Bryan Caplan  

When Doesn't Reputation Work Well?

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Paul Krugman can't believe how much I trust in the power of reputation to keep health insurers honest.  He's right about one thing: I think reputation works wonders - not just in insurance, but throughout modern economies.  I could talk about the miracle of the credit card, and how it has enabled hundreds of millions of strangers to trade via computer.  I could talk about the miracle that is CostCo - if they stock it, you know you're getting quality on the cheap.  Or consider a random example from my own experience:

When we wanted a new house built, we gave 10% of the purchase price to the builder upfront.  The builder gave us a contract almost devoid of legal remedies - practically everything was at the builder's "sole and absolute discretion."  A few months later, we moved into our house.  99% of the details were exactly right, and they fixed the rest for free.  Why would the builder treat us so well?  Altruism?  Ha.  Legal remedies?  Ha.  Even repeat business is a stretch.  What are the odds we'll ever ask them to build a second house for us?  The only answer that makes sense is reputation.

Reputation is so mighty a force, it makes me wonder: When doesn't it work well?   Reputation obviously fails for involuntary interaction; pirates and dictators often deliberately seek reputations for ruthlessness because it makes their job easier.  So let's refine the question: If interaction is voluntary, when doesn't reputation work well?

To me, venereal disease is the most striking response.  Unlike other disease, V.D. is simple to prevent: Only have sex with people who credibly show that they aren't infected.  How hard is that?  But according to Wikipedia, AIDS alone kills over 2 million people per year. 

What's going on?  I see one big problem with demand, and another with supply. 

The demand problem: Reputation can't protect those who ignore its importance.  Yet lots of people are strangely willing to gamble their lives by having sex with people they (a) barely know, and (b) who are themselves willing to have sex with people they barely know.  If people bought cars this recklessly, they really would be "unsafe at any speed." 

The supply problem: Reputable people - unlike reputable firms - cannot readily expand to take over the whole market.  (No puns please).  In the business world, one trusted supplier can ably serve all your friends and family.  The local singles bar doesn't work that way.

Question: What is your favorite example where reputation doesn't make voluntary interaction work well?   Is the problem demand, supply, or what?
 

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TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/2145
The author at Free Market Mojo in a related article titled Supply and Demand Curves for Reputation writes:
    Why bother making a rose out of a bar napkin for that pretty girl when you’ve got Free Market Mojo to help you explain to her your intimate understanding of the economics of intercourse? ... [Tracked on August 5, 2009 2:48 PM]
COMMENTS (22 to date)
Bruce Bartlett writes:

I've always thought the best example of reputation in action is the willingness of people to accept checks, which are nothing but pieces of paper that someone has turned into money just by signing their name to it. In practice, the reputation of the financial institution generally has no bearing on the transaction. It is solely the reputation of the checkwriter and that is based mainly on whether he or she looks honest and has a minimal amount of identification.

Michael Kolczynski writes:

Asymmetric reputation. "Failing upward." People who are superiors who are more or less incompetent but are good at getting subbordinates to make them look good.

The reputation of the superior is that of competency: when there are decisions made by the superior that are particularly poor, but do not fail as they would under normal circumstances due to subordinate's desire to not have their job made even more difficult.

Sometimes subordinates do more work to clean up their superior's mess, and are unable to efficiently communicate the reality of the situation to anyone higher.

The higher-ups don't see the problems the subordinates see, and the reputation is then asymmetric. Subordinates see incompetence, superiors see competence.

Michael Kolczynski writes:

I forgot to include this, but that is a situation that arises outside of a free market, it's an internal orginizational failure.

mobile writes:

Reputation probably isn't that important in the U.S. health insurance market. Most people get their health insurance through their employer, and the reputability of the health insurance provider is pretty far down the list of considerations when deciding what company to work for. Reputation would be more important if the choice of your health insurer was independent of your choice for employment, like all the other insurance you buy probably is.

Floccina writes:

Yes the problem with Krugman's theory is that it proves to much. Not only heath insurance but life and home insurance and many other big transactions should be full of fraud. Even the mafia pays out when your number comes in. Even most illegal drug deals go through without fraud.

I think that illegal drug transactions would be a good area of economic study. They are markets without legal protection.

And BTW A person particularity with a terminal illness could turn on the assets of an insurer that defrauded them so it is not so far from the drug dealers as one might think.

david writes:

Well, reputation is a kind of non-price market signal. As a model, we can say that companies can cheat and maintain lower prices, or not cheat and use nonprice signals like reputation to maintain market share. Reasonably we might say the non-cheating companies generally have higher prices.

Companies that rely on reputation have an incentive to keep supporting mechanisms that propagate such non-price signals (e.g., by sharing information with consumer groups, or asking you to tell your friends about them). Correspondingly, their marketing will focus less on price signals. Indeed such insurers would be trying to undermine confidence in mechanisms that propagate price signals.

Therefore all we need to do is observe how leading insurers advertise their insurance plans. Car insurance seems to be driven by price competition, since there are many famous marketing campaigns that focus on cheaper prices.

Major health insurers, on the other hand, anecdotally do not seem to be relying on price signals.

Joe Teicher writes:

mobile wrote:

"Reputation probably isn't that important in the U.S. health insurance market. Most people get their health insurance through their employer, and the reputability of the health insurance provider is pretty far down the list of considerations when deciding what company to work for."

I find this comment frustrating. Its not like your employer picks the insurance company it uses by random chance. How do you know what information the people that make that decision actually have? Maybe they know a lot about the reputation of various insurers. I don't know, but I do know that it is a big decision for a company since it costs so much, and companies tend to advertise their healthcare benefits to potential hires pretty hard. Also, a decent sized employer would be in a much better position than an individual to see how an insurance company reacts to sick people. If they notice that every time one of their employees gets sick the insurance company drops that employee, they will probably start shopping around for a new insurer.

Jeremy, Alabama writes:

For a business not based on reputation, I would suggest looking in the phone book. Any company called "AA", "AAA" or "A1" gets its business by being on page 1, and not for any other reason. Yep, taxi cabs and bail bonds.

But just about everything else is reputation-based. It is well understood that people are willing to pay slightly more for goods from a reputable vendor, even on the Internet where thousands of prices are instantly available. Thus, Amazon is merely low-priced vendor, rarely the lowest-priced vendor.

Jorge writes:

Reputation is highly dependent on getting caught for one's misconduct.

If you weren't a journalist/blogger, the chances of you getting the same treatment from the builder would have been slim.

As to your repeat business hypothesis: it's about referrals. Again, you being a journalist/blogger has a lot to do with that.

Francis writes:

To experience what is life when reputation doesn't count, just be a tourist on your own in a foreign country. Tourists who are not extra suspicious quickly fall in tourist traps. That's why tourists rely on travel guides, tours, etc. to avoid the worst.

Krugman doesn't seem to know about game theory.

Of course, to be charitable, Krugman's comment just means that reputation is not always valid and that it does not prevent fraud or outrageous behavior to happen sometimes. So, we should not make a strawman of him. But then, he himself posts Mr. Caplan as a strawman by sneering that he thinks that reputation is a panacea (pun intended).

Joe writes:

You would think Ford would be out of business right after the Pinto disaster revealed they woulrather pay out the estimated costs of lawsuits for bodily injury than reengineer the car. Who would want to drive one of those cars?

Reputation matters, but what matters more is that peopel Think you have a good reputation, not that you actually have one. People think Wal Mart always has teh lowest pices even though thsi is far from true.

In New York City, HIP has a horrible reputation (as a health insurance provider); they are known to deny services to patients and deny payments to providers so they are able to plug the cash outflow on both ends. But, they are still in business, and employesr still choose them as an option for your health insurance. Why?

Mark writes:

Actually, the illegal drug industry is a great example of this. In Sudhir Venkatesh's "Gang Leader for a Day", the gang leader punishes one of his employees for lacing his cocaine with an impurity, as this means that his customers will seek out other drug dealers.

Mark writes:

Oh, and as a recently graduated college student, I can attest that the reason behind the irrelevance of reputation relating to V.D. is that a certain minority of people will have sex with anything when intoxicated. So if health insurance retailers are primarily marketing to blacked out college kids, Krugman may indeed have a point.

Francis writes:

Joe,

You mistake whose reputation was at stake in the Pinto affair: Ford, or muckrackers who came up with the scandal.

Muckrackers have a bad reputation. Not many people believe them and there are reasons for that.

Joe writes:

Francis

I am afraid I do not understand you response. Are teh peopel who uncovered the memos muckrakers, or are the decision makers the muckrakers. Yes, the TV show was rigged, but the memos were real.

Joe

Daniil Gorbatenko writes:

Thanks for demolishing the myths about "predatory" insurers, Bryan.

As for Krugman, he is very much loyal to his tactics. He did not even bother to counter the essence of your argument or mention the facts that you referred to. But he did not miss the opportunity to caricature you as if you claimed that market players never cheat.

RL writes:

You claim STDs (venereal disease) is a counterexample to reputation, and if I understand you the reason is 2 million people die each year of STDs (mostly AIDS).

2 million is the numerator. What's the denominator? The number of people on earth? The number having sex? The number of copulations? What's your reasoning that 2 million is too large?

Francis writes:

Joe,

Remember: the facts are one thing, but reputation is something else. I am not arguing who was right, I'm arguing whose reputation wheighed heavier.

So, confronted with newspapers/consumer groups/lobbies/etc. that had cried wolf too often, for instance, and Ford whose products the layman knew because he had purchased them or his brother-in-law had, perhaps he decided the reputation of Ford was the least bad of the two.

Now, it is a strange thing that you choose the American auto industry as a counter-example of Mr. Caplan's statement. If there is an example of an industry that had a good reputation, even a favorable prejudice from the American population, then abused it by selling shoddy and unsafe products, and then finally got dumped by their consumer base, you have the perfect one. The auto industry illustrates very well what reputation does and what happens when one abuses it.

Alan Crowe writes:

In the American system, is the executive who choses a company's health plan choosing a single plan, providing a uniform standard of care to all employees, including himself and his family? Or is American society more stratified than that, with the executive receiving his health insurance from a separate executive plan, perhaps provided by a different health insurance company?

JayDee writes:

Also if you are going to argue that employers choose health plans based on reputation, surely you must assume the employer a) has a system for gathering employee complaints, b) gathers enough complaints to register a pattern ( would a small company notice?) and c) needs to use health benefits as a way to attract employees and keep them (if there is plenty of labor would they care?)

Robert writes:

According to Peter Boettke's podcast on EconTalk, Pirates did use reputations of ruthlessness--but for good. If merchant ships resisted, the Pirates would react violently. But, if the merchant ships allowed the Pirates to rob them, the Pirates wouldn't harm anyone. So I think that the pirates example actually argues in favor of your point.

Nik writes:

When doesn't it work? When there are:
1. A very large, fragmented population of consumers, most making infrequent purchases
2. Largely standardized products (ie: highly regulated or commoditized), leading to high inelasticity of demand to price ... causing price to be the major differentiator
3. A highly transparent market in terms of price

Airlines, credit card companies, and banks are all great examples. Major players make little investment in customer retention, preferring instead to counter attrition with new customer acquisition, based largely on price, combined with creation of monopoly/oligopoly power (usually only local or short-lived). Any marketer in these industries will tell you that their key metric is the ratio of attrition to acquisition.

Said concretely, an airline can delay a departure by hours, strand 300 customers in a layover airport overnight, make us stand in line for hours to get re-booked, pack each of us between sumo wrestlers on a tiny aircraft, and then over-charge us for a bottle of water, all the while making scant few attempts to satisfy us customers or retaining our business. They know they can lure most of us back next time by simply offering the cheapest fare for the route and time of our next trip.

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