Middlemen: the good, the bad, and the ugly

• Author: Fei Li,Gary Biglaiser
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/1756-2171.12216
• Date: 01 March 2018

RAND Journal of Economics

Vol.49, No. 1, Spring 2018

pp. 3–22

Middlemen: the good, the bad, and the ugly

Gary Biglaiser∗

and

Fei Li ∗

We examine the role of a middleman as an expert in markets. A seller’s effort determines the

quality of the good. Buyers observe neither the seller’s effort nor the good’s quality. A middleman,

after observing a signal about the good’s quality, decides whether to purchase it and then to sell

it. We show that the presence of a middleman may either reduce or exacerbate the seller’s moral

hazard problem.We also consider a model with multiple middlemen. We find that the seller’seffort

is minimized if either the middleman’s signal is perfect or the number of middlemen is large.

1. Introduction

The role of middlemen, sometimes called intermediaries, has been a hotly debated topic

over the years. In a recent book, Krakovsky (2015) argues that middlemen create value through

such diverse attributes as economizing on the physical costs of a transaction, as a certifier of a

good and an enforcer to ensure that the parties abide by the contract, and a bearer of risk. In

contrast, author Matt Taibbi famously called Goldman Sachs “a great vampire squid wrapped

around the face of humanity, relentlessly jamming its blood funnel into anything that smells like

money.”1Furthermore, many in the public believe that eliminating middlemen will lead to lower

prices for consumers and higher social welfare. See Spulber (1999) for an excellent discussion

of middlemen in general.

We offer a new perspective on the potential costs and benefits of having middlemen in

markets. In this article, we examine the role of middlemen as providers of information about a

seller’s good when the seller’s costly unobservable action affects the quality of the product. A

middleman observes a signal of the quality of the seller’s good and decides whether to make an

offer for it. If an offer is made, the seller can then choose whether to take the offer, where the

middleman then resells the good to buyers, or reject the middleman’s offer and sell directly to

buyers who observe a signal of the good’s quality, which is noisier than an expert middleman’s

signal. Moreover, because the seller’s effort cost is sunk when he faces the middleman, a hold-up

problem naturally appears.

∗University of North Carolina at Chapel Hill; gbiglais@email.unc.edu, lifei@email.unc.edu.

Wethank Attila Ambrus, Andrei Hagiu, Keiichi Kawai, Leslie Marx, Joel Sobel, Xi Weng, Jidong Zhou, twoanonymous

referees, Editor David Martimort, and participants of many seminars for insightful comments.

1Taibbi, Matt, “The Great American BubbleMachine.” Rolling Stone, July 2009.

C2018, The RAND Corporation. 3

4/THE RAND JOURNAL OF ECONOMICS

Many markets fit such a setting. First, take an ownerof durable goods such as an automobile,

home, or boat. Such an owner must take care of the good to maintain its quality. An automobile

owner needs to change the oil, change the timing belt, rotate the tires, and maintain other

systems such as the air conditioning. Furthermore, how and where an owner drives can affectthe

underlying quality and durability of a car. Although it is possible to document some of these, it

is very difficult to document others. An automobile owner who wants to sell his or her car can

trade it either through a car dealer, who will then resell it, or try selling the auto directly to private

buyers. A boat owner is in a very similar position. A homeowner must do maintenance on the

major systems (heating, ventilation, air conditioning, gutters, roof, plumbing, and crawl space) to

maintain their home. The effort cost is naturally sunk when the homeowner is selling the house.

During the financial crisis, distressed homeowners could sell their homes either directly to private

buyers or to institutional investors.2The institutional investors would have the homes inspected

and decide whether to make an offer, and if they made one that was accepted, they would either

rent out the home and then sell it or try to “flip it” and resell it immediately.

A second class of examples are the market for loans for durable goods, such as homes and

automobiles. The sellers are originators of the loan, who decide whether to lend money to the

borrowers for homes or other large assets, whereasbuyers are investors who can purchase the loan

for their portfolio. Loan originators will typically try to sell their loans to a financial intermediary

instead of directly to buyers. After inspecting the application, the financial intermediary decides

whether to purchase the loan; once purchased, the loan, along with many others, is securitized,

and then they are resold in tranches to investors. If the intermediary passes on purchasing the

loan, then the originator attempts to sell the loan on the private market directly to buyers.

In our model, once the seller has chosen her effort, then the situation becomes one of adverse

selection between the seller, the middleman, and buyers. This generates a situation of sequential

screening of the seller: first by the middleman and next by buyers. Under mild conditions, we

show that an equilibrium must be informative. That is, the seller and the middleman trade if and

only if the middleman obtains a positive signal about the quality of the seller’s good.

In the base model, the middleman makes a take-it-or-leave-it offer when the seller’s cost of

effort is sunk. One can interpret this as giving the middleman all the bargaining power. However,

despite giving a middlemen all the bargaining power, the seller has a credible outside option of

going directly to buyers if the middleman’s offer is perceived as too low;this will generally leave

the seller some surplus to owning a high-quality good. In the special case when the middleman

has a perfect inspection technology, we demonstrate that, despite having an outside option to

go to the market, the seller always chooses the minimum level of effort. This is because, when

the middleman can perfectly tell the seller’s type, buyers believe that only the low-type seller

goes to the market. This extreme adverse selection eliminates the seller’s outside option in the

market, allowing the middleman to extract the entire surplus regardless of the quality. Thus, in

the equilibrium, the seller has no incentive to exert effort at all.

More generally, when the middleman’s inspection technology is imperfect, having a mid-

dleman may either reduce or exacerbate the seller’s moral hazard problem. This is due to two

effects that we uncover. First, there is the misidentification effect, where a seller of a low-quality

good generates a positive signal with the middleman, who offers a relatively high price because

he believes the good is likely of high quality. The opportunity to fool a middleman gives a seller

an additional avenue besides selling directly to buyers to sell a lemon as a high-quality good.

This always reduces the incentive of the seller to invest in quality, and thus the presence of the

middleman reduces welfare via this effect.

The second effect is the market premium effect. The middleman is more likely to trade with

a high-type seller, resulting in an adverse selection of the type of the seller who visits the market.

In equilibrium, buyers take such an effect into account and rationally adjust their prior belief

about the seller’s quality and their willingness to pay. As a result, having a middleman will affect

2See dealbook.nytimes.com/2014/06/27/investors-who-bought-foreclosed-homes-in-bulk-look-to-cash-in/?_r=0.

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The RAND Corporation 2018.