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Competitive Analysis of Large Law Firms
Ram Jagannath, Class of 2007
Andrew Miller, Class of 2007
Elizabeth Stevens, Class of 2007
December 6, 2005

I. Introduction

           There are a multitude of law firms spanning the spectrums of size, geographical presence, service offering, and pricing methodologies in the United States today.  However, the most common segmentation of the legal landscape differentiates firms by size, or number of attorneys.  This paper focuses on understanding the competitive dynamic involved with one of the groups of this segmentation – the large law firm. 
           These firms exhibit certain particularly interesting characteristics, which are not easily explained by traditional micro-economic theory.  First, these firms are large in number and compete intensively to attract and retain mainly large corporate clients.  Second, differentiation among these firms along geographic and service-line offerings are blurring, indicating that the legal services they offer to clients is becoming more homogenous.  Traditional theory would thus anticipate that the price charged by these firms to their customers would decrease to marginal cost given the number of firms competing and their similar service offering.  However, exactly the opposite seems to hold true.
           The price for legal services has not decreased to the marginal cost of firms as expected in perfect competition despite the market factors at work in the market for large law firms.  In fact, price competition does not seem to exist among firms, even among those competing for the same clients.  While the corporate clients these firms serve are relatively price inelastic, the profits generated by these firms indicate they are operating close to monopolistic price levels.  This paper sets out to understand competition in the market for legal services among these large law firms, and to explain why these firms are able to operate at the price levels currently seen in the market.

II. Industry Overview: Large Law Firms

           Large law firms are defined by the National Law Journal to be 165 or more attorneys.   Growth in attorney headcount among these firms was 4.4% from 2004 to 2005, a significant increase from the 1.5% growth rate seen in 2004, and the 1.6% rate in 2003.   The highest growth rate in recent years was 8.2% in 2001. 
           Large law firms offer a multitude of service offerings to their typically large corporate clients.  The most basic division between the work of attorneys at these firms is between litigation and transactional services.  Litigation can encompass broad corporate antitrust, intellectual property, contract dispute, and general business disagreements.  Litigation services at these large firms can also include complex tax, estate, and white collar criminal matters as well.
            On the other hand, transactional services include the execution of financial and tax-related deals on behalf of corporate clients.  Examples of transactional projects include mergers and acquisitions (M&A) advisory work, legal diligence for acquisitions, and contract drafting for mergers and public offerings by public corporation clients.  Although some firms focus their efforts on specific industry specializations or offer esoteric services such as private equity fund formation; for the most part, the large law firms offer vastly the same array of services within the two main buckets of litigation and transactional services.

III. Are Law Firms Charging Perfectly Competitive Prices?

            Using the fee schedule a large national manufacturing firm paid its law firms, we compared the hourly fee rate per associate year to the estimated marginal cost of an average law firm.  Since law firms provide a service and all large law firms in major markets pay new associates $125,000 , we have assumed that their marginal costs are identical.  To estimate the hourly marginal cost, we estimated a 10% growth in salary per year for an associate, divided by average yearly billable hours (1800) , and added a 20% overhead factor.  The overhead factor captures the cost of support staff, bonuses, rent, and other overhead expenses.  To calculate the profit, we subtracted the per hour marginal cost calculated from the given hourly fee schedule for the appropriate associate year. See Figure 1.

Figure 1: Summary of Profits by Firm


            The large number of law firms would suggest that this market should be perfectly competitive and that price large firms are charging would be at or close to marginal cost.  Most large law firms in large markets have talented associates that have graduated from top law schools.  It is likely that the same percentage of associates at each firm have participated in law review, clerkships or national trial teams. The main cost to the law firm, labor, is indistinguishable from one large firm to the next, suggesting that no firm has a cost advantage and pricing should be similar to consumers.
           The larger profit margins demonstrated by the above figure call that suggestion into question.  Most of our sample law firms are making well above the marginal cost and profits are increasing per associate year.  This suggests that law firms are gaining profit based on the learning rate of associates.  Anecdotally, lawyers suggest that year one and two are an associate’s most inefficient years, and this data would suggest that this is true (note the large profit jumps between year one and two for firms two and five as well as between year two and three for firm one).

IV. Differentiation by Large Law Firms (Spatial Model)

            Because firms are charging close to the monopoly price, this must be explainable by some type of differentiation between firms.  Currently firms attempt to differentiate on the basis of geographies and service offerings in order to attract one client over another. 
Geography
           In the late 1980s and early 1990s, large law firms sought to be national law firms instead of the regional players that dominated the market previously.  Chicago-based law firm Kirkland & Ellis opened its New York office in 1990, its Los Angeles office in 1989, and its San Francisco office in 2003 .   
Now that most large law firms are located in all of the major domestic markets (New York, Washington, DC, Chicago, San Francisco, Houston and Atlanta) , growing internationally became the next step toward developing differentiation.  The hot markets internationally were, and still are, cities located in Asia and Europe.  Most firms have found the January 1, 2002 introduction of the common euro currency enabled easy business transactions across European Union-member countries, and many have established offices in London, Paris, and more recently, Brussels.   Most, if not all, large law firms are achieving international growth through either building small offices (two to three attorneys), or by acquiring or merging with locally based firms, such as Kirkpatrick & Lockhart’s merger with Nicholson Graham in early 2005.
           The race for all firms to be nationally and internationally situated has created a landscape where firms are no longer differentiated by location.  For example if the consumer needs a firm with both a Washington, DC office and a Shanghai, China office, most firms have both locations to serve that client.  This would suggest that most consumers are located in and around the central portion of the spatial model (as illustrated in the below graphic).

Figure 2: Spatial Model: Legal Services by Geography

Service Offerings
Firms also attempt to specialize in a variety of service offerings, notably litigation and transactional services .  Most large law firms offer a mix of litigation and transactional services but usually those that are complementary (for example they might offer mergers and acquisitions transactional services as well as antitrust litigation and compliance services).  The average business typically needs both litigation and transactional services but might go to different firms to get that mix.

Figure 3: Spatial Model: Legal Services by Service Offering

Applying this to the spatial model (see Figure 3) suggests that this type of differentiation could explain how competition among firms has not driven prices down.  Our analysis of fee structures of five law firms supports this intuition.  The two litigation firms were both charging higher fees and consequently, making larger profits given that marginal costs are identical across the firms.  However, our sample size is quite small, and might only explain the preferences (and the relative price inelasticity for litigation services versus transactional services).
           As Table 1 below shows, the top ten large firms in the industry (different from the five firms discussed in our sample above) make significant profits per partner, meaning that they are pricing well above marginal cost for their services.

Table 1: Top Ten Profits per Partner Earners

           As Figure 4 below demonstrates, five of the top profit earners per partner are primarily known for the transactional services.  Four of the top ten litigation firms are also top profit earners.  Interestingly, three of these firms are top firms in both litigation and transactional services suggesting that they are targeting all consumers and are differentiating based on other characteristics.

Figure 4: Comparison of Top Profit Earners to Top Litigation and Transactional Firms

VI. Conclusion

             In conclusion, the landscape for legal services among large law firms is characterized by near-monopolistic pricing and outsized profits, driven mainly by the idiosyncratic differentiation that clients of these firms find amongst them.  Using the Spatial models, we suggest that law firms are unable to differentiate from each other based solely on geographic presence and service offerings to explain their high profit margins.  Because clients may prefer law firms with specific expertise or in specific geographies, most large law firms (more than 165 attorneys) have responded by growing nationally and internationally. 
           Finally, given that our analysis has demonstrated that price is relatively fixed, we believe that volume fluctuations are the main driver of exit and entry into this market.  Volume, driven by demand for legal services, fluctuates based on economic factors and may cause firms specializing in certain industries to exit if volume decreases below a specific level.  The lack of significant exit from the industry and the recent trends of globalization and increased firm size confirm the significant profit opportunity for law firms, greatly in excess of those available in a perfectly competitive industry.