Incentives are greatly aligned when the Beneficiary is also the Payer and the Chooser of a product. The greater the social distance between the three entities of the P-C-B, the weaker is the alignment of incentives to have effective markets. The best case is that of private spending for a car where the P-C-B entities are vested in one. The worst case is that of public spending where the entities are extremely disparate.
Take a slightly complicated case of the textbook market that I have been observing over here, for primary schooling in parts of Andhra Pradesh. Please add on to it if my hypothesis or conclusions are incorrectly framed. Each class has, say, 7 subjects. Each subject probably has 5-15 companies vying to have their brand of textbook chosen. I have included workbooks under the genre of textbooks here. The school decides the list of textbooks to be bought by parents. However, in most cases, the school also supplies the particular set of textbooks. The incentives of the school (the Chooser in this case) are necessarily not that of the parents. Textbook suppliers compete to be on the textbook list.
However the schools have competition in the area of distribution from other textbook shops and second-hand book suppliers. Schools get around the second-hand book suppliers by not repeating the book chosen, maybe for atleast 2-3 years. The textbooks chosen by a school are often not found in the open market (especially in small towns) for two possible reasons, none of which are yet generalisable. Distributors dont supply to textbook shops in the area based on an “understanding” with the school or probably the shop doesnt keep those textbooks because they hold limited sale value. In sum, this hugely raises the search cost for parents in towns and villages. Of course, the textbook manufacturer may be passing on a bulk discount to the school, but whether the school passes it on to the parent (the final Beneficiary) is anybody’s guess. Another interesting hypothesis that I have come across here is that schools compete to have their textbooks different from other schools so that the switching costs to another school are effectively raised.
What this may imply is the prices of textbooks in this case is much higher because of lack of competition/ choice at the Payer/ Beneficiary level. The incentives for price-competition are much weaker for the school but only the school has the information/ decision power to make the textbook list.
I wonder to what extent is it mandatory to buy textbooks from the schools itself.
This situation is worse in the US. The profs there (the Chooser) have every incentive to focus on the quality of the textbook. But the burden of price falls on the student (the Payer and the Beneficiary). That coupled with lack of arbitrage opportunities (importing textbooks from other countries) and copyright issues (xerox ;-) has led to huge prices.
I remember one very smart textbook manufacturer in Bangalore who exploited a situation in this micro-market quite well. We had a new syllabus for all the engineering students that year. He was the one of the only two suppliers fast enough to come up with textbooks for the course. But the second-hand book market in Bangalore is huge. If you buy a brand new textbook in Bangalore, you are assured 40% of the book’s sale price in cash if you sell it. Buying second hand books is usually 70% of the sale price. So in the first year, the prices of the textbooks had a huge premium due to relatively near-monopoly status. In the second year, facing competition from the second hand book market he crashed the prices of his textbooks, to around 50% of their price in the first year which is probably closer to the real price). This virtually assured him of little competition from the second-hand book market. I am sure he must have made quite a killing. Given the non-perishability and replicability of the product, it is understandable why textbook manufacturers have utilised the decision-making power of schools at the primary school level. And joined hands with them.
This implies relatively little price competition at the final beneficiary’s end. And consequently higher prices. However the counter-argument may be that he is extracting the true rent in a situation of weak intellectual property rights and the entrepreneurial costs of providing such a non-perishable and replicable product in the first place.