Reputation and Competitive Selection

We demonstrate how selection in competitive markets can impede long-run reputational incentives. In our model, competent firms can exert costly effort to improve expected product quality, but inept firms cannot. With low entry barriers, we show competent firms cannot persistently exert effort, despite bounded memory. Such effort would cause consumers to select firms based on reputations for competence, eventually selecting a monopolist with an arbitrarily high reputation, which has no incentive for effort. More generally, reputation-based selection rules out long-run effort, which undermines the basis for such selection. Intermediate entry barriers provide stronger reputational incentives than low or high barriers. (JEL D21, D40, D82, L15)