Hongbin Cai† Ichiro Obara‡
March 14, 2008.
We study effects of horizontal integration on firm reputation. In an environment where customers observe only imperfect signals about firms’ effort/quality choices, firms cannot maintain good reputation and earn quality premium forever. Even when firms choose high quality, there is always a possibility that a bad signal is observed. Thus, firms must give up their quality premium, at least temporarily, as punishment. A firm’s integration decision is based on the extent to which integration attenuates this necessary cost of maintaining a good reputation. Horizontal integration leads to a larger market base for the merged firm, which leads to a more effective punishment and a better monitoring by eliminating idiosyncratic shocks in many markets. But it also allows the merged firm to deviate in a more sophisticated way: the merged firm may deviate only in a subset of markets and pretend that a bad outcome in those markets is observed by accident. This negative effect becomes very severe when the size of the merged firm gets larger and there is non-idiosyncratic firm-specific noise in the signal. These effects give rise to a reputation-based theory of the optimal firm size. We show that the optimal firm size is smaller when (1) trades are more frequent and information is disseminated more rapidly; or (2) the deviation gain is smaller compared to the quality premium; or (3) customer information about firms’ quality choices is more precise.
Keywords: Reputation; Integration; Imperfect Monitoring; Theory of the Firm; Merger JEL Classification: C70; D80; L14
∗We thank seminar participants at Brown University, Stanford University, UC Berkeley, UCLA, UCSB, UC Riverside, UIUC and USC for helpful comments. All remaining errors are our own. †Guanghua School of Management and IEPR, Peking University, Beijing, China 100871. Tel: (86) 10-62765132. Fax: (86) 10-62751470. E-mail: firstname.lastname@example.org
‡Department of Economics, UCLA, 405 Hilgard Ave, Los Angeles, CA 90095-1477. Tel: 310-794-7098. Fax: 310-825-9528. E-mail: email@example.com
Reputation has long been considered critical for firm survival and success in the business world. Since the seminal work of Kreps (1990), the idea of firms as bearers of reputation has become increasingly important in the modern development of the theory of the firm. For example, Tadelis (1999, 2002), Mailath and Samuelson (2001), and Marvel and Ye (2004) develop models of firm reputation as tradable assets and study the market equilibrium for such reputation assets. Klein and Leffler (1981) and Hörner (2002) analyze how competition helps firms build good reputations when their behavior is not perfectly monitored by customers. These studies provide very useful insights into how firm reputation can be built, maintained and traded. However, for reputation to be a defining feature in the theory of the firm, an important question needs to be answered: How does firm reputation affect the boundaries of the firm?1
In this paper we build a simple model to study the effects of horizontal integration on firm reputation. We consider an environment where firms produce experience goods in the sense that customers cannot observe product quality at the time of purchase, but their consumption experience provides noisy public information about product quality (e.g., consumer ratings).2 Absent proper incentives, firms will tend to shirk on quality to save costs, making customers reluctant to purchase. Using a model of repeated games with imperfect monitoring, it is easy to show that as long as firms care sufficiently about the future, they can establish reputations of high quality and earn quality premium while building customers loyalty.3 However, unlike the case with perfect monitoring, firm reputation can be sustained only if the public signal about a firm’s choices is above a certain cut-off point...