”Hard to Get, Easy to Lose” Endogenous Reputation and Underinvestment

Reputation concerns may help to achieve efficiency in cases where imperfect information impedes it. In this paper I highlight the endogenous property of reputation and analyze how it undermines the effectiveness of reputation to achieve efficiency. More reputation implies the possibility of undertaking more activity. At the same time, more activity generates more signals under which reputation can be constructed faster and more precisely. Firms with low reputation have the incentives but not the demand to achieve efficiency. Firms with intermediate and high reputation may have the demand but not the incentives to achieve efficiency. High reputation firms have more room to lose reputation than to gain reputation. Covering the whole demand has short-term benefits from a large activity but has long-term costs from increasing the precision of signals and the magnitude of the potential loss of reputation, with the corresponding difficulty to build reputation back. The result is high reputation firms may decide to under-provide and under-invest.