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Optimal contracting and the organization of knowledge

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  • Fuchs, William
  • Garicano, Luis
  • Rayo, Luis

Abstract

We study contractual arrangements that support an efficient use of time in a knowledge-intensive economy in which agents endogenously specialize in either production or consulting. The resulting market for advice is plagued by informational problems, since both the difficulty of the questions posed to consultants and the knowledge of those consultants are hard to assess. We show that spot contracting is not efficient since lemons (in this case, self-employed producers with intermediate knowledge) cannot be appropriately excluded from the market. However, an ex-ante, firm-like contractual arrangement uniquely delivers the first best. This arrangement involves hierarchies in which consultants are full residual claimants of output and compensate producers via incentive contracts. This simple characterization of the optimal ex-ante arrangement suggests a rationale for the organization of firms and the structure of compensation in knowledge-intensive sectors. Our findings correspond empirically to observed arrangements inside professional service firms and between venture capitalists and entrepreneurs.

Suggested Citation

  • Fuchs, William & Garicano, Luis & Rayo, Luis, 2014. "Optimal contracting and the organization of knowledge," LSE Research Online Documents on Economics 60531, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:60531
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    File URL: http://eprints.lse.ac.uk/60531/
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    Cited by:

    1. Luis Garicano & Esteban Rossi-Hansberg, 2015. "Knowledge-Based Hierarchies: Using Organizations to Understand the Economy," Annual Review of Economics, Annual Reviews, vol. 7(1), pages 1-30, August.
    2. Florian Scheuer & Iván Werning, 2017. "The Taxation of Superstars," The Quarterly Journal of Economics, Oxford University Press, vol. 132(1), pages 211-270.
    3. Anna Gumpert, 2018. "The Organization of Knowledge in Multinational Firms," Journal of the European Economic Association, European Economic Association, vol. 16(6), pages 1929-1976.
    4. Sheena J. Vachhani, 2020. "Envisioning a Democratic Culture of Difference: Feminist Ethics and the Politics of Dissent in Social Movements," Journal of Business Ethics, Springer, vol. 164(4), pages 745-757, July.
    5. Bernhard Resch & Chris Steyaert, 2020. "Peer Collaboration as a Relational Practice: Theorizing Affective Oscillation in Radical Democratic Organizing," Journal of Business Ethics, Springer, vol. 164(4), pages 715-730, July.
    6. Daron Acemoglu & Mohamed Mostagir & Asuman Ozdaglar, 2014. "Managing Innovation in a Crowd," NBER Working Papers 19852, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    Contracting; experts; professional service firms; partnership; venture capital;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • J44 - Labor and Demographic Economics - - Particular Labor Markets - - - Professional Labor Markets and Occupations
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure

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