Firm and Horizontal Integration
Firm Reputation and Horizontal Integration∗
Hongbin Cai† Ichiro Obara‡
March 14, 2008.
Abstract
We study effects of horizontal integration on firm reputation. In an environment where customers observe only imperfect signals about firms’ effort/quality choices, firms cannot maintain good reputation and earn quality premium forever. Even when firms choose high quality, there is always a possibility that a bad signal is observed. Thus, firms must give up their quality premium, at least temporarily, as punishment. A firm’s integration decision is based on the extent to which integration attenuates this necessary cost of maintaining a good reputation.
Horizontal integration leads to a larger market base for the merged firm, which leads to a more effective punishment and a better monitoring by eliminating idiosyncratic shocks in many markets.
But it also allows the merged firm to deviate in a more sophisticated way: the merged firm may deviate only in a subset of markets and pretend that a bad outcome in those markets is observed by accident. This negative effect becomes very severe when the size of the merged firm gets larger and there is non-idiosyncratic firm-specific noise in the signal. These effects give rise to a reputation-based theory of the optimal firm size. We show that the optimal firm size is smaller when (1) trades are more frequent and information is disseminated more rapidly; or
(2) the deviation gain is smaller compared to the quality premium; or (3) customer information about firms’ quality choices is more precise.
Keywords: Reputation; Integration; Imperfect Monitoring; Theory of the Firm; Merger
JEL Classification: C70; D80; L14
∗We thank seminar participants at Brown University, Stanford University, UC Berkeley, UCLA, UCSB, UC
Riverside, UIUC and USC for helpful comments. All remaining errors are our own.
†Guanghua School of Management and IEPR, Peking University, Beijing, China 100871. Tel: (86) 10-62765132.
Fax: (86)
Hongbin Cai† Ichiro Obara‡
March 14, 2008.
Abstract
We study effects of horizontal integration on firm reputation. In an environment where customers observe only imperfect signals about firms’ effort/quality choices, firms cannot maintain good reputation and earn quality premium forever. Even when firms choose high quality, there is always a possibility that a bad signal is observed. Thus, firms must give up their quality premium, at least temporarily, as punishment. A firm’s integration decision is based on the extent to which integration attenuates this necessary cost of maintaining a good reputation.
Horizontal integration leads to a larger market base for the merged firm, which leads to a more effective punishment and a better monitoring by eliminating idiosyncratic shocks in many markets.
But it also allows the merged firm to deviate in a more sophisticated way: the merged firm may deviate only in a subset of markets and pretend that a bad outcome in those markets is observed by accident. This negative effect becomes very severe when the size of the merged firm gets larger and there is non-idiosyncratic firm-specific noise in the signal. These effects give rise to a reputation-based theory of the optimal firm size. We show that the optimal firm size is smaller when (1) trades are more frequent and information is disseminated more rapidly; or
(2) the deviation gain is smaller compared to the quality premium; or (3) customer information about firms’ quality choices is more precise.
Keywords: Reputation; Integration; Imperfect Monitoring; Theory of the Firm; Merger
JEL Classification: C70; D80; L14
∗We thank seminar participants at Brown University, Stanford University, UC Berkeley, UCLA, UCSB, UC
Riverside, UIUC and USC for helpful comments. All remaining errors are our own.
†Guanghua School of Management and IEPR, Peking University, Beijing, China 100871. Tel: (86) 10-62765132.
Fax: (86)