Adverse selection and the difficulty of assessing the quality of law firms

A famous paper, “The Market for ‘Lemons’” by the economist George Akerlof, makes the point that where there is asymmetric information (See my post of Dec. 23, 2005 on asymmetry of information and outside counsel.), such as what a car seller knows and potential car buyers don’t, it can hobble the market. The risk is adverse selection.

Since buyers can’t know the real condition of a used car, they offer less, which keeps off the market sellers of cars in good condition, and perpetuates the downward spiral of quality and price. Adverse selection operates where people with health problems seek insurance, while healthier people decline the ever-costlier coverage. “Adverse selection might work in with any market in which quality was difficult to assess,” Warsh, Knowledge and the Wealth of Nations: A Story of Economic Discovery (Norton 2006 at 172).

Poor quality law firms might drive clients away from even good firms, except for what economists call signaling and screening. One way for law firms to work their way out of this predicament is through signaling behavior (See my post of May 1, 2006 about plaintiff’s firms that signal their quality by adhering to a standard contingency fee.). Plush offices in posh locations, fancy brochures, and waves of ads serve as signals. A second way is screening mechanisms, by which valuable information is provided to buyers, such as lists of the “100 best lawyers.” Articles selected for publication and speaking slots at conferences also signal.

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