Reputational economies of scale

Abstract

For many years, most scholars have assumed that the strength of reputational incentives is positively correlated with firm size. Firms that sell more products or services were thought more likely to be trustworthy than those that sell less because larger firms have more to lose if consumers decide they have behaved badly. That assumption has been called into question by recent work that shows that, under the standard infinitely repeated game model of reputation, reputational economies of scale will occur only under special conditions, such as monopoly, because larger firms not only have more to lose from behaving badly, but also more to gain. This article shows that reputational economies of scale exist even when there is competition and without other special conditions, if the probability that low quality is detected is positively correlated with the quantity of the good or service sold. It also shows that reputational economies of scale exist, under some circumstances, in a finite-horizon model of reputation. Reputational economies of scale help explain why law and accounting firms can act as gatekeepers, why mass market products are more likely to be safe, why firms are less likely to exploit one-sided contracts than consumers, and why manufacturers market new products under the umbrella of established trademarks.