Playing well together

Ability to share information about economic opportunities motivates firms to expand boundaries

Based on the research of Professor Thomas N. Hubbard

By Beverly A. Caley

	Thomas Hubbard  Photo © Evanston Photographic
	Insight insights: selections from the Kellogg online faculty research digest To find more articles, including faculty biographies and suggestions for further reading, or to join the conversation by leaving your own comments, visit Kellogg Insight.

Why do some people in human-capital-intensive industries, such as law and medicine, decide to work together in firms? When do firms "extend their boundaries" by including a wider range of work and people with a broader variety of expertise? Research published by Kellogg Professor of Management and Strategy Thomas Hubbard finds that the answers are shaped in part by the value of sharing economic information.

Hubbard and Luis Garicano (University of Chicago) investigated factors that determine firm boundaries in human-capital-intensive industries. They used confidential law office data collected by the U.S. Bureau of the Census and examined information that indicates how lawyers specialize and are organized into firms. Using this data, the researchers examined central issues in the organization of human capital.

Their findings suggest that organizing lawyers into firms facilitates the exchange of information about economic opportunities. "Firms essentially weaken individuals' incentives to withhold information from each other," Hubbard explains. Since lawyers in the firm share revenues, they know that giving one another useful information that benefits the firm also will benefit them individually.

Among the evidence for the value of referrals, the researchers found that lawyers who work in litigation-intensive fields tend to work in field-specialized firms while lawyers in transactional fields tend to work in firms with multiple kinds of specialists. Hubbard and Garicano explain this pattern by the relative referral value in each of these kinds of law. "If you're a litigator, clients can self-refer pretty easily," Hubbard says. "If I'm being sued for negligence, it's pretty obvious that I need a negligence lawyer, and I don't need an environmental lawyer." Thus, there is not much value in having these two types of lawyers in a firm, because the referral patterns between them are so low.

But for lawyers engaged in transactional work, the referral opportunity is greater. For example, if a client is buying a facility in the next county, the client may wonder about both the deal's tax and the environmental implications. In this case, the client cannot easily identify the need and match the need to the appropriate expert. This results in the original lawyer having knowledge of a potential economic opportunity. Expanding the firms' boundaries by affiliating the tax, environmental and contract lawyers, breaks down barriers to sharing information.

Hubbard explains that risk sharing offers a popular theory about why lawyers join firms. In fact, this explains why any firm diversifies: to insulate from demand fluctuations. However, the researchers found little evidence to support risk sharing as a motivator for collaboration in the context of law firms. "If you're a corporate lawyer, you are usually working with someone in a related specialty, such as a tax lawyer," Hubbard says, adding that these demands are positively correlated. "If law firms' boundaries were all about hedging their bets, corporate lawyers would never work with tax lawyers. They would work with lawyers in areas of the law where demands are not positively correlated, such as divorce lawyers."

Hubbard says that just because an industry is human-capital-intensive does not mean that large projects lead to large firms with many kinds of specialists. In the construction industry, it takes a variety of skills to build a house. If a house-building firm expanded its boundaries, it might result in a firm that consists of a carpenter, a plumber, a drywall installer and an electrician. This is rarely the case. "Just because you need various specialists to produce something doesn't mean that all these specialists will work within the same firm," Hubbard says.

Examining the nature of referrals enables the researchers to apply their findings to other industries. Hubbard describes a referral as an exchange of information about an economic opportunity; this collaboration transcends the realm of law and can be applied in other firms, such as a pharmaceutical company. Researchers in one division might make discoveries that could be more valuable in another part of the organization. If these were separate entities, the discovery's value might be minimized due to difficulties in sharing the information. When the researchers are in separate divisions of the same firm, this facilitates information exchange, and the entire firm benefits.

"The broad principles of what we found could apply generally to all human-capital-intensive firms," Hubbard says.

Beverly Caley is a freelance writer based in Corvallis, Ore.