On Reputation: A Microfoundation of Contract Enforcement and Price Rigidity

33 Pages Posted: 27 Aug 2008  

Ernst Fehr

University of Zurich - Department of Economics

Martin Brown

University of St. Gallen - Swiss Institute of Banking and Finance

Christian Zehnder

University of Lausanne

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Abstract

We study the impact of reputational incentives in markets characterized by moral hazard problems. Social preferences have been shown to enhance contract enforcement in these markets, while at the same time generating considerable wage and price rigidity. Reputation powerfully amplifies the positive effects of social preferences on contract enforcement by increasing contract efficiency substantially. This effect is, however, associated with a considerable bilateralisation of market interactions, suggesting that it may aggravate price rigidities. Surprisingly, reputation in fact weakens the wage and price rigidities arising from social preferences. Thus, in markets characterized by moral hazard, reputational incentives unambiguously increase mutually beneficial exchanges, reduce rents, and render markets more responsive to supply and demand shocks.

Keywords: wage rigidity, price rigidity, relational contracts, reciprocity, reputation

JEL Classification: D82, J3, J41, E24, C9

Suggested Citation

Fehr, Ernst and Brown, Martin and Zehnder, Christian, On Reputation: A Microfoundation of Contract Enforcement and Price Rigidity. IZA Discussion Paper No. 3655. Available at SSRN: https://ssrn.com/abstract=1251023 or http://dx.doi.org/10.1111/j.0042-7092.2007.00700.x

Ernst Fehr (Contact Author)

University of Zurich - Department of Economics ( email )

BlĂĽmlisalpstrasse 10
Zuerich, 8006
Switzerland
+41 1 634 3709 (Phone)
+41 1 634 4907 (Fax)

Martin Brown

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

Christian Zehnder

University of Lausanne ( email )

Lausanne, Vaud CH-1015
Switzerland

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