A Shirking Theory of Referrals

Abstract

Many service industries, including the medical and legal professions in some countries, display a gated structure. Rather than approaching a …nal producer directly, a consumer will …rst seek a referral from an intermediary. In this paper, we provide one possible explanation for such an industry structure. If the outcome of a transaction depends on producer e¤ort, which is unobservable and unveri…able, then the market may fail to generate a Pareto optimal outcome. This is the standard moral hazard problem. If consumers had a long-run relationship with producers, this type of market failure might be avoided. However, in some industries, consumers will only have a short-run relationship with producers. A gatekeeping intermediary may provide an opportunity for reputation e¤ects to apply in such a setting. By aggregating many potential consumers, gatekeeping intermediaries can create an arti…cial long-run relationship between a consumer and a producer. This long-run relationship reduces the incidence of shirking on the part of the producer.