Why are law firms partnerships?

After all, across the rest of the economy, corporations are more than
dominant; they own the landscape.  Ever
seen a trucking company, a retail chain, or even your friendly local
locksmith shop organized as a partnership? 

When economists ask such a question, it’s with the deep-seated instinct
that there must be a reason based on incentives and
the peculiar structure of the marketplace in question; it can’t possibly
be chance, or tradition, or "because everyone else does it that way."   (These
are all "reasons" with extremely short half-lives.)

Thanks to two professors at my alma
, we now have a nuanced explanation
of why "law firm" seems to equate to "partnership."

For the "executive summary" of their paper, check out this precis at
SmartEconomist.com (a highly recommended site, by the way, although rumor
has it they may soon put their stuff behind a pay-wall, which would be
exceedingly antisocial of them and would negate my endorsement in a heartbeat).  

a nutshell, partnerships prevail over corporations where:

  • The key performance metric is not total profits (corporations blow
    away everyone on this score), but profits per
  • Quality of service delivered is highly dependent on human capital.
  • Clients have a difficult time evaluating the actual quality of service,
    and therefore rely on reputation.  And, accordingly, where:
  • Firms supplying the service have a rational motivation to "signal"
    the quality of their service by applying stringent internal standards
    for elevation to partnership, thus explaining the traditional up-or-out
    model.  In other words, the informational asymmetry between the
    law firm and the client about the quality of the work product motivates
    the firm to supply an "indicator of excellence" by ruthlessly—and
    at great cost—firing all but the most outstanding senior associates.

Here’s the
entire paper, which is both subtle and marginally dense, at least to
those who don’t slug down their daily dose of academic economic studies
(I don’t either—but I’m not too rusty).   If you do look
at the full paper, Sections 2 and 3 develop the basic story-line, including
the fascinating theme of all the implications that flow from the assumption
that corporations strive to maximize total profits while partnerships
strive to maximize profits per partner.

To begin with, partnerships will have a higher quality threshold for
employment, since their interest is not to hire anyone who will not raise
partners’ average profit share, while corporations will theoretically
hire anyone whose marginal contribution to profits is greater than zero.  Stated
slightly differently, a partnership will always be striving to hire (or
promote) people whose economic value is at least as great as that
of the existing partners; whereas corporations feel at liberty to hire
anyone who’s not an absolute deadweight.

Section 4 gets more interesting yet.  While the earlier sections
of the paper assumed equal per-partner division of profits, the professors
now ask what happens if partner income is distributed based on a variety
of performance measures—or,
as we would put it here, if a firm moves from lockstep to eat-what-you-kill.   While
a corporation in this situation would have an incentive to hire cheaper,
albeit less talented, workers so long as the gap between their wages
and their productivity is sufficiently high, partnerships will always
aim to attract the most talented workers, period.  Now
what  happens
is that if relatively higher ability lawyers have higher "reservation
wages" (what
they won’t take less than), an equal-sharing partnership can unravel
if the most capable aren’t willing to play that game—in other words,
if their equal share seems less than their fair share.   As
the professors put it somewhat drolly:

“This suggests that labor market competition may force partnerships
to adopt more productivity-based compensation.

The basic story comes back to a theme we’ve sounded often:  Lateral
mobility of partners changes everything.
  The professors
put this with slightly less pith:  "To the extent that [there
has been a change] to a more active market for senior lawyers, our analysis
suggests that top lawyers in firms with equal-sharing compensation might
credibly threaten to leave if compensation practices were not altered."

And there’s more:  The move towards "productivity-based" compensation
is joined at the hip to the rise of a non-equity partnership tier.  How
so?  The classic up or out model dismisses senior associates who
might be of extremely high quality, and exceedingly profitable to the
firm, if they are not of ne plus ultra quality.  By contrast,
introducing a non-equity track permits the firm to retain them as positive
contributors to total profitability, albeit at the expense of razor’s-edge
quality.  As the professors put it:  "The idea that an up-or-out
system would become less attractive once the compensation scheme involved
less strict re-distribution fits naturally with our theory."

Or, as Dick Tyler, managing partner of CMS Cameron McKenna, memorably
:  "A tolerant lockstep system is disastrous."

And you thought partnerships were a matter of tradition?  As the
central insight of the law and economics movement has it, the life of
the law may not have been been logic, but it has been economically-informed

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