Who Wants a Good Reputation?

We examine a market in which firms confront a moral hazard problem in the provision of product quality, facing a short-term incentive to produce low quality but potentially earning higher profits from “committing” to high quality. There are two types of firms in the market, “inept” firms who can produce only low quality, and “competent” firms who have a choice between high and low quality. Firms occasionally leave the market, causing competent and inept potential entrants to compete for the right to inherit the departing firm’s reputation. In a repeated interaction, with consumers receiving noisy signals of product quality, competent firms choose high quality in an attempt to distinguish themselves from inept firms. Competent firms find average reputations most valuable in the sense that a competent firm is most likely to enter the market by purchasing an average reputation, in the hopes of building it into a good reputation, than either a very low reputation or a very high reputation. Inept firms , in contrast, find it profitable to either buy high reputations and deplete them or buy low reputations.

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