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 U ...