Advice Is Cheap: Information Is Not!
39 Pages Posted: 14 Oct 2017 Last revised: 12 Jul 2018
Date Written: June 28, 2018
An entrepreneur contracts with a consultant, who is protected by limited liability, to supply information about the state of a project prior to investing in it. For a given level of investment, a good project succeeds with higher probability than a bad one. The entrepreneur makes an upfront payment that the consultant can either invest in information acquisition (work) or divert for private benefit (shirk). If the consultant works, then he privately observes an unverifiable signal concerning the state of the project. Whether he works or shirks, the consultant reports a signal realization to the entrepreneur who then invests in the project in accordance with the advice she receives.
Two commonly observed contractual environments are considered:
(i) contingent contracts in which compensation to the consultant depends on his advice and the project outcome and
(ii) reputational contracts in which the consultant receives a non-contingent payment from a sequence of entrepreneurs so long as his informal referrals remain high.
The principal finds it optimal to under-utilize information if she uses a contingent contract. Under reputational contracting, investments are statically efficient but not sufficiently sensitive to advice from a dynamic perspective. Also, if the consultant has a high degree of expertise (i.e., receives a highly informative signal), then under reputational contracting he shirks with positive probability and, therefore, supplies garbled advice.
Keywords: Consultant, Expert, Information Acquisition, Reputation, Referrals, Fake News
JEL Classification: C73, D81, D82, D86, L14
Suggested Citation: Suggested Citation