Reputation-Driven Industry Dynamics

This paper studies the entry-exit dynamics of an experience good industry. Consumers observe noisy signals of past firm behavior and hold common beliefs regarding their types, or reputations. There is a small chance that firms may independently and unobservably be exogenously replaced. The market is perfectly competitive: entry is free, and all participants are price-takers. Entrants have an endogenous reputation uE. In the steady-state equilibrium, uE is the lowest reputation among active firms: firms that have done poorly leave the market, and some re-enter under a new name. This endogenous replacement of names drives the industry dynamics. In particular, exit probabilities are higher for younger firms, for inept firms, and for firms with worse reputations. Competent firms have stochastically larger reputations than inept firms both in the population as a whole and within each cohort, and thus are able to live longer and charge higher prices.