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On Reputation: A Microfoundation of Contract Enforcement and Price Rigidity

  • Fehr, Ernst

    ()

    (University of Zurich)

  • Brown, Martin

    ()

    (Swiss National Bank)

  • Zehnder, Christian

    ()

    (University of Lausanne)

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.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 3655.

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Length: 33 pages
Date of creation: Aug 2008
Date of revision:
Publication status: published in: Economic Journal, 2009, 119 (536), 333 - 353
Handle: RePEc:iza:izadps:dp3655
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