Safety hazards and industry reputation

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The evidence on consumer response to recalls is difficult to reconcile with the existing theory. According to the evidence, bad news conveyed in recalls may affect not only the specific company involved in the recall but also the reputation of other companies in the industry. Our model endeavors to fill this gap by introducing a safety hazard to the standard theory of experience goods and firm reputation. Following Horner (2002), consumers cannot observe firm effort but observe product quality after purchase. In their repeated interactions with the firms, consumers act as a disciplinary body purchasing products only from firms that always produce good outcomes. Consequently, in order to increase the chance of good outcomes, certain firms ('good firms') choose to always exert high effort whereas 'bad firms' always exert no effort along the equilibrium path ('a high-effort equilibrium'). In this framework, we analyze how safety hazards affect the industry along the equilibrium path. On the one hand, the remaining firms not involved in the recall may gain advantage over the failed ones, reflected in higher market shares and prices after a one-time reduction in price, 'the supply-side effect'. On the other hand, the realization of a safety hazard may harm the reputation of the remaining firms, reducing prices, 'the demand-side effect'. The combined effect of these two underlying forces dictates the path of prices over time depending on: 1) the severity or the spread of the safety hazard 2) the level of reputation the industry has gained over time, and 3) the prevalence of safety hazards in good firms. We further show that when consumers differ in their willingness to pay for quality, their composition may change as a response to the realization of a safety hazard. Specifically, the demand-side effect may cause the exit of consumers with high willingness to pay from the market. In this case, and also when consumers and firms do not share identical perceptions on the safety hazard, the industry may shift to an equilibrium where all firms excel no effort.