Diving into the recent “State of the Legal Market Report 2022”, we see a legal industry that is showing resilience, but could it be derailed by rising compensation costs?
The Thomson Reuters’ 2022 Report on the State of the Legal Market he described a legal industry immersed in a growing war for talent. Since major law firms like Milbank began raising their associates’ salaries in early 2021, the market has gotten better each subsequent month as the average salary of associates increased.
As of the end of the second quarter of 2021, associate compensation growth per full-time equivalent (FTE) associate had reached 5.9% on a 12-month rolling average. By November, that growth had ballooned to 11.3%, with no end in sight.
Law firms are slow to change, and even when faced with a crisis, they implement their traditional strategy. To that end, companies began to regularly increase compensation, relying on higher wages to maintain retention. However, based on the underlying economics, this is not simply a bad strategy, it is bound to lose.
In economics, the work-leisure model is a way of conceptualizing how people make decisions about their work and wages. Fundamentally, it’s an acknowledgment that all workers make a trade-off: Do they want to earn more money but enjoy fewer hours of personal time? Or do they want more leisure at the cost of lower income? We can show this in graph form, with leisure hours on the X-axis and earnings on the Y-axis. Under this system, a salary takes the form of a line, drawn from the far end of the X-axis to the end of the X-axis. top point on the Y-axis. This top point symbolizes the theoretical maximum an employee could earn if he devoted all his available time to work, while the opposite point on the line symbolizes the minimum income he would earn if he had to enjoy only leisure.
To complete the model, we need to add the worker or in this case, the associate. This is done by including a utility curve (also known as a indifference curve) which means an exchange of income and leisure in which the young associate obtains the same satisfaction. As long as the associate is somewhere on this line, he is indifferent to the exact combination of work and leisure. However, if another law firm were to offer the associate a higher offer (namelymore money for the same effort) the associate would move to a new utility curve that we have drawn earlier.
With all of this set up, we can determine how many hours people will work and for what wage, since they will select the point where the wage line contacts the highest utility curve.
Associates perennially reside on the left side of this graph, working absurdly long hours for very high pay. This is where the first problem arises for law firms: how to curb rising marginal costs. The utility curve is a curve for a reason. As leisure hours decrease, associates value the remaining hours more and more. As such, the pay that law firms must offer their associates for these few remaining hours adds up rapidly. The utility curve eventually becomes infinite as associates refuse to give up any more vital leisure time. This is why law firms cannot simply pay associates to work indefinitely, the cost per hour eventually becomes too much for even one law firm to bear.
This, of course, is nothing new. Companies have recognized a limit to this arrangement and have historically found a comfortable area of stability. He set the expectation of a certain payment for a certain number of hours from his associates.
And then the COVID-19 pandemic happened, and millions of people across industries reassessed their careers and lifestyles. En masse, profit curves shifted, upsetting the balances law firms had managed to strike with their associates. The same combination of wages and leisure moved down multiple utility curves as, instead of changing the job, the associates themselves changed. Simultaneously, companies began a bidding war for talent as the value of associates skyrocketed, while at the same time associate discontent increased.
The solution seemed obvious to many law firms. If the war for talent is a bidding war, the way to win is to keep up the pace. However, as we have said, companies that commit to this strategy are not only destined to see diminishing returns, they are also destined to lose.
Tale of two law firms
For example, suppose a law firm seeks to retain talent and does so by continually raising salaries. As noted above, because lawyers are already at the far left of the work-leisure graph and because of the nearly vertical utility curve at that point, paying associates more I will not do it make them more productive. Worse yet, the recruiting company isn’t really making its associates happier. A bit of calculation shows that the utility gains from wage increases in the upper right territory are just as marginal as the productivity gains, that is, very small. The contracted law firm has significantly increased its costs, has not achieved productivity gains, and its associate is only slightly happier
Now suppose there is a second company, one looking to recruit in the current market. His strategy is simple: match pay and require fewer billable hours from his new hires. If the only thing that keeps associates in a company is money, then by giving them the same salary for less work, another company can attract them. This is not a terrible solution for gaining talent. Although the profit generated by this new attorney will be lower, given the increase in direct costs and the lower number of hours billed, it will still be a positive profit generation for the firm.
What is the response of withholding companies to this strategy? If companies follow the traditional strategy, they increase wages even more. In response, the recruiting firm matches that salary and keeps the hours lower. The process is repeated infinitely until the economic benefit of this layer reaches zero.
Who wins and who loses? Well, obviously the associates win since they are reaping all the rewards of their work, while working the same hours or less. However, companies that engage in a pure compensation strategy lose. By engaging in an endless series of outdoings, companies fall prey to the cruelty of a commodity market where the highest bidder takes all. The only equilibrium that companies find and the only end point of this strategy is the one in which all the potential economic benefit of an associate has been squeezed out in salary negotiations. If companies treat the talent market like a commodity market, then the economics of a commodity market will take hold and drive profits down to zero.
So what should companies do? This is not a new problem, other industries have faced it and found solutions. By emphasizing a more tribal sense of belonging, companies can build a bond with their associates that goes beyond the transactional nature. Also, these binding Strategies don’t fall prey to this ever-increasing spiral of rising costs because associates may turn down offers that may be better financially because they’re imbued with the feeling that they’re getting happiness through their employment at their current company.
If law firms can help their associates find purpose and happiness through something other than monetary compensation, perhaps those firms can escape the harsh economic demands of an open market.