Optimal Contracting and the Organization of Knowledge

William Fuchs, luis garicano, luis rayo, , William Fuchs - 2018

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 diffi-
culty of the questions posed to consultants and the knowledge of those consultants are hard to
assess. We show that spot contracting is not e¢ cient 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 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 ob-
served arrangements inside professional service firms and between venture capitalists and
entrepreneurs.


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