Profit sharing and market structure☆

a r t i c l e i n f o We study how agents decide between working for firms with profit sharing and firms in which pay is based on individual productivity. Profit sharing has the disadvantages of free riding and adverse selection. The benefit of profit sharing is that it makes easier for agents to signal their productivity. We show that in equilibrium skilled agents are more likely to belong to profit sharing organizations. The analysis provides a framework for understanding the market structure of industries like law, accounting and consulting services in which both profit-sharing partnerships and " eat-what-you-kill " firms co-exist and compete with each other. In professional services and services in general, some firms share output among its members, and others divide output according to each member's production. For example, some law firms are lockstep seniority partnerships in which the compensation to each partner depends on seniority only, whereas other " eat what you kill " firms compensate their members according to the revenues they generate. 1 In some restaurants, the waiters keep the tips they receive for themselves, and in others, they divide tips equally. The decision on whether compensation should be more like lockstep seniority partnerships or eat-what-you-kill companies affects firms in two ways. First, it affects agents' incentives to exert effort, and second, it affects firms' ability to recruit and keep workers in the organization. Sharing agreements reduce the effort agents exert because such agreements create a free-riding problem. Sharing agreements also makes it difficult for the firm to recruit skilled agents that are reluctant to share with less productive partners. In spite of these problems, sharing partnerships remain the prevailing organizational form in some professional services industries. The aim of this paper is to understand how the market addresses these two problems and to characterize the conditions under which sharing partnerships emerge. Although there is an extensive economics literature on the free riding problem, the economics literature on partnership dissolution has fo-cused more how partners should divide assets after dissolution (see for example Crampton et al., 1987), rather than understanding how organizational form may affect the firm's ability to recruit and keep workers in the firm. This issue has received more attention among law and strategy scholars. For example, in an often cited paper Gilson and Mnookin (1985) discuss sharing partnerships, and describe them as unstable because the most productive partners …