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case, these firms have every incentive to expend excessive hours on the con-

tracted tasks. After all, the more time spent, the more hours billed. An alter-

native is to pay for results.^13 In the legal profession, one option is a contingency

arrangement, whereby the law firm gets a percentage of the attained settle-

ment amount or court award. Indeed, contingency fee payments have been an

increasing trend. (In 2011, General Electric converted almost all of its offen-

sive patent litigation from hourly to contingency-fee arrangements.) Still

another arrangement for legal services is flat-rate billing—that is, a flat rate for

a particular task regardless of the number of hours spent. In the earlier exam-

ple of building the regional corporate headquarters, the firm and contractor

might agree to enter into a fixed-price contract. In receiving a fixed price, the

contractor has an obvious incentive to keep costs under control.

Of course, paying for results is not without its problems. For example, if the

fixed price is the only factor in a building contract, the contractor might sac-

rifice quality or finish behind schedule. Investment bankers get paid for bring-

ing acquisition targets to clients. The problem is that they get paid only when

a deal is completed, whether or not the deal is a good one. They earn nothing

if the deal is abandoned or if they steer a client away from a bad deal.

(Financier Warren Buffet has likened taking advice from investment bankers

to asking a barber if you need a haircut.) This criticism extends to other pro-

fessions as well, such as stockbrokers and real-estate agents.

SUMMING UP The message of this section is that the principal-agent rela-

tionship comes with an associated cost. While possessing the necessary infor-

mation to make an appropriate decision, the agent also has interests that

conflict to a lesser or greater degree with those of the principal. Certainly, the

parties will attempt to mitigate these problems. As the examples have shown,

this might mean monitoring or limiting the agent’s decision-making discretion

or improving the agent’s incentives. Nonetheless, the loss in group welfare

because of suboptimal decisions or costly controls represents a real agency cost.

As we shall see in the next section, an important task of managers is to organ-

ize large-scale firms in ways that minimize these agency costs.

ORGANIZATIONAL DESIGN

Having examined the economics of different market structures in previous

chapters, we now take a closer look at the organization of firms. What eco-

nomic factors determine the size and breadth of firms? Why do some economic

transactions take place within firms, whereas others are transacted via markets?

(^13) For a discussion of changes in legal billing practices, see V. O’Connell, “Law Firms Feel Pinch,”
The Wall Street Journal, March 10, 2011, p. B8; and S. Covel, “Firms Try Alternative to Hourly Fees,”
The Wall Street Journal, April 2, 2009, p. B1.
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