On the Interaction between Legal and Reputational Sanctions
40 Pages Posted: 24 Jan 2012
Date Written: January 23, 2012
The literature on the relationship between legal and informal penalties has overlooked an important interaction between the two kinds of sanctions. The reputational sanction for certain conduct will generally depend on the size of the legal penalty for that conduct because observers will draw different inferences about the wrongdoer’s type depending on the size of the legal sanction. The overlooked intuition is basic. If a wrongdoer is willing to act in a certain way despite a significant expected legal sanction for such behavior, then the wrongdoer is of a type that is especially willing to engage in such behavior; the size of the sanction thus affects the inference about the wrongdoer’s type. Relying on a signalling model, this article shows that reputational sanctions depend on legal sanctions. It relates this finding to the existing theoretical and empirical literature, showing, amongst other things, that since a single instrument, legal penalties, affects both deterrence of a wrong and signalling, the law cannot generally induce optimal deterrence and optimal signalling. The optimal legal approach is further complicated by the result that increasing the legal sanction may increase or decrease the reputational sanction depending on the context.
Keywords: reputation, deterrence, signalling
JEL Classification: K00, K10
Suggested Citation: Suggested Citation