Is bigger better? Customer base expansion through word-of-mouth reputation

Abstract

We develop a model of gradual reputation formation through a process of continuous investment. We consider a market in which quality is un-observable at the time of purchase so that consumers base purchasing de-cisions on \u85rmspast performance- their reputation. The model has two main ingredients. First, we assume that the ability to produce high-quality products requires continuous investment. Second, we assume that as a con-sequence of informational frictions, such as search costs, information about rms reputations di¤uses only gradually in the market. This leads to a dual process of increase in a \u85rms customer base and an increase in its investment in product quality. As long as a \u85rm continues to invest and deliver high quality, its reputation as a high quality \u85rm grows, new cus-tomers are attracted and the \u85rm increases in size. However, if quality deteriorates, the \u85rms customer base shrinks and remains stagnant until We thank two anonymous referees and especially Fernando Alvarez for detailed and thought-ful commentary on a previous version. We also thank Braz Camargo and Eduardo Faingold for carefully reading the manuscript and making suggestions. Rob acknowledges the support of NSF and Fishman acknowledges the support of ISF. All remaining errors are our own. it is able to resurrect its reputation through successful investment. Since a good reputation is costly to acquire and takes a long time to regain once it has been lost, it becomes increasingly valuable the longer a \u85rms tenure as a high quality producer. Therefore, the longer its tenure, the more a \u85rm stands to lose from tarnishing its reputation and hence the more it invests to maintain it