Reputation and liability in experience goods markets with imperfect monitoring

This paper investigates the interaction of reputation and product liabilities from a new perspective. We introduce a reputation model in an experience good market with imperfect monitoring, in which reputation incentives without product liability are not sufficient for inducing a desired outcome. Even a firm with high market reputation will cheat consumers, and the reputation will eventually collapse. We then introduce two product liabilities into the reputation model: strict liability and negligence rule. It is shown that under certain conditions, these two liabilities can both improve firms’ incentives and final outcomes. What is the best product liability depends on the costs of firms and courts as well as courts’ professional level. The paper also sheds light on which liability regime is optimal in this reputational setting.