Media Briefings

HOW PEOPLE’S CONCERNS ABOUT REPUTATION BOOST MARKET PERFORMANCE AND REDUCE PRICE RIGIDITY

  • Published Date: March 2009

New empirical research indicates that the formation of reputation in repeated interactions between people and/or organisations strengthens the positive impact of considerations of fairness on economic outcomes. The study by Ernst Fehr, Martin Brown and Christian Zehnder, published in the March 2009 issue of the Economic Journal, shows that this happens in two distinct ways:

  • First, reputation formation strongly amplifies the positive effect of fairness preferences on contract enforcement. The reason is that in repeated interactions, reputation concerns motivate self-interested people to behave as if they were fair-minded.
  • Second, reputation formation limits the extent to which fairness considerations lead to price stickiness. Reputation formation provides strategic incentives, which partially unburden prices from their function of providing non-competitive rents that motivate fair-minded people.

Transactions in labour, credit and service markets are often plagued by limited contract enforceability. Experimental and field evidence show that fairness considerations have a positive impact on economic outcomes when contracts are difficult to enforce.

If a trading party chooses terms that provide his partner with a non-competitive rent, the partner often refrains from exploitation and reciprocates the kindness with high performance. But the efficiency enhancing effects of fairness come at a cost. Sharing rents according to fairness standards leads to sticky prices and prevents flexible reactions to supply and demand shocks.

Since many economic transactions involve repeated interactions, it is natural to ask how reputation formation affects the positive and negative influences of fairness on economic outcomes. This study provides new evidence suggesting that reputation formation has a double positive impact on the relationship between fairness and market performance.

Based on data obtained in laboratory experiments where participants face monetary incentives, the researchers show first that reputation formation strongly boosts the positive effect of fairness considerations on contract efficiency.

The reason is that the opportunity for reputation formation implies that selfish people have incentives to behave as if they are fair-minded. Building up a reputation for fair behaviour is valuable for selfish people, because it motivates future trading partners to offer them non-competitive rents. The presence of reputational incentives implies that a relatively small fraction of fair-minded people suffices to generate large efficiency gains.

Fehr, Brown and Zehnder also show that reputation formation alters the nature of interactions in a fundamental way: economic transactions no longer take place in an open market place, where traders often change their partners.

Instead, transactions take place in long-term bilateral relationships. One might conjecture that this bilateralisation of market interactions would increase the prevalence of rent-sharing norms and reinforce the stickiness of prices. But the authors find the opposite to be true: reputation formation leads to a reduction in price stickiness relative to a situation in which fairness alone affects economic outcomes.

The intuitive explanation behind this finding is that reputational incentives provide an alternative means to motivate fair-minded and selfish workers, so that the provision of non-competitive rents becomes less important. This increases price flexibility in the face of supply and demand shocks.

These findings identify limited enforceability of contracts and the resulting reliance on fairness motivations as an important source for price rigidity. The presence of repeated interactions and reputational concerns alleviates this price stickiness, but it does not remove it completely.

The study suggests that policy-makers in central banks and competition authorities should adapt their policy instruments to the fact that price stickiness is not only caused by the usual suspects like imperfect competition and transactions costs, but may also result from inherent contract enforcement problems.

ENDS

Notes for editors: ‘On Reputation: A Microfoundation of Contract Enforcement and Price Rigidity’ by Ernst Fehr, Martin Brown and Christian Zehnder is published in the March 2009 issue of the Economic Journal.

Fehr is Director of the Institute for Empirical Research in Economics at the University of Zurich. Brown is at the Swiss National Bank. Zehnder is at Harvard Business School.

For further information: contact Ernst Fehr on +41 44 634 3709 (email: efehr@iew.uzh.ch); or Romesh Vaitilingam on 07768 661095 (email: romesh@vaitilingam.com).