Reputation and Performance

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