Is Bigger Better? Customer Base Expansion through Word-of-Mouth Reputation
We develop a model of gradual reputation formation through a process of continuous investment. We consider a market in which quality is un- observable at the time of purchase so that consumers base purchasing de- cisions on …rms'past performance - their reputation. The model has two main ingredients. First, we assume that the ability to produce high-quality products requires continuous investment. Second, we assume that as a con- sequence of informational frictions, such as search costs, information about …rms'reputations diuses only gradually in the market. This leads to a dual process of increase in a …rm's customer base and an increase in its investment in product quality. As long as a …rm continues to invest and deliver high quality, its reputation as a high quality …rm grows, new cus- tomers are attracted and the …rm increases in size. However, if quality deteriorates, the …rm's customer base shrinks and remains stagnant until � We thank two anonymous referees and especially Fernando Alvarez for detailed and thought- ful commentary on a previous version. We also thank Braz Camargo and Eduardo Faingold for carefully reading the manuscript and making suggestions. Rob acknowledges the support of NSF and Fishman acknowledges the support of ISF. All remaining errors are our own.