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Article Excerpt
We develop a model of consulting (advising) where the role of the consultant is to reveal signals to her client that refine the client's original private estimate of the profitability of a project. Although the client can perfectly observe and evaluate these signals, the consultant may only be able to do the same imperfectly, or not at all. This captures the idea that the expert may not fully understand the impact of her advice on the client. We characterize the optimal contract between the consultant and her client. It is a menu consisting of pairs of transfers specifying payments between the two parties in case the project is undertaken by the client and in case it is not. The main result of the article is that in the optimal mechanism, the consultant obtains the same profit as though she could perfectly observe and evaluate the impact of the signals whose release she controls on the client's profit estimate.
1. Introduction
*** In many real-world advisor-client relationships, the degree to which the expert understands the impact of her information on the client's objectives lies between two extremes: complete understanding and total ignorance. For example, a competent personal tax advisor is expected to know not only the tax law but also how certain regulations affect her client's actual tax obligations. On the other hand, a computer scientist who is invited to explain cryptographic techniques to counter-terrorism officials may be intentionally kept in the dark about aspects of the project for which her advice is needed. In this article, we study models where the situation is anywhere between these two extremes, and the client's action (what he does with the advice) is contractible. We try to understand how consultants "create value" and characterize optimal contracts between them and their clients.
We propose a model where a consultant (she) is able to reveal signals to her client (him) that refine the client's original private estimate regarding the profitability of a project. We assume that the client can perfectly observe and evaluate these additional signals; however, the consultant may only he able to do the same imperfectly. This captures the idea that the expert may not fully understand the impact of her advice on the client. In an extreme case, she may not even know a priori whether her advice made the project look more or less profitable to the client. However, the parties' actions--in particular, whether or not the project is undertaken--are observable and contractible, hence the consultant can make inferences from the client's choices. The central question is how much information the consultant should disclose (with or without observing), and how she can reduce the client's rents stemming from his ability to see and evaluate her signals. (1)
We characterize the optimal contract between the consultant and the client. It can be represented by a menu that consists of pairs of transfers specifying payments between the two parties contingent on whether or not the project is undertaken by the client. If the client chooses an item from the menu, the consultant agrees to release to him whatever information she has, and the transfers take place according to the client's action. (2) In the optimal menu, there may be items where the client pays a fee to the consultant upon undertaking the project, as well as items where the consultant pays the client if the project is carried out. The client's choice among the different pairs of transfers depends on how optimistic or pessimistic he is regarding the profitability of the project prior to listening to the advice of the consultant. Intuitively, the client is willing to pay for the consultant's advice because it may induce him to take an action different from the one he was planning to take. Indeed, in certain special cases, the client pays the consultant a positive fee exactly when her advice changes the client's mind as to whether or not to undertake the project. If the client is either very optimistic or very pessimistic regarding the success of the project, he chooses not to contract with the consultant.
The main result of the article is that even if the consultant cannot perfectly (or at all) evaluate the "new information" that she discloses, she can design a contract in which she obtains the same profit as though she could. In other words, in the optimal contract, the client enjoys information rents only for the information he already has prior to meeting the consultant. The client does not get any rents from the information whose release is controlled by the consultant, even if that information becomes his (the client's) private information when released. We also show that the optimal contract does entail inefficiencies, that is, the first-best is not achieved.
[] Motivating examples, applications. Suppose that a large software company (e.g., Google) is looking for a senior engineer to oversee the development of a new, secret product. They bring in a headhunter to evaluate potential candidates. The headhunter (in our model, the consultant) has superior information about the skills of the candidates, whereas only the company (the client) knows exactly what project the new chief engineer would be in charge of. (The project and the job description are kept secret because Google does not want to risk a competitor preempting their product launch.) Therefore, when describing a candidate, the consultant may not exactly know whether a specific characteristic makes the candidate more or less attractive for the client, only the client does. However, the client's hiring decision is observable and contractible. In this setup, we look for the headhunter's optimal contract, which includes the rules of information disclosure and payments contingent on the client's action.
Another situation that fits our model is where the client is a potential investor in a firm's shares. He is uncertain of various characteristics of the asset, such as the covariance of its return with other stocks' returns. The consultant is a finance expert who has access to this type of information. She does not know the client's willingness to pay for the stock and, in certain situations, she may not even know precisely how her information would change the client's valuation. This can be the case if the client cares about the covariance of the stock's return with the return of his own portfolio whose composition is also his private information. (3) The goal is to design the optimal contract for the consultant when the client's action (whether or not he buys the stock) is contractible, but the effect of the consultant's information on the client's valuation is not.
Yet another example is where the consultant is a real estate broker and the client is a prospective home buyer. The buyer's preferences over houses are his private information. The broker has detailed information about the amenities that various homes offer, but she does not know what the buyer is looking for. For example, is a neighborhood with an active night life a plus, or a minus? The buyer may not be able or inclined to disclose his preferences--after all, the broker is a self-interested economic agent, and she would use the information gleaned from the buyer to her own advantage. (If the broker becomes fully informed about the buyer's preferences, then she can deliberately show expensive homes with amenities that the buyer likes in order to increase her commission set as a fixed percentage of the price.)
More broadly, it is a widely held belief that the role of strategy and management consultants is to help uncover their clients' own ideas so that the clients can realize what they are capable of. (4) Consultants often only talk about the correct general criteria to be used in decision making (what types of tradeoffs to consider, common fallacies, etc.), instead of the particularities of the client's decision problem. By discussing general ideas, industry trends, or similar cases, they provide useful information as the client's private knowledge regarding his project becomes more nuanced. Nevertheless, the consultant may only imperfectly (or never) learn exactly what effect her advice has had on the client's objective function. (5) In many cases, it is conceivable that only the client's actions are observable and contractible. We characterize the contract that maximizes the consultant's profit. This reflects the assumption that the consultant has a (local) monopoly on the type of information sought by the client.
Our results imply that in all the applications mentioned above, the consultant should offer a menu of contingent-fee contracts where her remuneration depends on the client's action. We show that by offering such a contract, the consultant can extract as much profit as if she could perfectly observe the actual effect of her advice on the client's objective function. Our main result implies that it is irrelevant how well the consultant understands the impact of her advice on the client--as long as she controls the disclosure of information, she appropriates its rents.
In many real-world examples of professional advice, such as real estate, law, management, or IT consulting, we observe fees that are contingent on the client's action. In mergers, for example, it is customary for the consultant of the buyer to demand a "success fee" due upon the completion of the deal. Because the acquisition of the target is ultimately the client's decision, we may interpret such success fees as action-contingent transfers. Our model shows that this may be the outcome of an optimal contract between the consultant and her client. In this contract, the consultant discloses as much information as she has even though she is unaware of its impact on the client's preferences, because she captures all the additional rents arising from the information whose release she controls.
[] Related literature. The literature on information transmission between experts and client-customers (see Milgrom and Roberts, 1986, Pitchik and Schotter, 1987, Wolinsky, 1993, Emons, 1997; and references therein) often treats the expert's information disclosure as cheap talk (a la Crawford and Sobel, 1982). The advisor has unverifiable information, and the question is how precisely she can reveal it if the interests of the parties are not perfectly aligned and the client's actions are not contractible. Our model does not have much in common with cheap-talk models, as in our setup it is the client, not the expert, who can perfectly observe the disclosed signals; moreover, the client's action is contractible.
There are other, more related models of advice in the literature concerning the attorney-client relationship. This line of research is motivated mostly by the observation that attorneys are paid contingent fees, that is, payments that substantially differ depending on the success or failure of the client's case. The literature (see Dana and Spier, 1993 and references therein) offers several types of economic explanations for such...
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