the agency relationship and how it can best be managed.
Agency Benefits
Why are agency relationships so pervasive in negotiation? Because an agent can provide significant benefits to her principal. These benefits derive from four sources:
• Knowledge: An agent may have specialized knowledge—that the principal lacks—about market conditions, formal or informal norms, or relevant risks and opportunities. An investment banker will know potential buyers for her client’s company, for example, and may be better able to price the deal.
• Resources: An agent, by reason of his reputation and relationships, may be able to provide access and opportunities that would otherwise be unavailable. For example, a well-known literary agent can get a publisher to read a new author’s manuscript, and later negotiate favorable deal terms, because of the agent’s reputation for having good judgment.
• Skills: An agent may be a better negotiator than the principal, whether owing to experience, training, or natural ability. A client may hire an attorney to negotiate a settlement or a deal, for example, because the client believes that the lawyer will be more effective.
• Strategic advantages: An agent may be able to use negotiation tactics on behalf of the principal in a way that insulates the principal from their full impact. The principal can remain the “good cop” while the agent plays the bad cop. For example, a sports agent can engage in hard-bargaining tactics with the team’s general manager while the player remains on good terms with the team. Conversely, a collaborative agent may be able to settle a dispute with an agent on the other side even if the principals are in conflict.
In many cases, the agent will be able to do things the principal could never do on his own, and the possibility for both the principal and agent to benefit from trade between them is clear. The agent may have an absolute advantage over the principal with respect to those activities. In Sam and Betty’s case, Betty may have skills, knowledge, and resources that Sam lacks. But economic theory suggests that even if Sam knows as much—or more—about selling residential real estate as Betty, that doesn’t necessarily mean that he should sell his house himself. The economic principle of comparative advantage dictates that there can be gains from trade when each party (whether a person, firm, or country) specializes in the production of goods and services for which that party’s opportunity cost is lower. If Sam’s opportunity costs are high, it may be more efficient for Sam to hire Betty as his agent and spend his time doing what he does best.
Imagine that Sam has decided to talk to Betty about whether to hire her. They meet at his home on a Saturday afternoon. Betty walks through the house, noting approvingly many of the details and features that might raise the selling price. As Sam gives Betty a tour, she asks him all sorts of questions—about the square footage of the house, when he purchased it and what he paid for it, the age of the appliances and heating system, the condition of the roof, any electrical work or other upgrading he might have done. By the time they sit down to talk, Betty has a fair picture of the investment that Sam has made.
BETTY: Well, it’s a beautiful property. You obviously care a great deal about your home. The kitchen is lovely—you made a wise choice to remodel there. I think you should do very well, given the way houses are selling this season. The first thing we would need to do is agree on a listing price and a date to put the house on the market. I’d suggest sooner rather than later. As for a price, I’ve brought some information we can look at.
SAM: That’s great. But before we get into the numbers, I wondered if we could talk about your services. To be honest, I’m still trying to decide whether to retain an agent at all, rather than sell the house myself.
BETTY: Oh, sure. No problem. I would definitely go with an agent, but then I’m biased. But let me tell you the sorts of advantages having an agent brings.
In describing the role she will play for Sam in the transaction, Betty emphasizes the sorts of benefits described above. First, Betty says she can help Sam get the best possible price for his house. “Setting the right asking price is critical,” Betty says. “I know the market.” She’s brought lots of information showing recent sales in his neighborhood and town, recent trends in the market, and detailed comparables that she would use to justify whatever price they ar
rive at. “It’s not easy setting just the right price,” Betty says. “Too low and it’s easy to sell but you don’t get full value. Too high and you can scare off potential buyers. Or if you do find one, the bank won’t finance their mortgage.”
Betty then describes her approach to marketing and shows Sam a few sample brochures of other houses she has sold recently. She also emphasizes how her relationships might benefit Sam. “I have some clients of my own who might be interested, and I know every important broker in town,” she explains. She tells Sam that after putting his house on the market she would first bring a caravan of other real estate brokers through in order to expose the house to those working in the area. Then she would invite brokers to bring their own clients for a few days before hosting the first open house on a Sunday afternoon. “That’s a big draw,” Betty says. Brokers who have seen the house already will try to get their clients back before the open house. And then the open house should attract lots of casual lookers and those clients who weren’t able to make it during the week. After the initial open house, Betty explains, she would hold open houses for two more weekends. “I can also save you from what would otherwise be a real nuisance. I’ll be responsible for showing your house, and I’ll be sure that we set these open houses and other visits at times that are convenient for you.”
SAM: That would be great. The less hassle, the better.
BETTY: Last but not least, I’ve had lots of experience at negotiating home sales. Not only can I help you get the best price, I can help you figure out which offers to take seriously, how best to make counteroffers, and what secondary terms are reasonable. In my experience it’s best if the seller doesn’t have to deal directly with the buyer or the buyer’s agent. You’ll find it a lot more comfortable to hold out for the good price if you don’t have to deal directly with the other side.
SAM: What about after I’ve accepted an offer?
BETTY: Well, I’ll take care of moving toward a formal purchase and sale agreement. I’ll make sure any necessary inspections get done, and sometimes I even help the buyers get their mortgage.
Betty and Sam keep talking, and Sam sees the advantages that Betty will confer in terms of skills, resources, and knowledge. She has access to clients and other brokers, she knows the market, and she has lots of time to invest in selling his house. He decides that he’ll use an agent, and he feels comfortable with using Betty. She seems open and easy to talk to, and not too pushy.
SAM: OK, but what about fees? What would your commission be on a sale?
BETTY: My commission is the standard 6 percent of the sale price. You pay nothing unless we sell the house. Actually, the fee is normally split with the buyer’s agent, assuming there is one. But whether or not the buyer has an agent, the fee is 6 points.
SAM: Hmm. What happens if you sell the house very quickly? Is the fee still 6 percent?
BETTY: Yep, if we sell it quickly, isn’t that a good thing? That’s what we want, right?
SAM: Sure, I guess. But the quicker the sale, the less work you have to do, right? And what if there isn’t a buyer’s agent? What if a random buyer just walks in to the first open house and plunks down my asking price? Is the fee still 6 percent?
BETTY: Yes, it is.
THE PROBLEM: AGENCY COSTS
Sam sees the advantages of hiring Betty. But there’s a nagging question in his mind: Are these fees really worth it? What if she sells the house without much effort? Or what if she doesn’t work hard enough? How will Sam know? Despite Betty’s upbeat attitude and optimism about working together to sell his house, Sam fears there may be problems down the road. At this point, however, he’s not sure exactly what those might be.
Hiring an agent is not a simple matter. Bringing an agent into a negotiation introduces a third tension: between the principal and the agent. Because agents often have expert knowledge, substantial experience, and special resources that the principal lacks, the relationship can create value. At the same time, however, because the agent’s interests may not align with those of the principal, a number of unique and intensely stubborn problems can arise. The literature on this subject is vast, largely because these problems are so pervasive and cut across so many activities.1 Here, we introduce some of the central issues.
The Sources of the Tension
Agency costs are not limited to the amount of money that a principal pays an agent as compensation for doing the job. They also include the money and time the principal spends trying to ensure that the agent does not exploit him but instead serves his interests well. To understand why agency costs exist, consider that principals and agents may differ in three general ways:2
• Preferences
• Incentives
• Information
DIFFERENT PREFERENCES
First, the preferences, or interests, of an agent are rarely identical to those of the principal. Consider their economic interests. Betty’s primary economic interest is in her own earnings as a real estate agent. In this transaction, Sam’s primary economic interest is in the net sale price for his house. Betty may have other interests as well. She has a strong interest in her reputation and in securing future clients. She has an interest in maintaining good relationships with other agents, banks, home inspectors, and insurance agencies. Betty is a repeat player in this game, while Sam, particularly if he intends to leave the community, is a one-shot player who might be more than willing to sacrifice Betty’s reputation in order to get a better deal for himself. Conversely, Betty may be reluctant to bargain hard for certain advantages for Sam because of her desire to maintain a congenial relationship with the buyer’s agent, who may be a source of future client referrals.
DIFFERENT INCENTIVES
Agency problems may also arise because the incentives of the principal and the agent are imperfectly aligned. The culprit is typically the agent’s fee structure, which may create perverse incentives for the agent to act contrary to the principal’s interests. This discrepancy is sometimes called an incentive gap.
For example, Sam wants an arrangement that maximizes his expected net sale proceeds after her fee. Betty, on the other hand, wants a fee structure that yields her the highest expected return for her time spent. If they agree to a percentage fee, Betty may prefer a quick and easy sale at a lower price to a difficult sale at a higher price because with the former she will get more return for hours spent working. Indeed, a recent study suggests that when realtors put their own homes on the market, they tend to get higher-than-average prices, because they get the entire benefit of their additional hours of work, not just 6 percent of it.3
DIFFERENT INFORMATION
The information available to the principal and the agent may differ. We are speaking here of kinds of information that either side may have an incentive to keep to itself. Betty may know that market conditions are improving, for example, but she may be reluctant to share this with Sam for fear of inflating his expectations. Similarly, it may be difficult to know how much effort an agent is actually putting in on the principal’s behalf. Because the principal cannot readily discover this information, the agent might shirk her responsibilities and earn pay without expending effort.
Management Mechanisms and Their Limitations
These potential conflicts can be controlled somewhat, through three basic management mechanisms:
• Incentive contracts
• Monitoring systems
• Bonding
INCENTIVE CONTRACTS
Incentives can be built into contracts between principals and agents to better align their interests. For example, instead of paying employees an hourly wage, a manufacturing firm might choose to pay its workers by the piece, thereby tying compensation of these agents directly to volume. Or a distributor might pay its salespeople on a commission basis, compensating them only to the extent that their sales efforts boost the bottom line. Similarly, farm workers are often paid by the amount of produce harvested instead of by the hour, to minimize slacking, and waiter
s are paid through tips, to encourage more attentive service.
Many different incentive structures exist, including:
• Percentage compensation
• Hourly fees
• Fixed fees
• Bonuses or penalties
These methods can minimize the principal-agent tension, but no incentive structure can ever completely resolve it. To see why, consider our real estate example. Real estate agents are commonly paid a commission only if a sale is completed. This is an incentive contract: the agent’s reward depends on successful performance. Such contracts have both benefits and drawbacks. On the one hand, Betty profits—and Sam incurs agency-related costs—only if Betty manages to sell his house. On the other hand, as we have seen, this incentive may induce Betty to pressure Sam to accept a deal that is not optimal for Sam but which guarantees Betty a quick profit in comparison to her efforts. To be perfectly aligned, Betty’s incentives vis-à-vis the sale would have to be identical to Sam’s. But for this to occur, Betty would have to buy the house herself and resell it; only then would she have a 100 percent stake in the sale, as Sam does. This, of course, would transform her into the principal stakeholder and eliminate the agency relationship altogether.
Because Betty does not have as great a stake in the sale as Sam does, Betty and Sam may face conflicting incentives at various points in the transaction. Suppose that with very little effort, maybe 25 hours of work, Betty could sell Sam’s house for $250,000. With a 6 percent commission, this would generate a $15,000 fee—$600 an hour. Assume that with a great deal of effort, perhaps 100 hours of work, the house could be sold for $275,000. Sam would pay Betty an additional fee of $1,500 on the extra $25,000. From Betty’s perspective, the marginal effort may not be worthwhile. She works 75 extra hours for only $1,500—which works out to $20 an hour. Even if Betty could sell the house for $300,000 with only 50 extra hours of work, she might still decide that it was not worth the extra $3,000 fee at $60 per hour. She might feel that her 50 hours would be better spent selling someone else’s house at a much higher hourly rate—even though Sam would almost surely feel that an extra $47,000 in his pocket justified the additional time on Betty’s part.
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