Advice is Cheap: Information is Not!
55 Pages Posted: 24 Oct 2017
Date Written: October 13, 2017
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. Three contracting environments are considered: (i) complete contingent contracts in which compensation to the consultant may depend on reports, investment levels, and project outcomes; (ii) incomplete contingent contracts in which compensation may depend only on reports and project outcomes; and (iii) reputational contracts in which the consultant receives a non-contingent payment from a sequence of entrepreneurs so long as his referrals remain high. The principal under-utilizes information in settings (i) and (ii). In setting (iii) investments are statically but not dynamically efficient. For some parameter values the consultant shirks with positive probability and, therefore, supplies garbled advice. Finally, it is shown that if the consultant delivers no advice, then he nevertheless must be compensated in setting (i) and penalized in setting (iii).
Keywords: Consultant, Expert, Information Acquisition, Reputation, Referrals, Fake News
JEL Classification: C73, D81, D82, D86, L14
Suggested Citation: Suggested Citation