The role of reputation and signaling in highly fragmented industries.

Author:Brown, Richard S.


The reputation of a new firm is incredibly important in order to overcome what Stichcombe has labeled the "liability of newness (Stinchcombe 1965)." While this may seem obvious, the mechanisms by which entrepreneurs inform other market participants about their reputational value are not so obvious. While new ventures must sometimes garner legitimacy prior to worrying about reputation, it is important to study ways that entrepreneurs project an abstract value (i.e. reputation) when they are incredibly young. However, newness is not the only hurdle in selling the idea of one's reputational score in the marketplace. Because new ventures tend to coalesce in industries which by their nature are highly fragmented (Porter 1980), information problems exist by and between market participants in attempting to send and receive information while minimizing noise.

This paper will empirically study the mechanisms by which small and new firms in highly fragmented space disperse information concerning their value. The contribution of this paper is in empirically studying the value of reputation as well as signals of reputation in markets and industries that are highly fragmented. While other published works study the effect that reputation has on performance measures, there has been little work that theoretically attempts to explain in what types of market conditions this may or may not be more effective. The paper proceeds as follows. Section II puts forth current theory on reputation and signaling as well as proposing specific hypotheses. Section III addresses the data and methods used. Section IV contains the results of the empirical study. Finally, Section V is a discussion that incorporates the results with both current theory and potential future directions.


Reputation and Signaling in Fragmented Markets

The literature on reputation is found in multiple disciplines including entrepreneurship, management, marketing, finance and economics. In the management literature, reputation has been viewed as a strategic intangible resource that allows firms to capture incremental rents over rivals (Weigelt and Camerer 1998; Roberts and Dowling 2002). In a study of manufacturing firms, Herremans, Akathaporn and McInnes (1993) found that firms with a reputation for social responsibility outperformed competitors. Carmelli and Tishler (2004) found a relationship between perceived organizational reputation and a series of performance variables in a sample of Israeli government authorities. Choi and Wang (2009) likewise found evidence that reputational effects, observed through positive stakeholder relations, aids firms in recovering from inferior performance. While a full literature review of the reputation-performance link is beyond the scope of this paper, the vast majority of empirical papers in management find a positive relationship between the two measures (Bauer 2010).

In the economics literature, reputation has been both theoretically modelled and empirically tested (Kreps and Wilson 1982). Klein and Leffler (1981) introduce a model of unobservable quality whereby sellers decide between selling goods that are either low or high quality but which are both sold at premium prices. They find that the gains from producing a high quality good, which equates to a high reputation, are greater than the one-shot gains from producing low-quality goods and pricing them at premium, which would equate to a bad reputation. Shapiro (1983) set forth an equilibrium model by which sellers, in order to compensate for unknown product-quality, add a premium to high quality items in order to signal the reputation of the firm earned through previous periods. Following on these two works, Allen (1984) argued that firms produce goods of a certain quality with the expectation that consumers will be able to discern the cost functions of firms with high-quality and, subsequently, will not purchase from these firms if they decided to cut costs and enter the low-end of the market.

Titman (1984) and Maksimovic and Titman (1991) posit models by which a firm's capital structure is a signal of its quality. Other actors may be apprehensive to transact with the focal firm due to high debt loads because this debt may signal an inability to offer high-quality products. This can be due to the increased probability and costs of a future bankruptcy (Titman 1984) or to the inability of a firm to honor its future contract obligations regardless of its bankruptcy propensity (Maksimovic and Titman 1991). In a seminal work, Fombrun and Shanley (1990) find empirical evidence that firms send different signals to different agents with respect to corporate reputation. These include market, accounting, institutional and strategy signals to convey performance, conformity and strategic posture.

The crucial aspect of many of the works in economics is the inclusion of asymmetric information where buyers are unaware of the true reputation of the seller. In order to reduce...

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