Billable hours and the distribution of costs

Pretty much everyone involved in the legal profession in any meaningful way spends much if not most of his/her time trying to allocate costs. Whether you’re a judge structuring a judgment or consent decree, a litigator structuring a settlement, a transactional attorney structuring a deal, or a legislator or regulator structuring new rules or laws, you’re inevitably left with the fundamental question: “Who is going to bear the cost?” Indeed, any transaction between two or more parties (and even parties acting alone, if you consider externalities) implicates questions of cost distribution.

This is why it is absolutely mind-boggling to me that law firms – ostensibly the veritable pinnacles of rationality and enlightened self-interest – overwhelmingly employ a direct billable-hour model, a model which creates perverse incentives and uncritically distributes costs inefficiently and inequitably.

O, let me count the ways:

First, billable hours create perverse incentives. Hourly wages are reasonable for jobs which consist in substantial part in presence (i.e., security guard, cashier, etc.), since that part of the job cannot be made more or less efficient. For professional, skilled labor, hourly wages create a tension between skill (a function of quality and efficiency) and financial incentive (the slower you work, the more you earn). Law firms, doubtless realizing this, pay salary rather than wages. This might have been a valid approach, granting arguendo that market forces would prevent firms from intentionally hiring slow lawyers, if there were no billable-hour targets for individual attorneys and if their bonuses weren’t contingent on billable milestones.

Second, billable hours are hugely inefficient. Economists often talk about things having diminishing marginal value, meaning that each consecutive unit of that thing is worth less than the one before. The standard example is money: another $100 is worth a lot when you have $1000, but very little when you have $100,000. Of course, labor is the flip-side of capital, so the more you’ve already worked, the less work you’ll ordinarily be willing to do for the same pay – consider the difference between your third consecutive hour working on something and your ninth. Because hourly billing does not account for this, clients can be effectively timeline-indifferent: starting a 40-hour project two weeks in advance costs the same as starting it two days in advance. The individual attorney, on the other hand, would of course rather bill four hours per day over the course of 10 days than 20 hours per day two days in a row. This results in what economists call deadweight loss – the difference between what-it’s-worth-to-you (the fair market value) and what-you-actually-pay – since the attorney works more highly-valued hours (hours five through 20 on each of two days) than he/she would have otherwise, and that difference in value doesn’t flow as gain to either the client or the firm. This is textbook inefficiency. (Alternatively, the firm could take on the cost of scrambling several attorneys to each work four to eight hours on both days. In this case, the inefficiency harms the firm instead of the lawyer while the client remains indifferent.)

Third, billable hours create all kinds of externalities and financial and non-financial costs. Because billable targets are high, individual attorneys can’t turn away clients, and clients tend to spring large projects at the last possible moment (or later), lawyers work ridiculous hours. This imposes physical and mental health costs on them, social and emotional costs on their families, and human capital costs on the firms (on the one hand, attrition due to burnout, and on the other, the opulence necessary to convince associates that life is still worth living). Indeed, the externalities reach the profession itself – lawyers are significantly more likely than any other professionals (probably even rock stars) to be substance abusers.

Now, I’m not sure that market forces can solve every problem. But it seems to me that in this case, shifting some of the costs back onto the client would do everyone involved a world of good. And that includes the clients, since law firms inevitably have to drive up prices to cover the costs to them and offer salaries high enough to convince people to subject themselves to the almighty billable hour. I cannot imagine it being all that difficult to figure out a way to charge a premium for expedited or otherwise high-stress, high-intensity work. And again, the goal is not to reduce the amount of work, but simply to smooth out the workload over time, thereby mitigating the diminishing marginal value problem.

Come on now, law firms – chop chop!