Search, Bargaining, And Agency in the Market for Legal Services
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 ï¿½buy the firmï¿½ 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 ï¿½no-transferï¿½ case), in equilibrium the first lawyer visited demands a higher contingent fee for lower-valued cases, signaling the caseï¿½s 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 clientï¿½s expected payoff, but it does reduce the lawyerï¿½s 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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