Fee Effects

Abstract

Intermediaries are a pervasive feature of modern economies. This article draws attention to an under-theorized cost arising from the use of specialized intermediaries — a systematic shift in the mix of transactions consummated. The interests of intermediaries are imperfectly aligned with the parties to a transaction. Intermediaries seek to maximize their fees, a transaction cost from the perspective of the parties. Numerous factors, including the requirement that a transaction create value in excess of the associated fees to proceed and an intermediary’s interest in maintaining a good reputation, constrain an intermediary’s tendency to use its influence in a self-serving manner. Nonetheless, these constraints are generally imperfect. As a result, when parties rely upon influential intermediaries, there is often a shift in the total mix of transactions consummated toward the transaction type that yields the greatest fee for the intermediary involved. This “fee effect” does more than influence the allocation of gains from trade. The primary cost takes the form of a foregone gain, that is, the difference between the welfare gains produced by the transaction actually consummated and the greater gains that would have been produced had the transaction type not been biased by the intermediary’s self interest. Moreover, reliance upon financial intermediaries can give rise to externalities, altering how capital is allocated in socially costly ways. The article’s contributions are two-fold. First, it provides a theoretical framework for assessing an intermediary’s tendency and capacity to use its influence in a way that affects the type of transaction consummated. This enables parallels to be drawn across disparate settings. Second, applying that framework, the article shows why fee effects may be particularly great in financial markets. In addition, the article considers ways to address fee effects. As a first step, the article suggests that policymakers and market participants should “follow the fees” to better understand the effects of intermediary influence.