If you hire a law firm, as an individual or the owner of a small business, there is a pretty good chance they will bill you by the hour. So if the work performed takes 100 hours rather than 50, you will pay them twice as much. From the law firm’s perspective, this is reasonable, because each one of their work hours is about as valuable to them as every other one (holding the specific employees on the project constant). However, if we are justified in assuming that law firms are entities that can reasonably be modeled as profit maximizers, this arrangement can be problematic.
A law firm using hourly billing has a profit incentive to exaggerate how long work takes. And, unless the firm is already right at capacity in terms of the workload they are able to manage, it is advantageous for the firm to stretch out the time that your work takes so that it fills the otherwise free hours of their employees. It is easy to make a project take longer in ways that don’t feel very unethical: for example, spending extra time on formatting documents nicely, double and triple checking work, compiling cases that are unlikely to be all that relevant, or meeting unnecessarily to further discuss the case. Parkinson’s Law may also be at play here: if a project must be completed in two weeks, there may be a tendency to work on it for two weeks, regardless of how many hours optimally would be spent.
Two obvious incentives law firms also have are to avoid getting sued and to avoid looking incompetent. If they provide you with inaccurate information, or make obvious mistakes in their work, they are putting themselves at risk. You, of course, also don’t want inaccurate information or large mistakes in the work they hand you. But it is not necessarily the case that you care about these mistakes to the same degree as the firm. For instance, some errors affect them much more than you, such as irrelevant spelling errors in work that is merely intended for you to read. Such errors make the firm look bad but don’t impact the quality of the legal work. Yet a law firm may spend extra hours scrutinizing documents to eradicate such unimportant mistakes. On the other hand, other errors are far more likely to harm you than to harm the law firm, such as terms in a contract that are not what you intended, but which you would not have a strong legal case to sue the firm over.
The profit incentive of a law firm will tend to impact how its employees act, as it will incentivize upper management to put structures in place to promote this profit generation. But we can also consider the incentives of the individual lawyers assigned to work with you. They too have a reason to exaggerate how long work has taken. More recorded billable hours make employees look good to bosses, and make them appear to be more valuable employees (which, for associates, may increase their chance of making partner). Some associates at top law firms don’t even bother to use timers to keep track of time billed. In such cases, you can imagine how easy it can be for them to fudge the numbers, or conveniently round up. Even workers with no intention of dishonesty may rationalize over billing, or simply have an exaggerated sense of their own productivity. When we simultaneously have a strong incentive to do X, and also to believe that X is not immoral, we humans are remarkably good at coming up with reasons why X is a fine thing to do (conveniently not searching for reasons why it wouldn’t be fine). And, of course, nobody can verify how many hours were actually worked by any particular lawyer.
Whereas firms as a whole have a profit incentive to do work slowly when the firm is operating below maximum work capacity, individual lawyers have mixed incentives when it comes to doing work slowly. On the one hand, slow work increases billable hours, which makes the lawyer look good. On the other hand, being able to turn around work quickly is viewed as a virtue by bosses, and in some cases, the faster a lawyer gets her work done, the sooner she can go home at night. [Note: it has also been reported to me that sometimes new lawyers will under report their hours worked, so their bosses don't realize how much they struggled with the work they had been assigned.]
Incentives aside, another challenge of hourly billing is that it can make it difficult for a client to know whether the service for which they are hiring a law firm is worth the cost, since they don’t even know what the cost is going to be. Some firms will produce estimates of the time that a project will take, but these can be quite unreliable (I personally know of at least one case where a firm was off by a factor of more than five) and while there is little incentive to overestimate the time a project will take, underestimating it will encourage a client to work with your firm rather than another. Even without such financial incentives, it is well-known that people tend to underestimate the time that projects will take. Remarkably, this often still holds even when people are aware that project completion times are usually underestimated (perhaps an instance of Hofstadter’s law).
One countervailing force to the incentive alignment problem is that law firms have to worry about reputation and getting repeat business. If they take a long time to do your work, or exaggerate the number of hours that work took, or give you bad estimates of how long future work will take, you will be less likely to hire them in the future, and may speak poorly about them to others. Unfortunately, due to the difficulty of acquiring information, this probably produces less of an incentive than many people assume. It is very hard for an outsider to estimate how long specific legal work should take, or evaluate the quality of the work done. How do you know, for instance, whether the will a law firm produced for you is a good one? Are you, as a non-lawyer, able to evaluate its quality? And if you never get sued, how do you know whether a contract you hired a firm to create truly protects your interests? For that matter, how do you know whether the 30 hours billed was a reasonable amount of time to produce that particular contract? As a non-expert, you most likely would not be able to tell from the contract itself if they had in fact only spent 20 hours working on it. Even in the instance of a case that was won or lost, while it may seem easy to evaluate the firm’s work quality, it is unclear what would have happened with that case if you had gone to competitors. Did you win because of your lawyer’s skill, or despite their lack of it? Did you lose because of weak performance, or because the case was very difficult? Would a competitor have achieved a better settlement, or a better plea bargain, or gotten the same result but at 80% the cost? It is fundamentally difficult for a non-expert, non-lawyer to measure the quality of work produced by lawyers. Of course, many issues similar to these apply to areas outside of law as well, when the person hiring lacks the ability to evaluate the quality of the product that they receive. [As some commenters have noted below, when large corporations hire law firms, they should be capable of holding these firms much more accountable than individuals are, because they have internal legal counsel with expertise in evaluating the quality of worked performed.]
What about reputation? Many people will choose a firm in part based on personal relationships, or what they happened to have heard said about that firm, or based on the firm rankings, or based on how famous the firm is. But if most individuals hiring law firms can’t evaluate the quality of the work that they are hiring firms to produce, it is not clear that firm reputation will be updated very efficiently. Does the fact that a friend of yours had a good experience working with large law firm X imply very much about that firm’s average quality? First of all, he likely only worked with a tiny fraction of their lawyers. Second, it is fairly likely that your friend is basing his assessment largely on softer factors like how attentive the firm was, how closely they matched his expectations of what a good lawyer seems like, and how much he personally liked the people he dealt with there, not on the quality of legal work produced and cost effectiveness (since as we’ve said these can be hard for a non-lawyer to evaluate).
The law firm ranking systems can be problematic as well. For instance, the Vault ranking, which is one of the most commonly used, is based on the opinions of law associates. They rate firms “on a scale of 1 to 10 based on prestige” (not being allowed to rate their own firm, and being asked to not rate firms they are not familiar with). How much does this really correlate with how good or cost-effective the work of a firm is for a typical client? Somewhat, surely, but it is far from an ideal measurement. What’s more, the prestige that an associate assigns to a law firm itself probably depends somewhat on the prior year’s vault rankings, adding circularity to the process.
Fame is a problematic measure as well. Older firms will tend to be more famous, as will those involved in famous cases, or that frequently appear in the news. But again, this may not correlate that well with quality of service and cost effectiveness for a typical client. In fact, famous firms and older firms may have less incentive to provide good service to new clients, since they have long established relationships and so can typically afford to rely less on new business.
There is little question that hourly billing creates misaligned incentives between you and your law firm. Project based billing (where a cost for the project is fixed in advance) fixes some of these problems, but produces new ones. With project based billing you at least know what hiring the firm will cost you, and so may be able to do a better job of estimating whether the project is worth the expense. But, in this case, firms have an incentive to get your work done in the least hours possible, since they get paid the same whether it takes them 100 hours or 200. So they may spend less than an ideal amount of time working on your project in this framework, and produce lower quality work than under the hourly billing paradigm.
When you hire a law firm, their incentives are not very well aligned with yours. You may be able to improve this problem, in some cases, by consulting with an unbiased lawyer about the quality and cost effectiveness of another lawyer’s work (compared to the available alternatives) before hiring the latter. Of course, the former lawyer would have to be reliable herself and quite familiar with the latter’s work.