Reputation and repeat purchases

A conventional method to counter the quality uncertainty is to build brand name and a

seller-specific reputation. The key issue to building a reputation for providing high quality.

 With the underlying assumption that consumers care about the environmental behaviour of hotel establishments, some examples of tour operators that have programs on environmental quality are Orizzonti (an Italian TO), Japan Travel Bureau, Scandinavian Leisure Group and TUI.

Products is that the firm be a long run player or that the product is purchased repeatedly. While in a one shot interaction the firm has large incentives to misreport quality to the potential buyer, in a framework with repeated interaction the firm may have an interest in maintaining a sound reputation so as to ensure future business.

The same incentive to build a sound reputation may appear in case the firm interacts

repeatedly with different buyers – in that case the reputation is passed along consumers. For products or services which are used only once, the reputation is built over a firm rather than a product so that firm specific reputation becomes the brand name by which the firm may transfer consumers’ trust from product to product. Furthermore, a basic requirement for any system of reputation is that each side (both the seller and the buyer) should be able to evaluate quality correctly after purchase, that is, evaluate the past behaviour of the other side. In box 2 we provide a numerical example in which a hotel establishment is able to build a reputation for providing high quality goods or services.

Box 2. Reputation for quality.

Consider one hotel that can provide two types of accommodation services: high quality and low quality service. A high quality service has a cost of 80 ? per night of accommodation, whereas low quality service costs 40 ?.

Anne is planning to spend a night in the hotel, and she values it by (her willingness to pay is) 100 ? in case the service is high quality, and by 50 ? in case the service is low quality.

The price per night of accommodation is 90 ?. This implies that in case the service is high quality, Anne will have a utility of u=100 ? - 90 ? = 10 ?; whereas if the service is low quality she will have a utility of u = 40 ? - 90 ? = -50 ?. This implies that if Anne expects a low quality service she’d better not stay in the hotel. In case Anne stays in for the night, the hotel has two options: either offer a high quality service or a low quality service. The hotel’s profits per night with a high quality service is 90 ? - 80 ? = 10 ?; whereas with a low quality service, the profit per night is 90 ? - 40 ? = 50 ?. If the ‘game’ is played only once, that is, if Anne in any case will only stay one night at the hotel, the only Nash equilibrium is that Anne chooses not to stay in the hotel and, in case Anne stayed in, the hotel would offer low quality service. This is a clear cut result: the hotel is better off offering low quality service since its profit is then 50 ?, rather than 10 ? offering high quality service. In that case, foreseeing such behaviour, Anne will choose not to visit.

However, when the ‘game’ is played indefinitely (repeated infinite times), then the hotel may have an incentive to offer high quality service. Consider that Anne gives a bow of confidence to the hotel and chooses to visit, and then repeat if and only if the quality of the service was high. Then, the hotel must choose between two options. On one side, offering low quality service and gaining 50 ? one night, and then never again accommodating Anne and thus having zero profit in the future. And on the other side, offering high quality service and thus keep hosting Anne repeatedly. This implies that the hotel’s profits are (since they must be discounted, which we do at the daily interest rate.

As a consequence, the hotel will choose to offer a high quality service whenever

Then, in such a case, supplying high quality service and Anne staying in the hotel as long as quality is high is a Nash equilibrium. We see then that the hotel has an incentive to build a reputation of providing high quality service since this ensures future business. Thus, when interaction between the seller and the buyer is not frequent or, when it is difficult for an outsider to the transaction to ascertain the quality of the good that has been exchanged, building a reputation is difficult or impossible. And this is quite exactly the case for the tourist industry in a direct exchange between final sellers (e.g. hotels) and tourists.

Consider the way in which, for instance a hotel company, could build a reputation for

providing high quality service. Many times, interaction between a tourist and a hotel

establishment occurs only once, since tourists switch destination or place of accommodation quite often. Which is then the incentive for a hotel company to maintain, to provide a high quality of the service? Since the tourist will most likely not repeat anyway, and since for outsiders (potential future tourists) it is difficult to know whether quality has been high or low, the incentive to save by providing low quality is high. Thus, each final seller in the tourist industry would not have much incentive to provide high quality. Thus, intermediation by a TO provides a solution to these the lack of incentives of final sellers in the tourist industry to acquire and maintain a reputation and a brand name to signal high quality. A TO has a double incentive to maintain a good reputation. First, with the tourist. Since the TO is going to supply a package tour consisting of many different products, in different places and to many consumers who are potential repeaters, a TO has the right incentives to ensure that quality of the package is as promised; otherwise, the unsatisfied tourist will not repeat purchase to the same TO of the (same or another) package tour. And second, with the final seller (hotel establishment, car rental company). Since the TO is a repeat buyer of the final seller’s product, this final seller has also an incentive to maintain an appropriate quality. Otherwise, in case quality is not good enough, the TO will stop distributing that firm’s product so as to keep its reputation with the consumers.

Three caveats to the previous analysis on the role of tour operators apply to large firms, to firms (of a destination) with a high rate of repeat visitors, and to low quality firms. Large sellers (for instance, large hotel chains such as Hilton) might themselves have powerful incentives to build a reputation and a brand name for quality: since a tourist has the option to accommodate in an establishment of the chain in many different locations, the likelihood that a buyer will repeat is high (or that someone known to the tourist might accommodate in the same chain). As a consequence, a large chain does have an incentive to maintain a reputation for high quality. The same caveat on reputation building can apply to (small) firms of a tourist destination where tourists have a high rate of repetition. When tourist repetition is high, even a small firm may show high levels of quality if it expects that a high proportion of present tourists are likely to come back in a near future. And finally, and intuitively, low quality firms have no need of a tour operator to certify its quality as being low. As we explained above in the market for lemons example, the exchange of low quality goods is not impeded by the existence of asymmetric information.