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

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Working paper
Andrew F. Daughety and Jennifer F. Reinganum
Issue number: 
No. 11-W06
Vanderbilt University
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.
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