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Search, Bargaining, And Agency in the Market for Legal Services

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  • Andrew F. Daughety

    ()
    (Department of Economics, Vanderbilt University)

  • Jennifer F. Reinganum

    ()
    (Department of Economics, Vanderbilt University)

Abstract

We show that, in the context of the market for a professional service, adverse selection problems can sufficiently exacerbate moral hazard considerations so that even though all agents are risk neutral, welfare can be reduced by allowing the agent to �buy the firm� from the principal. In particular, we model the game between an informed seller of a service (a lawyer) and an uninformed buyer of that service (a potential client) over the choice of compensation for the lawyer to take a case to trial, when there is post-contracting investment by the lawyer (effort at trial) that involves moral hazard. Clients incur a one-time search cost to contact a lawyer, which parametrically influences the market power of the lawyer when he makes a demand of the client for compensation for his service. The client uses the demand to decide whether to contract with the lawyer or to visit a second lawyer so as to seek a second option, which incurs a second search cost. Seeking a second option shifts the bargaining power to the client because she can induce the lawyers to bid for the right to represent her. We allow for endogenously-determined contingent fees alone (that is, the lawyer covers all costs and obtains a percentage of any amount won at trial) or endogenously-determined contingent fees and transfers; in this latter analysis, lawyers could buy the client's case. Under asymmetric information with only a contingent fee (the �no-transfer� case), in equilibrium the first lawyer visited demands a higher contingent fee for lower-valued cases, signaling the case�s value to the client. If a transfer is also allowed, then in equilibrium the higher contingent fee (and transfer from the lawyer to the client) is obtained by the more valuable case, with only the highest-value case resulting in the lawyer buying the entire case (100% contingent fee with a transfer); again, in equilibrium, the value of the case is signaled. In both settings the client uses an equilibrium strategy that involves seeking a second option a fraction of the time, which induces separation. In equilibrium the presence of asymmetric information does not affect the client�s expected payoff, but it does reduce the lawyer�s expected payoff and it does increase moral-hazard-induced inefficiency on the part of the lawyer in the post-contracting investment. We also show that welfare under the no-transfer compensation scheme may increase with an increase in search costs, and shifting from a no-transfer to an unrestricted-transfer scheme can result in a reduction in expected social efficiency, as the adverse selection effect exacerbates, rather than ameliorates, the moral hazard problem.

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File URL: http://www.accessecon.com/pubs/VUECON/vu11-w06.pdf
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Bibliographic Info

Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 1106.

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Date of creation: Jun 2011
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Handle: RePEc:van:wpaper:1106

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Web page: http://www.vanderbilt.edu/econ/wparchive/index.html

Related research

Keywords: Signaling; Agency; Search; Contingent Fee;

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References

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  1. Yuk-fai Fong, 2005. "When Do Experts Cheat and Whom Do They Target?," RAND Journal of Economics, The RAND Corporation, vol. 36(1), pages 113-130, Spring.
  2. Daughety, Andrew F, 1992. "A Model of Search and Shopping by Homogeneous Customers without Price Precommitment by Firms," Journal of Economics & Management Strategy, Wiley Blackwell, Wiley Blackwell, vol. 1(3), pages 455-73, Fall.
  3. Santore, Rudy & Viard, Alan D, 2001. "Legal Fee Restrictions, Moral Hazard, and Attorney Rights," Journal of Law and Economics, University of Chicago Press, University of Chicago Press, vol. 44(2), pages 549-72, October.
  4. Cotten, Stephen J. & Santore, Rudy, 2012. "Contingent fee caps, screening, and the quality of legal services," International Review of Law and Economics, Elsevier, Elsevier, vol. 32(3), pages 317-328.
  5. Nancy A. Lutz, 1989. "Warranties as Signals under Consumer Moral Hazard," RAND Journal of Economics, The RAND Corporation, vol. 20(2), pages 239-255, Summer.
  6. Michael McKee & Rudy Santore & Joel Shelton, 2007. "Contingent Fees, Moral Hazard, and Attorney Rents: A Laboratory Experiment," The Journal of Legal Studies, University of Chicago Press, University of Chicago Press, vol. 36(2), pages 253-273, 06.
  7. Daniel F. Rubinfeld & Suzanne Scotchmer, 1993. "Contingent Fees for Attorneys: An Economic Analysis," RAND Journal of Economics, The RAND Corporation, vol. 24(3), pages 343-356, Autumn.
  8. Andrew F. Daughety & Jennifer F. Reinganum, 1991. "Endogenous Availability in Search Equilibrium," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 287-306, Summer.
  9. Andrew F. Daughety & Jennifer F. Reinganum, 1992. "Search Equilibrium with Endogenous Recall," RAND Journal of Economics, The RAND Corporation, vol. 23(2), pages 184-202, Summer.
  10. Emons, Winand, 2000. "Expertise, contingent fees, and insufficient attorney effort," International Review of Law and Economics, Elsevier, Elsevier, vol. 20(1), pages 21-33, March.
  11. Wolfgang Pesendorfer & Asher Wolinsky, 2003. "Second Opinions and Price Competition: Inefficiency in the Market for Expert Advice," Review of Economic Studies, Oxford University Press, vol. 70(2), pages 417-437.
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