Reputation and Competition

Reputation and Competition By JOHANNES HO¨ RNER* This paper shows how competition generates reputation-building behavior in re- peated interactions when the product quality observed by consumers is a noisy signal of firms’ effort level. There are two types of firms and “good” firms try to distinguish themselves from “bad” firms. Although consumers get convinced that firms which are repeatedly successful in providing high quality are good firms, competition endogenously generates the outside option inducing disappointed consumers to leave firms. This threat of exit induces good firms to choose high effort, allowing good reputations to be valuable, but its uncompromising execution forces good firms out of the market. (JEL C7, D8) We are what we repeatedly do. Excellence, Examples of such “experience good” markets then, is not an art, but a habit. include nondurables such as wine, durables —Aristotle, Nicomachean Ethics such as appliances and cars, and most service providers such as lawyers, mechanics, and air- In traditional competitive theory, economists lines.1 In these settings, a consumer’s experi- assume that market participants have complete ence with a particular product becomes a knowledge of all relevant factors. This assump- precious guide—providing imperfect informa- tion has long been criticized as limiting the tion about a combination of the seller’s efforts, applicability of the theory, especially when ability, and luck. In these markets a seller’s competition is thought of as a dynamic process. reputation for quality therefore becomes a valu- (See, e.g., Friedrich A. Hayek, 1946; Joseph A. able asset. Schumpeter, 1950.) Indeed, the shortcomings of Since the seminal work of Benjamin Klein this approach are particularly clear when we and Keith B. Leffler (1981), several authors acknowledge that competition is in a large mea- have shown formally how firms in such markets sure competition for reputation and consumer may be induced to exert costly effort when the good will. The costly and apparently unwaver- fear of losing their reputation exceeds the tem- ing efforts many firms make in order to estab- porary advantage of cheating their customers. lish and maintain a reputation for excellence are (See Carl Shapiro, 1983; Russell Cooper and difficult to account for in the traditional Thomas W. Ross, 1984; Bengt Holmstrom, framework. 1999.) These theories of rational reputation Consider for instance the markets in which building must contend with two fundamental customers can only assess the quality of a sell- problems, as described by Joseph E. Stiglitz er’s product by purchasing and consuming it. (1989). First, a consumer’s refusal to purchase from a firm that has sold her a low-quality good must also be rational. In particular, it must be * Managerial Economics and Decision Sciences, optimal for a consumer to end a long relation- Kellogg School of Management, Northwestern University, ship with a firm she had considered trustworthy 2001 Sheridan Road, Evanston, IL 60201. This is a revised version of Chapter 1 of my Ph.D. dissertation, and I would after perhaps just a short string of bad experi- like to thank my adviser, George Mailath, for his invaluable ences. Second, as a reputation is only valuable if help and support. I would also like to thank Steven Mat- success brings profits, how could those possibly be thews, Andy Postlewaite, and Larry Samuelson for their driven down to zero in a competitive environment? encouragement and helpful advice, and particularly Dan Silverman, Steven Tadelis, and two referees for detailed comments. Any remaining mistakes are mine. The author gratefully acknowledges financial support from an Alfred P. 1 Phillip Nelson (1974) introduces the concept of an Sloan dissertation fellowship. experience good. 644 VOL. 92 NO. 3 HÖRNER: REPUTATION AND COMPETITION 645 However, the most formidable obstacle that a and this proposed equilibrium with high effort theory of rational reputation building faces re- unravels. mains the argument developed by Holmstrom Under persistent competition, however, firms’ (1999), in the framework of a monopoly, which revenues do not vary continuously with con- will be examined shortly. His reasoning shows sumers’ expectations. Because any consumer why there exists no equilibrium in which a can break off her relationship with a firm and single firm repeatedly exerts high effort. take some other preferred option, it does not This paper suggests how these three prob- matter how good a firm is thought to be, but lems may be simultaneously overcome and the- rather whether it is thought to be better than ories of competition and reputation reconciled. its rivals. This outside option, endogenously It offers a model in which many consumers and generated by competition, is precisely what is firms repeatedly trade. In each period, consum- required for consumers’ behavior to exert effec- ers pay up front for a good the expected quality tive discipline over sellers. of which increases with the effort exerted by the This crucial outside option will exist as long firm. Some firms, however, are inherently lazy as operating rivals with worse, similar, or better (inept) and always exert low effort. Consumers reputations charge appropriate prices. In view cannot distinguish inept firms from opportunis- of the price dispersion that these conditions tic firms, do not observe the effort level exerted, imply, it may seem that a firm could profitably and are thus confronted with both adverse se- attract consumers with a slight price decrease. lection and moral hazard problems. On the other This need not be so, however, if consumers hand, consumers do observe the prices posted believe that such a firm is bound to exert low by firms and (the existence of) their customer effort as a result. Indeed this consumer concern bases. Moreover, for those trades in which they is justified if the sequence of equilibrium prices were personally involved, consumers of course posted by a firm over time is so low that any realize the quality obtained (but since the out- further decrease in price necessarily violates its come reflects both the luck and the effort of the incentives to exert high effort. firm, this monitoring is imperfect). Consumers In this uncertain environment consumers are may freely switch firms at any time. able to identify preferred options because they I show in this setting how competition sup- observe both the prices and the customer bases ports the existence of equilibria in which oppor- of other firms. Importantly, it is the behavior of tunistic firms always exert high effort—a result the other consumers that ensures that the infor- that contrasts sharply with the results obtained mation conveyed by prices is dependable. In for a monopoly. To illustrate the importance particular, consumer knowledge of customer of competition for maintaining effort, consider bases prevents firms from raising their prices in the following version of Holmstrom’s argu- order to mimic rivals with better reputations. If ment (see also George J. Mailath and Larry a firm tried to do so, the flight of its old cus- Samuelson, 1998a). Suppose that in equilibrium tomers would effectively deter any potential a monopolistic (opportunistic) firm chose to ex- new ones. ert high effort always, and that its revenues The model sketched above has many equilib- varied continuously with consumers’ expecta- ria distinguished by the degree of patience tions about the efforts of the firm. As the firm’s shown by consumers when they experience low average product quality converges almost quality. In some equilibria, consumers may be surely to the expected quality associated with willing to stick with a firm in spite of a low- high effort, consumers become convinced quality experience, provided that the price de- that this firm is opportunistic rather than inept. creases sufficiently. This paper focuses instead Since this type of firm is always supposed to on the simpler, more dramatic case in which exert high effort, over time consumers’ expec- consumers are so exacting that they leave a firm tations—and hence the firm’s revenues— as soon as it disappoints them with a low- become inelastic to a bad outcome. In these quality experience. In these equilibria, the firms circumstances, low-quality outcomes will sim- that retain loyal customers are therefore those ply be attributed to bad luck. But then, of that always provide high quality; and the repu- course, the firm has an incentive to slack off tations of these firms increase with their age. 646 THE AMERICAN ECONOMIC REVIEW JUNE 2002 Along with the zero-profit assumption, the I. The Basic Model conditions described above uniquely identify the equilibrium prices and market shares. Prices This section outlines a model which isolates are shown to rise with a firm’s reputation, a the role of competition in providing incentives. result that accords with the findings of the em- For simplicity, it does not allow for entry of pirical literature on reputations (see, for in- firms after the beginning of the game and pos- stance, Allen T. Craswell et al., 1995). In tulates an exit behavior for firms that is justified addition, prices are initially low enough to deter in the richer model of Section II. fly-by-night attempts, and eventually reflect a premium for quality. A. The Market In the related literature, the exit option mechanism of this paper is close to that of Albert O. Consider a market in which firms and con- Hirschman (1970), though its role is rather com- sumers repeatedly trade. Time is discrete, in- plementary. Hirschman discusses how consum- dexed by t ϭ 0, 1, . and the horizon is ers’ exit may constitute a mechanism of infinite. In each period, firms and consumers recuperation for firms that accidentally fell be- may trade. In this event, a consumer pays the hind. This paper shows instead why the exit firm up front and enjoys either a good outcome option keeps a firm “on its toes” in the first or a bad outcome, depending on the unobserved place.

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