Legal Services and the Market for Lemons

This post is a copy of the chapter “Why there might be a market for lemons: Some thoughts on competition, quality and regulation in legal service markets” published today in the LSB volume (‘Understanding the economic rationale for legal services regulation – A collection of essays‘).  There are many interesting contributions there.  The essays were commisioned to respond to a report by Decker and Yarrow.  That report suggests that increased legal services markets are not likely to lead to the race to the bottom in terms of quality characteristic of the classic ‘market for lemons’ arguments.  This chapter challenges that view.

Decker and Yarrow’s report (“the Report”)  speaks to three issues key to understanding the Legal Service Board’s approach to regulating legal service markets:  competition; independence of regulatory judgment; and, the importance of empirical evidence to support those judgments.  The report emphasizes a number of presumptions in considering those issues which also fit well with the LSB’s direction of travel.  It suggests:

  • in the absence of evidence to the contrary, competition is a better public policy tool than restrictive practice;
  • restrictive practices reduce price competition, inhibit innovation and may dampen potential improvements in quality;
  • even where regulation is justified it should be proportionate and risk-based; and,
  • there is a need for scepticism of the mechanisms and rules of self-regulation, whilst acknowledging the benefits that self-regulation may also bring.

Furthermore, the Report sensibly suggests that regulatory dilemmas should not be posed in absolute terms.  In particular, theoretical risks based on economic models with assumptions which bear no relation to reality should be treated with caution.  Instead, a context specific, institutional economic approach should look at what can be realistically done to deal with regulatory problems.  This approach should be evidence based (and perhaps incremental[1]) in nature.  Regulation should be proportionate and pragmatic not dogmatic and ideological.

Whilst careful to balance its messages, in important respects the report leans back on two related assumptions.  One is that competition for legal services is unlikely to lead to a race to the bottom (or a ‘market for lemons’).  That is, it argues increased competition for legal services is not likely to lead to quality being undercut to dangerously low levels.  The second is that in principle self-regulatory approaches are likely to drive up quality beyond what is necessary rendering legal services less affordable and so posing access to justice problems.  Indeed, in considering “market for lemons problem” they indicate, “a market for gold plate is more likely”.[2] Competition under conditions of self-regulation will drive quality too high.  Against this background, the LSB’s priority would be to ensure legal services become more affordable (and so accessible), whilst ensuring consumer confidence in the quality of legal services.  In public policy terms, the idea is win-win: consumer trust and affordability can both increase the size of legal service markets.  It is also reasonably clear in its trajectory, being deregulatory in approach: the case for regulation has to be made with evidence not the other way round.

In what follows, I challenge the strength of this presumption in favour of competition.  I take it as read that competition has benefits, but I believe the Report under-estimates the risks posed to quality.   In particular, I aim to advance a debate about how we might sponsor the right kinds of competition in legal services.  To do this, I look at some of the evidence on competition in health services.  The central idea is that regulators need to be sure that the markets the govern stimulate competition on quality rather than just price.

What the health economics literature says about competition

In so far as Decker and Yarrow tend to dwell on specific elements in the economic literature, they rely on utilities regulation.  For me, it is a surprising choice.  Given the asymmetries of information between supplier, patient (and purchaser) and the involvement of (powerful) medical professions, where there are some important analogues with legal services, health economics might provide more interesting insights.  It is also an area where there is an emerging empirical literature on the relationship between competition, price and quality.[3]

This empirical work tends to examine competition either in the NHS in England and Wales and in the United States.  It looks at competition on price; competition on quality; and competition on both quality and price.    The findings from this research tend to suggest that competition on price alone diminishes quality.  In social welfare terms that is not necessarily bad: prices and quality may be higher than the client needs: the dentists’ smile may be expensive and beautiful but if it is not affordable or necessary then lower quality dental services may be justified.  It is also important to note that whether a diminution in quality is good or bad depends on the appropriateness of the price.  If price is too low, then quality can diminish to unacceptable standards: a market for lemons can develop. In health services, competition on price alone can kill.
Conversely, the research suggests that competition on quality alone increases quality.   This is heartening but unsurprising.  Suppliers who have no other means of competing, do so on quality and raise their observable quality to attract more clients.  Their ability to do this depends on their ability to signal meaningfully higher levels of quality.

The research on competition where there is quality and price competition is more mixed.  It suggests that competition reduces price, but quality appears to have been reduced sometimes and increased in others.  The most likely way of explaining this difference in results is whether consumers know about and respond to differences in quality.  That is, for competition to occur successfully on the basis of quality consumers have to perceive real differences in quality and perceive that those differences in quality are worth paying for.  Put another way, for quality to improve under price and quality competition, signals of differences in quality have to be of comparable strength to differences in price.  Critically, competition on quality is dependent on consumers knowing about and responding to differences in quality.  In health services such competition has typically occurred because the purchasers were informed, volume purchasers such as insurers, GPs or primary care trusts (PCTs).

Where does this leave us in relation to legal services?  The most important thing that this suggests is that for a market for legal services to function effectively signals about the relative quality of legal services have to be at least as meaningful as signals on price.  If they are not quality is likely to diminish significantly as a result of competition.  That is not to say consumers cannot, or should not, choose price over quality, but that they should do so on a reasonably informed basis (as long as signaling quality in this way can be done on a proportionate basis).

Most of the research on consumers of legal service suggests that would-be clients assume that all lawyers are equally competent, although I suspect also – based partly on my own work – that clients have some inchoate ideas about relative quality[4] (some use specialisation and price (‘you get what you pay for’) as proxies).  Ensuring that stronger signals of relative quality develop within legal service markets should be a central goal of professional service providers and professional regulators.  Whether we should let the market work this out for itself or the regulators should step in first is an interesting question which may vary depending on the risks posed in particular markets and the costs of intervention.

The market can be seen to be responding to the quality issue through evolving markets for intermediaries.  Referral sites pass on clients (e.g. Wigster.com) and franchise operations  (e.g. QualitySolicitors) assure their customers that they are referring them onto firms who’s quality is monitored.  The extent of such quality assurance can, on publicly available evidence at least, best be described as modest.  Limited service standards deal with things like the time to be taken to respond to telephone queries.  For some, at least, there is a degree of monitoring of consumer satisfaction.  To the extent that legal services are ‘experience goods’ where consumers “becomes aware of the quality as it is being consumed”[5], monitoring (if conducted well) may usefully aggregate consumer judgments on quality that are nevertheless somewhat imperfect.  We simply do not know how important those imperfections are, though we do know consumer satisfaction can mask professional incompetence.[6] There are some claims that the reputation of firms is subject to scrutiny before being admitted to at least one of these arrangements.[7] Again, the nature and efficacy of these reputational tests are unknown.  It is reasonably clear that the notions of quality being utilized so far are heavily service oriented: they concentrate on aggregating and ensuring the service issues that clients can evaluate themselves.  They are empitomised in the friendly faces (interestingly, animated rather than real) used to market the services in adverts and websites.  The benefits of aggregation are not to be sniffed at, but the question is whether such mechanisms will be sufficient protection of quality if competition pushes down on technical elements of quality which clients (and intermediaries) are not in a position to judge.

It should also be emphasised that there are differences between the legal services sector and the health sector.  Barriers to entry are different (especially at the specialist end given the infrastructure hospitals require) and the role of public finance is stronger: in legal services the dominant model is clients purchasing for themselves; in health it is third parties purchasing for clients (be they insurers/HMOs, GPs or PCTs).  The existence of divisions of labour in a system may aid purchasing decisions and the process of competition.  Competition on quality works when purchasers understand and value quality appropriately with reference to cost.  Hence the assumption that GPs (or PCTs) might make a better job of choosing specialist health services than the patients.  Whether they do so depends in part on economic and other incentives acting on them of course, including the ability to ‘know’ and act on quality.  The historic divide between the solicitors and barristers is one such division of labour, albeit being eroded by a succession of reforms.  Furthermore, the impact of the advocate-litigator division may have relatively limited purchase given the relative rarity with which litigated cases involve substantial advocacy.  Claims management companies provide another, more controversial division of labour.  The emergence of referrers and franchises discussed above suggests another developing.

It might be expected that useful divisions of labour will survive (or evolve) through competition.  This was the approach the OFT[8] took to Bar’s referral only rule and one which at bottom informs the report.[9] There are some reasons to raise doubts, however.  One is the complications posed by the commercialisation of referral decisions within the process either tacitly or formally.  Any referrer has a desire to keep their clients happy (enough) but also a need to earn any referral fees they can.  This may partly be about satisfying rather than maximising client interests.  However, in balancing commercial self-interest and service quality, technical quality might be what is squeezed out.

An equally important consideration is what information can referrers (or clients) use to evaluate the quality of any provider.  One might argue that as the market for intermediaries matures, so will its approach to quality.  Keen to protect their brand, firms will become increasingly choosy about which lawyers they refer business too, or permit into their networks.  The risks posed by having technical incompetency exposed might be a salutary incentive to develop better systems of quality control encompassing technical quality.  One answer to that might be that the same incentives were operating on the professions but they (arguably) did not respond effectively.  Conversely, if such referrers or franchises begin to take significant market share, they will be able to exercise choice over who their ‘members’ are in a way that professions cannot.  Such networks have the potential to be exclusive (and so able to demand higher quality) when professions are under significant political pressure from their members to be inclusive (having to work much harder to justify to their existing members why they should set standards higher).  Theoretically then plausible cases can be made that intermediaries may be prone to gold-plating in the way that it is claimed the profession is (if it leads them to more business) or to ignoring technical-quality for reasons of commercial self-interest.  In the absence of solid signals of quality the latter is more likely.  For me this suggests that regulators need to find ways of understanding and shaping the behavior of these organizations to maximize the chances that they will base referral decisions on quality rather than purely economic grounds.

A final point is that one defence against a race to the bottom is a strong regulatory floor (i.e. robust basic competence standards properly enforced).  Here the important question is whether regulation is both proportionate and strong enough to prevent quality dropping to dangerously low levels.   I have been involved in a number of research projects which have looked at the levels of quality provided by practitioners in the legal aid scheme.  All of these suggest levels of incompetence which were worryingly low.[10] Why would we think increased competition would make this better unless there is a greater and more imaginative focus on quality in regulation?


[1] The paper does not state that an approach should be incremental but it seems to me this fits with the overall direction of the authors.

[2] Pages 31 and 32 of the Report.

[3] See, for example, M. Gaynor (2006) ‘What Do We Know About Competition and Quality in Health Care Markets?’; http://papers.ssrn.com/sol3/papers.cfm?abstract_id=910834; Z. Cooper et al (2010) ‘Does Hospital Competition Save Lives? Evidence from the English NHS Patient Choice Reforms’, LSE Health Working Paper No 16|. London; C. Propper (2010) ‘Healthcare Competition Saves Lives’,  http://www.bristol.ac.uk/cmpo/publications/bulletin/winter10/propper.pdf

[4] See, Moorhead and Cumming (2010) Something for Nothing : Employment Tribunal claimants’ perspectives on legal funding (London: BIS).

[5] Report, Page 31

[6] Moorhead R, Sherr A and Paterson A (2003) ‘What clients know: client perspectives and legal competence,’ International Journal of the Legal Profession, 10 (1) (2003) 5-36.

[7] See, further, Moorhead (2009) ‘Branding and Quality: What is Five Star Service?’ https://lawyerwatch.wordpress.com/2010/10/12/branding-and-quality-%E2%80%93-can-a-franchising-model-work/

[8] Office of Fair Trading (2001) Competition in professions – A report by the Director General of Fair Trading (London: OFT).

[9] Report, page 60

[10] For summaries see, Moorhead R, Sherr A and Paterson A, (2003) ‘Contesting Professionalism: Legal Aid and Non lawyers in England and Wales,’
Law and Society Review, 37 (4) 765-808 and Moorhead R (2010) ‘Lawyer Specialization – Managing the Professional Paradox,’ Law & Policy, 33 (2) 226-259.

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About Richard Moorhead

Director of the Centre for Ethics and Law and Professor of Law and Professional Ethics at the Faculty of Laws, University College London with an interest in teaching and research on the legal ethics, the professions, legal aid, access to justice and the courts.
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