Signaling by an informed service provider

• Date: 01 December 2017
• DOI: http://doi.org/10.1111/jems.12208
• Author: Yuk‐fai Fong,Frances Xu Lee
• Published date: 01 December 2017

Received: 16 August 2013 Revised: 31 January 2017 Accepted: 8 February 2017

DOI: 10.1111/jems.12208

ORIGINAL ARTICLE

Signaling by an informed service provider

Frances Xu Lee1Yuk-fai Fong2

1Quinlan School of Business, Loyola

UniversityChicago, Chicago, IL, USA

(Email: francesxu312@gmail.com)

2Department of Economics, Hong Kong

Universityof Science and Technology,

Clear WaterBay, NT, Hong Kong

(Email: yfong@ust.hk)

Abstract

We study a service provider,who, at t he time of offering a contract, is better informed

than the potential client. A service provider that is hired to increase the client’s chance

of a gain, an “enhancer,” may be better informed of whether the client has a big or

small opportunity. A service provider that is hired to reduce the client’s chance of a

loss, a “problem solver,” may be better informed of whether the client has a big or

small problem. We show that an enhancer predominantlyoffers a contingent contract,

while a problem solver predominantlyoffers a flat fee due to their signaling incentives.

This explains the differences in real-world contracts and also provides a novel expla-

nation for the existence of low-powered incentive contracts. We evaluate the policy

intervention that limits the contingent part of the service providers’ contracts.

1INTRODUCTION

Some service providers offer contingent contracts that will pay the service providers more if the outcomes turn out to be better

for the clients. Some other service providers, despite having access to the same contractible future outcome, offer noncontingent

contracts that pay the service provider the same regardless of the outcome. A notable example is that, in U.S. tort and contract

litigation, the plaintiff attorneys typically charge a contingent fee, usually a third of the settlement or judgment won in the

litigation. However, the defense attorneys typically charge the clients an hourly rate regardless of the settlement or judgment

amounts.1A similar contrast exists in the debt service industry. Debt collection agencies, hired to collect hard-to-collect debts

for creditors, typically chargethe creditors a percentage of the debt eventually collected, which means that their pay is contingent

on the service outcome. On the other hand, debt settlement companies, hired to negotiate down the debts for debtors, typically

charge a percentage of the “unsecured balance,” the amount of debt initially owed bythe debtors, plus other flat consult ation or

application fees.2That is, their charges are independent of the service outcome. In this paper, we explain the different contract

forms through how the service provider’spr ivateinformation interacts with t heir service roles: whether they are hired to increase

the chance of a good outcome or to decrease the chance of a bad outcome.

The difference between the two service roles can be best illustrated by the example of the attorneys. First, consider a plaintiff

attorney (the service provider) and a plaintiff (the potential client). The plaintiff attorney can increase the chance that the client

wins in a litigation, but the extent of which depends on the nature of the client’s case. If the client has a promising case, the

increase in the probability of winning due to the attorney’s service is largert han if the client has an unpromising case. Because of

the attorney’s past experiences and professional knowledge, the attorney is better informed about whether the case is promising

or not for the client. In contrast, a defense attorney is hired to decrease the chanceof a bad outcome: t he chancet hat the defendant

loses the litigation. The attorney may be better informed about the merit of the case brought against the defendant. The more

We would like to thank Dan Bernhardt, Andrew Daughety,Winand Emons, Nuno Garoupa, Renato Gomes, Ting Liu, Jennifer Reinganum, and the audience

at Midwest Theory Conference, International IO Conference, Universityof Hong Kong, Peking University HSBC School of Business, 21st Annual Meeting of

the American Law and Economics Association, Asian Law and Economics Association, HKUST, and SHUFE. Wethank t he support from Hong Kong RGC

Grant 756911. All errors remain our own.

J Econ Manage Strat. 2017;26:955–968. © 2017 WileyPeriodicals, Inc. 955wileyonlinelibrary.com/journal/jems