Optimal Contracting and the Organization of Knowledge

William Fuchs, Luis Garicano, Luis Rayo, Luis Garicano, Luis Rayo - Dec 13, 2016

In a model of endogenous hierarchies with adverse selection. We show that spot contracting is not efficient since lemons 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 opti-mal 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

hierarchies adverse selection theory of the firm venture capital