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

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.

Keywords: Signaling, Agency, Search, Contingent Fee

JEL Classification: D8, K4, L2