Managing Reputation with Litigation: Why Legal Sanctions Can Work Better than Market Sanctions

A long-lived firm sells a good to a sequence of consumers, where the good’s quality imperfectly depends on the firm’s unobservable e§ort. To solve the moral hazard problem, the firm can promise to pay damages (formal sanctions) or facilitate reputational punishment (informal sanctions). Formal sanctions engender litigation costs and possible court error while informal sanctions involve ine¢cient failures to trade. Using formal sanctions, however, are generally better because increasing damages induces more lawsuits (marginal deterrence) and makes existing lawsuits a stronger deterrent (inframarginal e§ect). Increasing reputational sanctions lacks the second, infra-marginal e§ect. We would like to thank Ken Ayotte, Bob Ellickson, Nicola Persico, Kathy Spier, Abe Wickelgren, and workshop participants at University of Chicago Law School, UC Berkeley Law School, Washington University in St. Louis Law School, 2013 NBER Law and Economics Mid-year Meeting, and 2013 American Law and Economics Association Annual Meeting for many helpful comments and suggestions. Comments are welcome to [email protected] and [email protected].