Rust

Firm Reputation and Horizontal Integrationв?--

Hongbin Cai†Ichiro Obara‡

March 14, 2008.

Abstract

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

в?--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: hbcai@gsm.pku.edu.cn

‡Department of Economics, UCLA, 405 Hilgard Ave, Los Angeles, CA 90095-1477. Tel: 310-794-7098. Fax:

310-825-9528. E-mail: iobara@econ.ucla.edu

1

1 Introduction

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 HÐ"¶rner (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 in every period. With positive probability the public signal

will fall below the cut-off point, in which case firm reputation will be lost: either customers will

never buy again or the firm must pay large financial penalties to win back previous customers.

We then consider a situation where several firms, each serving an independent and symmetric

market, merge into one large firm.4 Horizontal integration leads to a larger market base for the

1The boundary of the firm question was first raised by the classical work of Coase (1937). Several influential

theories have been proposed to answer the question, for example, Alchian and Demsetz (1972), Williamson (1985),

and Hart (1995). Holmstrom and Roberts (1998) offer a review and critique of these theories.

2Professional