Reputation and Performance

Transcription

1 Reputation and Performance Armin Falk, Ernst Fehr and Christian Zehnder 1 University of Zürich February Very preliminary - Please do not circulate Abstract In this paper we provide experimental evidence for the importance of reputation in markets with experience goods. In this type of markets high quality cannot be enforced by complete and enforceable contracts. This leads to low efficiency or even the breakdown of markets. A potential remedy to overcome these inefficiencies is reputation formation. In order to study the causal effect of reputation formation for market performance we analyze two treatments. In the no reputation treatment reputation formation is ruled out by design. In this treatment quality and prices are rather low. In the reputation treatment, previous quality choices of sellers are publicly known, i.e., sellers can individually build up a reputation for providing high qualities. This treatment difference generates vast changes in how markets function. We find that buyers initiate repeated interactions with sellers whose qualities are high and buyers are willing to pay rents to performing sellers. This creates strong incentives for sellers to invest in a good reputation. As a result sellers provide high qualities, which generates a significantly higher market efficiency compared to the market where reputation formation is impossible. Reputation formation also changes the way how trades are initiated and how rents are shared between sellers and buyers. JEL-Classification: C91, D21, D40, D63 Keywords: Reputation, Contract Enforcement, Incomplete Contracts, Repeated Interaction, Fairness Preferences 1 Corresponding author: Christian Zehnder, Institute for Empirical Research in Economics, University of Zurich, Blümlisalpstrasse 10, CH-8006 Zürich, falk@iza.org, efehr@iew.unizh.ch, zehnder@iew.unizh.ch.

2 Falk, Fehr and Zehnder Reputation and Performance 2 A good reputation is more valuable than money. Publilius Syrus (~100 BC), Maxims 1 Introduction In a perfectly competitive world a good reputation is of no value. In this world market participants are perfectly informed and there is an authority, which defines property rights and guarantees their enforcement. With perfect information consumers can always determine a good s quality by inspection and complete and enforceable contracts make it impossible for sellers to cheat on their buyers. In such a world there is no need for building up reputations. In reality, however, firm managers are very concerned about having a good reputation. They know only too well, that a bad reputation resulting from, e.g., unsatisfying performance or faulty or delayed deliveries, may cause profits to fall dramatically. A recent example for the far-reaching consequences of a loss of reputation is the recent Enron scandal, especially with regard to its auditor Arthur Andersen. When Arthur Andersen was found guilty of obstructing justice by shredding evidence relating to the Enron scandal, they immediately suffered from a massive loss in clients due to a heavy damage in reputation. Arthur Andersen was eventually forced to cease auditing public companies. The Enron scandal led to the disappearance of one of the leading accounting firms from the market by irreparably damaging its reputation. The reason why reputation is apparently of great importance in the business world, is the absence of complete and symmetric information about quality and perfect enforceability of contracts. In many markets consumers can evaluate the quality of a seller s product only by buying and consuming it. Typical examples for such experience goods are used cars (Akerlof (1970)), rubber (Kollok (1994)) or services delivered by medical doctors, lawyers or mechanics. In markets for these products both assumptions perfect information and complete and enforceable contracts do clearly not hold. As a result the market participants are facing a social dilemma: Consumers are not interested in paying high prices for goods of unknown quality and sellers are therefore not willing to offer high quality products. As a consequence there is a serious danger that the market fails in the sense that only cheap low quality products are sold despite the fact that buyers and sellers could be better off by trading high quality products at higher prices 2. 2 Warranties can typically not fully solve this problem because they are usually imperfect. It may therefore be possible to use warranties to enforce minimum qualities of certain products, but the incentive problem as a whole cannot be solved (see also Shapiro (1983)).

3 Falk, Fehr and Zehnder Reputation and Performance 3 The problems inherent to markets for experience goods can be resolved only if the incentive structure is changed such that it is in the interest of sellers to supply high-quality products and not to cheat on customers. One possible mechanism is reputation. Following the seminal work of Klein and Leffler (1981), a number of authors have theoretically shown that the possibility to build up a reputation can be an effective means to motivate sellers to deliver high quality products. The condition for the existence of a cooperative equilibrium in which sellers sell high-quality products and buyers pay high prices, is, that the prices of the high quality products must be sufficiently above the production costs such that the non-performing firms lose a stream of rents on future sales which is greater than the additional short-term profit attainable by cheating on the buyers (e.g. see Shapiro (1983), Bull (1987), Malcomson and MacLeod (1998), Holmström (1999)). In contrast to the progress of theory empirical evidence has been sparse. This is not surprising insofar as showing the impact of reputation formation on market outcomes with field data is anything but trivial. In order to derive causal inferences the researcher has to compare similar markets with and without the possibility for reputation formation. Finding such data in the field proves to be extremely difficult. It is therefore not surprising that only few econometric studies of markets with enforcement problems have been conducted 3. While lack of empirical knowledge is always problematic, in our context this lack is even more serious because in the presence of repeated interactions there is, in general, a plethora of equilibria (see e.g., Fudenberg and Maskin 1986). For this reason theory alone gives little guidance regarding the likely consequences of reputation formation for the functioning of markets. In an experiment it is possible to compare identical markets with and without opportunities to build up reputations. In this paper we therefore experimentally investigate to what extent reputation formation facilitates the formation of well functioning markets for experience goods. The implemented experimental game captures the basic features of a product market, where the buyers cannot determine the quality of the traded goods by inspection but only by consumption experience. In the first stage of each period buyers can 3 McMillan and Woodruff (1999) examine the determinants of trade credits for customers in Vietnam s emerging private sector. Contract law and the courts provide only weak enforcement of agreements in Vietnam so that it seems plausible that the trading parties rely on reputations. McMillan and Woodruff provide interesting evidence showing that firms are more likely to offer trade credit if (i) the customer has difficulties finding an alternative supplier, (ii) the longer the trading relationship has already lasted, and (iii) the more the customer is integrated into business networks. Banerjee and Duflo (2000) analyze the role of reputation in determining contractual outcomes in the Indian software industry. Their results show that ex-ante contracts, as well as the bargaining outcomes after ex-post renegotiation of the contracts, vary with those firm characteristics that are plausibly associated with reputation.

4 Falk, Fehr and Zehnder Reputation and Performance 4 make offers to the sellers. An offer consists of a price and desired quality. The sellers can accept these offers. In the second stage all sellers who have accepted an offer determine the actual quality of their product, which can be higher, lower or equal to the desired quality. Since providing above minimum quality is costly for sellers, they have always a monetary incentive to provide low quality products. The potential effect of reputation formation on market performance is studied by comparing two treatments. In the reputation treatment (REP) all market participants have a fixed ID-number for the whole experiment. In addition all quality choices of sellers are made publicly know to all market participants. In this treatment, reputation formation is possible. In the no reputation treatment (NOR), sellers cannot build up reputation because in each period their ID-numbers are randomly reassigned. Our results impressively show the potential importance of reputation formation in markets for experience goods. In the condition in which we exclude reputation formation the most frequently chosen quality by sellers is the minimum quality. When allowing for reputation formation, however, it is the maximum quality that is chosen most often. The argument why reputation is effective even in a finite game rests on the presence of different types of sellers, selfish and reciprocally motivated ones. In section 3 we derive a perfect Bayesian equilibrium in the spirit of Kreps et al. (1982), where we show that selfish sellers have an incentive to disguise their true type by imitating reciprocal sellers. This equilibrium prediction is well supported by our data. We find that the fixed identities of the sellers allow buyers to condition their offers on their sellers past performance. Due to the reciprocal behavior of fair sellers it is attractive for buyers to offer high prices to those sellers who are believed to be of the reciprocal type. Since receiving high price offers generates rents for selfish sellers, they have an incentive to hide their true type and imitate the fair sellers behavior. Early in the experiment high price offers do therefore not only motivate fair sellers to provide high quality but also the selfish ones who imitate them. The market participants succeed in trading high quality products for high prices. At the end of the experiment, however, the reputation of being reciprocal is not valuable any more for selfish sellers and they do no longer hide their type. This leads to a significant drop in performance in the last period. The remainder of the paper is organized as follows: In the next section we give a detailed description of the experimental design and the procedure in the laboratory. Section 3 contains the theoretical predictions and some hypotheses. In addition to the standard prediction based on the assumption of strictly payoff-maximizing behavior, we also present an alternative prediction, where we take into account that a considerable fraction of the subjects

5 Falk, Fehr and Zehnder Reputation and Performance 5 may exhibit social preferences. In section 4 we present our results and point out our interpretation of the observed behavior. Finally, in section 5 a short summary and some conclusions follow. 2 The Experimental Design In this paper we study the impact of reputation on performance in markets for experience goods. The ideal data set for investigating this question contains data on two markets, which are identical in every respect other than the possibility to build up reputations. It is of course very hard to find or generate such data in the field. In a laboratory experiment, however, we can perfectly control the market conditions and we have the possibility to implement truly exogenous ceteris paribus variations. This allows us to observe the market participants behavior in a very clean and controlled environment, where many of the measurement and endogeneity problems present in field data can be overcome. 2.1 Experimental Game and Procedures In order to be able to study the behavior of buyers and sellers in a market for experience goods we set up the following experimental procedure: At the beginning of an experimental session the 17 participants are split up into two groups. Seven of them are assigned the role of a buyer; the other ten are in the role of sellers. Roles of subjects are fixed for the whole session and each participant knows only his or her own assignment. A session contains 15 trading periods. In every period each seller can at most sell one product and each buyer can buy a maximum of one product. A trading period has two stages. In stage one, buyers can state their price offers. An offer of a buyer consists of three pieces of information: the desired quality of the product q ~, the price the buyer is willing to pay for the product p and at whom the offer is targeted. With respect to the third piece of information there are two possibilities. Either the buyer makes a public offer, which can be seen and accepted by all sellers, or he makes a private offer, which is only addressed to a specific seller and cannot be seen or accepted by the other sellers. Public offers are also displayed on the other buyers screens. A buyer can make as many public and private offers as he wants. But as soon as a seller accepts one of a buyer s offers a contract is concluded and the trading partners reach the second stage of the period. At the same time all other outstanding offers of this buyer disappear from the market and can no longer be accepted by sellers. To prevent them from making useless offers to sellers who have already concluded a contract, buyers are always informed which sellers are still in the market.

6 Falk, Fehr and Zehnder Reputation and Performance 6 At the beginning of the second stage the buyer and the seller immediately learn the IDnumber of their trading partner. Then sellers have to determine the true quality q of their product. Since we want to study a market with incomplete contracts, the buyer s desired quality is in no way binding for the seller, and therefore the seller can freely choose the quality of his product. To be able to investigate the role of beliefs in this experiment we also ask the buyers to indicate the quality they expect from their seller and how certain they are that their expectation comes true. Once the seller has determined the product s quality, payoffs are calculated and displayed on the participants screens. Both, the sellers and the buyer, get to know their own payoff and the payoff of their trading partner. To make sure that all market participants always remember the outcomes of all their past trades, they are asked to fill in a paper form at the end of every period which contains all information from the profit screen. When all subjects have reviewed the payoffs the next period begins. To make sure that participants fully understand the decision process and the payment structure of the game, each subject has to read a detailed set of instructions before a session is started. After reading the instructions participants have to pass a test with control questions. We don t start a session before all subjects have correctly answered all control questions. 4 Additionally there are two practice periods before an actual session is started in order to make the participants familiar with the bidding procedures. In both practice periods subjects only go through the first stage of a real period, i.e. there are no effort choices. Of course subjects cannot earn money in the practice periods. 2.2 Treatments To study the effect of the possibility to build up a reputation on contractual performance we implement the following two treatment conditions. In the first condition, which we call the reputation condition (henceforth denoted as REP-condition), an ID-number is assigned to each subject at the beginning of the session. These ID-numbers are fixed for all 15 periods. At the end of a period all buyers get a sheet of paper, which contains the complete trading history of every seller up to the current period, i.e. all buyers know exactly in which past periods a seller concluded a contract, the price he got and the quality he delivered. This arrangement allows sellers to build up a reputation as a reliable trading partner who delivers high quality products to the customers. The second condition, which is called the no-reputation condition (henceforth called NOR-condition), is identical to the REP-condition except for the fact that reputation formation is ruled out in the former. This was achieved by randomly reassigning 4 Instructions and control questions are available on request.

7 Falk, Fehr and Zehnder Reputation and Performance 7 the ID-numbers for both the sellers and the buyers in each period. Since market participants cannot achieve a reputation in the NOR-condition, a comparison of the market outcomes in the NOR- and the REP-condition tells us to what extent the possibility to build up reputations contributes to a better contractual performance in a market with incomplete contracts. 2.3 Parameters and Payoff Functions The buyer s payoff function reflects that the higher the quality of the product a buyer purchases the higher the value of the product. This is implemented in the experiment by using the following formula to calculate the material payoff of a buyer who acquires a product of quality q at a price p: π b = 10 q p, 0, if a contract was concluded if no contract was concluded We always have seven buyers and ten sellers in an experimental session. Since every participant can conclude at most one contract per period this means that there is an excess supply of three sellers. Sellers who are not able or do not want to conclude a contract in a period automatically choose an outside option which gives them a certain payoff of 5 (spot contract in another market). For those sellers who conclude a contract a higher quality of the product is associated with additional costs c(q). The set of feasible quality levels is given by {1, 2, 3,, 10} and wages have to be chosen from the set {1, 2, 3,, 100}. The cost schedule for the seller is depicted in Table 1. It shows that c(q) is convex and strictly increasing in the quality level. q c(q) Table 1: Cost schedule of sellers The material payoff of a seller is therefore calculated according to the following formula: π s = p c(q), 5, if a contract was concluded if no contract was concluded Payoff functions, the number of sellers and buyers, the cost schedule and the number of trading periods were common knowledge. The payoff calculation and the conversion rate (XX Points = YY Swiss Franc (~US $ ZZ)) are identical in the two treatments. The total income of

8 Falk, Fehr and Zehnder Reputation and Performance 8 participating subjects consists of the show up fee and the sum of generated incomes in all periods. 2.4 Subjects and Sessions All experimental subjects were volunteers. They were all participating for the first time in such an experiment, and each participant could only participate in one session. All participants were students of the University of Zurich or the Swiss Federal Institute of Technology Zurich (ETH). Economists and psychologists were excluded. In total we conducted nine experimental sessions, five in the REP-condition and four in the NOR-conditon. 5 We had 17 subjects in each session, which makes a total of 153 participants in the experiment. The computerized experiment was programmed and conducted with the experimental software z-tree (Fischbacher (1999)). A session lasted approximately ninety minutes and subjects earned on average XX Swiss Francs (sfr. XX ~ US $ YY). 3 Predictions and Hypotheses In this section we present the theoretical predictions for our experiment. The first subsection contains a game theoretic analysis of the implemented game for the case where all market participants are strictly rational payoff-maximizers. Under these conditions the same inefficient equilibrium, in which buyers pay low prices and sellers sell low-quality products is obtained in both treatments. However, in the second subsection we show that - in the presence of a sufficient number of subjects with social preferences cooperative equilibria can be sustained in the REP-condition, in which buyers pay high prices and all sellers provide highquality products in all but the last period. In sharp contrast to the very inefficient equilibrium derived under complete rationality and selfishness the cooperative equilibria allow the market participants to realize almost all potentially possible gains from trade. 3.1 Predictions for Payoff-Maximizing Agents Under the assumption of common knowledge of rationality and payoff-maximizing behavior it is straightforward to derive a prediction for this experiment. The NOR-condition can be regarded as a series of 15 one-shot games. Since higher quality levels are associated with additional costs, each seller who gets a contract chooses the minimal quality (q = 0), irrespective of the buyer s desired quality q ~ and price offer p in all periods of the NORcondition. Of course a seller accepts only contracts in which his payoff is at least as high as 5 All sessions were performed at the computer lab at the University of Zurich.

9 Falk, Fehr and Zehnder Reputation and Performance 9 his certain outside-option of 5. Hence, in equilibrium all seven buyers state price offers of p = 5 and all contracts are accepted by sellers who deliver the minimal quality q = 0 in every period. In the REP-condition the one-shot game from above corresponds to a stage game in a finitely repeated game. In the last period of the REP-condition the outcome is the same as in the one-shot game. By backward induction, the same outcome will be obtained in all preceding periods. Thus, if the market participants are rational payoff-maximizers it doesn t matter at all whether market participants have the possibility to build up a reputation or not, the result is always the same: Buyers pay low prices of p = 5, sellers deliver minimal quality products q = 0 and therefore a very inefficient outcome is reached. Due to the excess supply of sellers the resulting small surplus per trade, π π 5 = (10 1 5) + (5 0) 5 = 5, goes s + b entirely to the buyer. How severe the inefficiency of this outcome is, can be seen by comparing the obtained surplus per trade of 5 to the maximal possible one, which is max ( + ) 5 = (10 10 w) + ( w 18) 5 π s π b = Predictions for Agents with Social Preferences In this section we examine our experimental game under the assumption that a considerable fraction of the market participants exhibit social preferences. We show that the existence of people who are not only concerned with their own material payoff but also take fairness considerations into account, allows for cooperative equilibria. For tractability reasons our analysis is based on the fairness theory of Fehr and Schmidt (1999). Fairness is modeled as self-centered inequality aversion. Inequality aversion means that people dislike unequal outcomes and are willing to give up material payoff to reach more equal outcomes. For the two player case the idea of inequality aversion is formally captured by assuming the following utility function: U i ( π i, π j ) = π i αi max{ π j π i, 0} βi max{ π i π j,0}, for i,j {1, 2}, π i and π j denote the monetary payoffs of the players and β i α i, 0 β i 1. The second term in the utility function measures the disutility from disadvantageous inequality, whereas the third term measures the utility loss from advantageous inequality. To make the analysis as simple as possible without losing the main implications, we use a strongly simplified version of the Fehr-Schmidt-Model. We assume that there are two types of 6 The equilibrium presented in this section is a not strict subgame-perfect Nash equilibrium. There is a second subgame-perfect nash equilibrium, which is strict. The only difference between the two equilibria is that in latter the buyers offer prices p = 6 in every period, such that sellers are strictly better off by accepting a contract. The important result that only minimal quality products are sold in every period remains of course the same.

10 Falk, Fehr and Zehnder Reputation and Performance 10 people in the subject pool. Each market participant knows only his own type and the distribution of types in the population. The distribution of types is assumed to be as follows: 40 percent of the subjects are completely selfish (α i = β i = 0), whereas the other 60 percent exhibit identical fairness preferences (α i = β i = α = ε, where ε is a small positive number). Furthermore we assume that, after the conclusion of a contract the respective trading partner is the only reference agent of a fair subject. This allows us to use the utility function for the two-player case from above to analyze the subjects behavior. At first sight this seems to be a rather strong assumption. But since a market participant s actions can only influence his own and his direct trading partner s payoffs, the trading partner s payoff is clearly a salient reference point. Therefore, we believe it to be natural to concentrate on the comparison of these two values and we therefore abstract from social comparisons to other market participants. We further simplify the setup by assuming that a buyer has only the choice to make either one public offer or one series of identical private offers to an arbitrary number of sellers. These offers are assumed to be made simultaneously. We need this assumption for tractability reasons, because continuous auctions have defied a fully rigorous analysis for now. We therefore approximate the bargaining situation in the experiment with a posted contract situation. Our last assumption concerns the acceptance of contracts by the sellers. We assume that the sellers decide one by one whether they want to accept one of their private offers, a public offer or none of both, whereas the order of the sellers is randomly determined in every period Cooperation Equilibria in the NOR-condition In the NOR-condition the derivation of an equilibrium is simple. Since the NORcondition is simply a series of one-shot games, it suffices to derive an equilibrium for one period. From above we know that selfish sellers accept every offer with a price of at least 5 and provide always minimal quality. The fair sellers behavior, however, is different. In the context of the given experiment the utility function of a fair seller can be written as follows: U fair s { 2 p c( q) 10,0} ( p, q) = p c( q) α max q. The marginal utility of quality is therefore given by: U s fair q = 10α (1 α) c'( q) > 0, = 10α (1 + α) c'( q) < 0, if 2 p c( q) 10q > 0 otherwise.

11 Falk, Fehr and Zehnder Reputation and Performance 11 This means that for a given wage offer fair sellers are always ready to improve their products quality as long as there is inequality to their advantage. The optimal quality is reached at the point where the surplus is equally shared between the seller and the buyer. A further increase in quality would not only lower the seller s own payoff, but also lead to disadvantageous inequality. Based on this analysis we are now able to calculate the necessary price offer to induce a certain quality decision from a fair seller. Note that in order to induce above minimum quality sellers do not have to offer the payoff equalizing price, but a slightly lower one. The reason for this is the discrete nature of our cost schedule. In all these cases a fair seller would reap a lower utility by reducing his quality, as this would lead to inequality to his advantage. In Table 2 we display for each quality level the payoff equalizing price p e (q) and the necessary price p(q) resp. the marginal price increase p (q) to induce it. q p e (q) p(q) p (q) Table 2 Given the p(q) relation for fair sellers the expected material payoff of a buyer can be written as a function of the quality the buyer wants to get from fair sellers: [ ( q) ] = 0.4( 10 p( q) ) + 0.6( 10q p( q) ) E π b. Since selfish buyers simply maximize their payoff, their optimal choice has to satisfy p ( q) = 6. According to Table 2 this is the case for all qualities q {4,, 8}. Due to the discrete nature of the seller s quality choice the selfish seller is therefore indifferent between all (minimal) prices, which induce one of the quality levels q {3,, 8}. All the price offers generate an expected payoff of [ ( q) ] = 8 E π. b Fair buyers, however, are not pure payoff-maximizers but also experience disutility from inequality. Their expected utility from a certain price offer can be expressed as follows: 7 E [ U ] fair ( q) = 0.4[ 10 p( q) α (2 p( q) c( q) 10) ] + 0.6[ 10q p( q) α(10q + c( q) 2 p( q)) ]. b 7 One could think, that fair buyers might want to pay the payoff equalizing price p e (q) instead of p(q). This is not the case. The reason simply is, that the costs of paying p e (q), consisting of a reduction of the own payoff and an increase in disadvantageous inequality in case of a selfish seller, are larger than the benefit, which is a reduction of advantageous inequality in case of a fair seller.

12 Falk, Fehr and Zehnder Reputation and Performance 12 The first order condition for the fair buyers therefore is: E [ U ] fair b ( q) = 6 (1 0.4α ) p ( q) 0.6α (10 + c ( q)) < 0, q {1,2,...,10} q The optimal price offer for a fair buyer is therefore p = 5, the price, which induces fair and selfish sellers to accept the contract and provide the minimum quality. The risk of meeting a selfish buyer and experiencing disadvantageous inequality prevents fair buyers from offering higher prices. A price offer p = 5 yields an expected utility of E[ π ( q = 1) ] = 5 b. Thus, while the existence of fair sellers induces selfish buyers to offer high prices, the existence of selfish sellers induces fair buyers to offer low prices. Since selfish buyers are indifferent between all prices p(q), which induce one of the quality levels q {3, 4,, 8}, there are multiple equilibria. In each of these equilibria all fair buyers state price offers (p = 5, q ~ = 1) and all selfish buyers choose one of the following offers {(p = 14, q ~ = 3), (p = 20, q ~ = 4), (p = 26, q ~ = 5), (p = 32, q ~ = 6), (p = 38, q ~ = 7), (p = 44, q ~ = 8)}. All seven contracts are always accepted and while fair sellers deliver the desired quality q = q ~, selfish sellers always provide the minimal quality q = 1, irrespective of the quality desired by the buyer Cooperation Equilibria in the REP-condition In the REP-condition the market participants ID s are fixed for the whole experiment and all buyers are always informed about every seller s behavior in all previous periods. These features fundamentally change the information situation and the strategic environment of the market participants. In strong contrast to the NOR-condition the REP-condition allows for reputation formation and selective repeated interaction of market participants. In section 3.1 we have argued that in the case of common knowledge of rationality and selfishness the opportunity to build up a reputation does not affect the market outcome. By backward induction the same inefficient stage game outcome is obtained in all periods of the finitely repeated game. However, in the presence of market participants with social preferences reputation formation can be of great importance. The reason is that the existence of fair minded sellers who reciprocate high prices by delivering high quality products may motivate buyers to offer high prices in the last period. The opportunity to be offered a high price in the last period in turn generates an incentive for selfish sellers to skim rents by imitating the behavior of fair minded sellers in early periods and exploiting the buyers in the last period.

13 Falk, Fehr and Zehnder Reputation and Performance 13 In the following paragraphs we illustrate the potential importance of reputation effects in the REP-condition. We derive two examples of perfect Bayesian equilibria, in which the reputation mechanisms can be easily understood. To make later references to the equilibria easier, we call our first equilibrium the Public Cooperation Equilibrium (PUCE). The PUCE is characterized by the following strategies and beliefs of buyers and sellers. The buyers strategy is: Buyers always make public offers as long as no seller has ever provided a quality which is lower than the one a fair seller would provide for the offered price in a one-shot. Once a seller s behavior reveals that he is not of the fair type, all buyers exclude him and make private offers to all other sellers. In period 1-13 all buyers offer the contract (p = 58, q ~ = 10). In period 14 all buyers offer the contract (p = 26, q ~ = 5). In period 15 the selfish buyers offer (p = 32, q ~ = 6), while the fair buyers offer (p = 5, q ~ = 1). The sellers strategy is: Fair minded sellers choose their utility maximizing quality level in every period. They accept the best available contract, as long as this gives them a utility of at least 5. Selfish sellers imitate the behavior of fair sellers as long as the cost of doing this is not greater than the value of a good reputation. All sellers have the belief that they are included in each buyer s seller pool as long as they behave according to the utility function of fair sellers. To demonstrate that these strategies are indeed part of a perfect Bayesian equilibrium we start our analysis at the end of the game. We consider the situation, in which buyers cannot distinguish selfish from fair sellers at the beginning of the final period. In this case the strategic situation in the last period of the REP-condition is exactly the same as in any period of the NOR-condition. In section we have shown that there are multiple equilibria for this game. For this example we assume that in the final period selfish buyers choose the (nonunique) utility maximizing offer (p = 32, q ~ = 6), while the fair buyers choose (p = 5, q ~ = 1). Under these conditions the expected payoff for a selfish seller, whose type is not yet revealed and who succeeds in selling a minimal quality product in the last period is selfish [ ] = = E π s. This expected payoff is very high compared to the secure payoff of 5 in the cases in which the seller does either not get a contract or has already revealed his type. 8 Now, the actual value of a good reputation for a selfish seller in period 14 depends on the probability with which the seller gets a contract in period 15. But this probability clearly depends on the buyers strategy. Under our assumption that no information on the sellers types has been revealed until the beginning of the last period, buyers are

14 Falk, Fehr and Zehnder Reputation and Performance 14 indifferent between public and private offers. In the theoretical literature the standard assumption under perfect ex-post information on performance is that buyers will purchase from a seller randomly chosen from the group of sellers, who have never cheated their customers in the past. Since the buyers cannot distinguish the sellers at all in our case this corresponds exactly to what happens if buyers make public offers in the final period. Accordingly with 7 buyers and 10 sellers in the market, the probability of getting a contract is 0.7 for each seller. The value of a good reputation or in other words the expected rent a selfish seller can gain from hiding his type in period 14 is therefore given by E selfish [ ] = 0.7 (15.8 5) R s t= 14 =. From this we know that a selfish seller is willing to hide his type in period 14 as long as the cost of doing this is smaller than From the cost schedule in Table 1 it can be deduced that to hide their type sellers are willing to fulfill a contract proposed by a buyer as long as the desired quality is not higher than 5. In order to motivate fair minded sellers to deliver products with a quality of 5, buyers must offer a price of 26 (see Table 2). Paying lower prices reduces the quality delivered by all sellers, because the selfish sellers imitate the fair sellers behavior to hide their type. We can now go further backward and calculate the value of a good reputation for selfish sellers in earlier periods. If all sellers choose (p = 26, q ~ = 5), the value of a good reputation for a selfish seller in period 13 can be calculated as follows: E selfish [ ] = ( R s + t= 13 2 ) ( ) (5 + 5) = This rent is high enough to induce selfish sellers to provide qualities up to the maximum quality of 10. The price necessary to induce fair sellers to provide a quality of 10 is 58. Therefore in period 13 the buyers optimal offer is (p = 58, q ~ = 10). By backward induction this is also the optimal offer in all previous periods. With this argumentation we have established that our strategies described above constitute a perfect Bayesian equilibrium. The PUCE is obviously not a unique equilibrium in this game. However, we think that based on the corresponding theoretical literature it represents a natural starting point and it is very simple example that clearly shows the potential importance of reputation effects in the presence of market participants who exhibit social preferences. Now we want to turn to a second equilibrium, which we call the Relational Cooperation Equilibrium (RECE). 8 If a selfish seller has revealed his type before the beginning of the last period, no buyer will be willing to offer him a higher price than 5. The reason is that as soon as everybody knows that the seller is of the selfish type the backward induction argument developed in section 3.1 applies.

15 Falk, Fehr and Zehnder Reputation and Performance 15 In contrast to the PUCE the RECE is an equilibrium in which the market participants form bilateral relationships. The equilibrium strategies and beliefs can be described as follows. The buyers strategy is: Buyers make public offers in the first period. After period 1 they always make private offers to their sellers from the previous period as long as the sellers delivered the desired quality. In case the contract is not renewed because the seller misbehaved, buyers make a private offer to all sellers who have never provided a quality which is lower than the one a fair seller would provide for the offered price. In period 1-13 all buyers offer the contract (p = 58, q ~ = 10). In period 14 all buyers offer the contract (p = 38, q ~ = 7). In period 15 the selfish buyers offer (p = 32, q ~ = 6), while the fair buyers offer (p = 5, q ~ = 1). The sellers strategy is: Fair minded sellers choose their utility maximizing quality level in every period. They accept every contract, which gives them a utility of at least 5. Selfish sellers imitate the behavior of fair sellers as long as the cost of doing this is not greater than the rent from being employed with certainty in the following periods. The strategies described above are supported by the seller s out-of-equilibrium beliefs that a buyer breaks up the relation at the end of the period if he does not make an offer of the form (p( q ~ ), q ~ ). To show that these strategies constitute a perfect Bayesian Equilibrium, we start our analysis again at the beginning of the final period and consider the case where no information on the sellers preferences has been revealed in the previous periods. So far we have assumed that buyers conclude contracts with sellers randomly chosen out of the pool of sellers with a good reputation. Since buyers are indifferent with which seller they conclude a contract, it is also legitimate to assume that buyers renew the contract with their seller from the previous period. To be precise we consider the following strategy of buyers: A buyer always renews the contract with his seller from the previous period if the seller provided the desired quality. To be able to compare the outcome of the RECE to the one of the PUCE, we stick to our assumption that in the last period the following (non-unique) stage game equilibrium is played: selfish buyers offer (p = 32, q ~ = 6) and fair buyers offer (p = 5, q ~ = 1). The expected rent for a selfish seller who provides the desired effort in period 14 can now be calculated as E selfish [ ] = R s t= 14 =. This rent is of course higher than the corresponding one in the PUCE, because with the renewal strategy of the buyers the probability of getting a contract is 1 for a performing seller instead of 0.7. According to Table 1 the maximum a selfish seller can be induced to deliver is a quality of 7. As a next step we have to determine the optimal price for a selfish buyer in period 14. For this we have to take the following problem into account: The rent of a performing selfish seller in a certain period only depends

16 Falk, Fehr and Zehnder Reputation and Performance 16 on prices in future periods but not on the price of the current period. This leads to a potential commitment problem on the side of buyers. Buyers must be able to commit themselves to paying high prices in all periods, because the incentive of sellers to perform in earlier periods depends on this. However, once a period is reached, buyers know that their price in this period does not further influence the seller s incentive constraint, and they may have an incentive to lower their price. The existence of fair sellers reduces the incentive to lower the wage, since the quality chosen by fair sellers is determined by current and future wages. But since fair sellers also earn a rent from being able to sell a good in period 15, the problem is not completely solved. Following Malcomson and MacLeod (1998) we therefore assume that sellers have the out-of-equilibrium belief that the buyer breaks up the relation at the end of the period if he does not make an offer of the form (p( q ~ ), q ~ ). Taking these beliefs into account the optimal offer for all buyers in period 14 is (p = 38, q ~ = 7). Accordingly the expected rent for a performing selfish seller in period 13, who gets with selfish [ R s probability 1 contracts in the last two periods, is: E ] = (38 10) = t= 13 This is by far enough to motivate the selfish sellers to provide the maximum quality in period 13. By backward induction the same quality can also be induced in all previous periods. Herewith we have shown that our strategies constitute a perfect Bayesian Nash-Equilibrium Hypotheses In general there are two possible ways to get information on other market participants: personal experience and information on experiences of others. In cases where the communication between consumers is very costly and information on sellers can only be gathered from personal experience the engagement in repeated bilateral interactions makes a lot of sense. In a recent experimental paper Brown, Falk and Fehr (forthcoming) show that in such situations market participants establish stable bilateral long-term relations and succeed in realizing efficient outcomes. By forcing themselves into repeated games the market participants make it possible to condition their actions on the past behavior of their trading partner. The threat of terminating a mutual beneficial relationship is a very strong discipline device, that enables them to overcome the incentive problems inherent to incomplete contracts. If, on the other side, consumers can freely communicate with each other, bilateral relations are not necessary for the ability to punish unsatisfactory past behavior of other market participants. The perfect transmission of information allows consumers to condition their actions on the past behavior of all sellers. From the viewpoint of information

17 Falk, Fehr and Zehnder Reputation and Performance 17 accumulation it is therefore intuitively clear, that bilateral relationships and public reputation are substitutes. A comparison of the PUCE and the RECE shows, however, that information gathering is not the only driving force behind the formation of relationships. In the PUCE the buyers randomly choose their seller out of the pool of performing sellers. In equilibrium the probability of getting a contract for a performing seller is therefore 0.7. In the RECE the promise of the buyer to renew the contract in the next period -if the seller performs as desiredcauses the seller s probability of getting a contract to be 1. Given that the same actions are chosen in the last period of the experiment the higher probability in the RECE increases the selfish sellers rent from hiding his type and allows the buyers to induce a higher quality from the sellers in the next to last period. Since the realization of higher qualities means higher profits for the buyers, buyers prefer the RECE compared to the PUCE. Those sellers who are engaged in a relationship in the RECE are also better off than in the PUCE. The losers in the RECE are of course those sellers who do not succeed in establishing a relation to a buyer and do not get a single contract in any period. As a consequence of the higher sustainable performance level and the constant number of concluded contracts the performance of the market as a whole is also higher in the RECE than in the PUCE. As already mentioned there is a large number of other equilibria beside the PUCE and the RECE in this game. From a game theoretic perspective there is no reason to expect one of the equilibria to be more likely than the others and the actual behavior of the market participants remains an empirical question. However, based on our reasoning from above we have the intuitive feeling that the RECE is a very plausible equilibrium. Of course we do not expect our experimental subjects to play the RECE in a strict sense. But we think that the underlying mechanisms in the RECE may also be the driving forces in our experiment. Therefore we suggest the following qualitative hypotheses: Presence of social preferences [H1] On average sellers who are offered higher prices provide higher qualities. In both, the REP- and the NOR-condition, prices and qualities are therefore positively correlated. As a consequence average prices and average qualities are clearly higher than theoretically predicted under the assumption of common knowledge of rationality and money-maximizing behavior. Effects of Reputation Formation [H2] In the REP-condition selfish sellers have an incentive to imitate the fair minded sellers. Therefore higher price offers do not only motivate fair sellers to provide higher

18 Falk, Fehr and Zehnder Reputation and Performance 18 qualities but also selfish ones who imitate reciprocal behavior. As a result the average quality provided for a certain price is higher in the REP- than in the NOR-condition. [H3] The imitation of fair behavior by selfish sellers enables the buyers to induce higher performance. In all but the last period the market performance is higher in the REPcondition than in the NOR-condition. [H4] In the final period of the REP-condition the selfish seller provide minimal quality products, because they do no longer hide their type. This leads to a significant decrease in performance in the last period. Formation of Bilateral Relationships [H5] Buyers and sellers establish bilateral long-term relations in the REP-condition. Many contracts are therefore concluded by market participants who repeatedly interact with each other. [H6] To sustain their bilateral relations buyers make repeated private offers to the same seller. After period 1 most contracts are therefore initiated by private offers in the REP-condition. 4 Results In this section we report our main findings. On the whole, our experimental results are very favorable for our hypotheses. In the NOR-condition the existence of fair minded sellers, who reciprocate high price offer by providing high quality products, makes it profitable for buyers to offer prices above the outside-option of sellers. Market participants are able to reap some fraction of the available gains from trade. However, compared to a socially optimal outcome the realized performance of the market is still very inefficient. Our results in the NOR-condition indicate that the existence of fair minded market participants alone only slightly mitigates the incentive problems in markets for experience goods and is not enough to guarantee a well functioning market. The opportunity to build up a reputation has a strong positive effect on the market performance. Buyers and sellers succeed in establishing stable long-term relationships, in which buyers offer high prices and sellers provide high quality products. As predicted, the market experiences a strong drop of quality in the final period, when many sellers, who provided high quality products before, reveal their true type. Overall the market participants realize a large fraction of the available gains from trade. On average both, sellers and buyers, benefit from the increase in performance and compared to the outcome in the NOR-condition a pareto-superior situation is reached. This result shows that social preferences and reputation

19 Falk, Fehr and Zehnder Reputation and Performance 19 formation are a very powerful combination, which makes the existence of a functioning market for experience goods possible. The remainder of this section contains a detailed description of our results. The section is organized as follows: In the first part we report our observations on the differences in market performance in the two conditions and investigate the effect of the possibility to build up reputations on the distribution of incomes. In the second part we investigate the process of reputation formation and analyze the characteristics of the long-term relations that emerge endogenously in the market. 4.1 Market Performance and Income Distribution The overall efficiency of the market in our experiment is completely determined by the number of realized contracts and the actual quality chosen by the sellers. The number of realized contracts is not a big issue. In both, the NOR- and the REP-condition, more than 99 percent of the potentially possible contracts are realized. This is not surprising, as already a trade of a minimum quality good generates a positive surplus of 5. Sellers and buyers can therefore always find a price which improves the situation of both trading partners. Hence, the crucial point for the market efficiency is the provided quality. If all market participants were selfish payoff-maximizers, game theory would suggest that in both conditions only minimum quality products are traded at prices equal to the outside-option of sellers. However, based on the assumption that a considerable fraction of market participants exhibits social preferences we predict that firms offer prices above the outside-option of sellers and that sellers reciprocate these high price offers by providing non-minimal qualities. Moreover, in the REPcondition, where reputation formation is possible, selfish sellers may have an incentive to imitate the behavior of fair sellers to skim rents. In this case higher price offers of buyers do not only motivate fair sellers to provide higher qualities but also the selfish ones who imitate them. Therefore we expect a stronger positive dependence of quality on prices in the REPcondition compared to the NOR-condition. We start our examination of the market outcome by looking at the price offers of buyers. Table 3 shows the average prices of traded products in every period of the REP- and the NOR-condition.