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CEP discussion paper
Optimal Contracting and the Organization of Knowledge
William Fuchs, Luis Garicano and Luis Rayo
October 2014
Paper No' CEPDP1308:
Full Paper (pdf)

JEL Classification: D86; L22; J33; J44

Tags: contracting; experts; professional service firms; partnership; venture capital

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.