19 July 2011

Reputational Capital

One example he used was of Jonathan's Coffeehouse, a private club that preceded the London Stock Exchange. In the 18th century, the government refused to enforce stock exchange contracts, seeing them as a form of gambling. Nevertheless, the Coffeehouse became a centre of commerce and contracts were usually upheld voluntarily. If you were a trader, you could rip somebody off once, but would be barred from the club. For people whose livelihoods were based on stock trading, it wasn't worth it.
The same phenomenon exists today in a whole range of exchanges. When I go to a restaurant and get a bland meal, it's practically certain that I won't sue. Does this mean that profit-maximising restaurants will constantly give out bland meals? No – if it serves bad food, I'll stop going and tell my friends not to go either. Reputational capital, so to speak, is enormously valuable, and losing it can be worse than just losing a court case. As a side-point, the reason that restaurants in touristy areas are usually so bad is down to this fact as well. Tourists typically don't know anything about the restaurants they go to – could things like TripAdvisor bring an end to tasteless, expensive tourist food?
One complaint about the unfettered free market is that there is no way to “make sure” that people behave ethically and fairly in their business dealings. The unspoken assumption is that only government can provide the final guarantee against fraud, presumably through the use of force. What’s neglected in this fairly shallow analysis is that most people expect to participate in the market over the long term, the market can exert plenty of force, and the government is far from perfect anyway.

Since most people expect to participate in the market over the long term, it would be foolish for them to do things that would cause consumers to distrust them. As was already noted, if someone were to even sell a shoddy product, they would presumably suffer negative consequences. And if they intentionally defrauded customers, they would find that they would go out of business quite quickly.

The reason for this is due to the effect of social pressure, which exists outside of the state. Most people with decent faculties will find that it is in their best interest to “play by the rules” because doing so ensures that will have social acceptance, which in turn ensures that there is some degree of implicit trust which then enables trade. This social pressure ensures that most people conform to social norms, and this is itself a form of force.

Unlike the state, though, the market does not have coercive power, in the sense that conformity can be forced. Anyone can opt out of the society in which they live, if they so choose. Incidentally, if one were to opt out of a given society, the market in that society would improve because those who opted out would no longer participate in that market.

Finally, the coercive force of the government is not always used for good. Even if the market cannot ensure that no one ever gets hurt when engaging in market transactions, it does not follow that the government will. As such, the argument that the government needs to regulate the market for the good of consumers is simply specious.


  1. Look at American car companies for an example of what you're talking about. Years ago, they made shoddy products, so people bought cars from foreign companies. For years, Detroit has turned out good products, products that are just as good as those from Japan. However, their lost reputational capital is STILL hurting them decades later...

  2. @MarkyMark- good example. Ford is only now beginning to recover even though Consumer Reports has spoken favorably of Ford cars for nearly a decade. In fact, CR often compares Ford to Toyota, but this comparison has not yet reached it's way to the general public even though the data backs it up.

  3. Simon,

    Here's a GREAT example of what I'm talking about. Years ago, my mom had a couple of Dodges that were lemons; both cars were poor quality (a 1974 Swinger and an Omni). After the Omni, my mom vowed NEVER to buy an American car again, and she hasn't.

    A couple of years ago when her old Camry was in the shop, my mom rented a new Chevy Malibu. She LOVED the car; she thought it was great. Here's the kicker: she said that if she didn't know it was an American car, she'd have BOUGHT one...


  4. @MAarkyMark- that's funny. That reminds me of when my dad asked for my advice on whether to buy a mid-90's Dodge Caravan. I told him no because Dodge vans in the 90s were pretty much crap. He bought it anyway and it has been nothing but trouble since. Anyway, both he and my mom have come to the conclusion that they will simply buy Japanese cars anytime they need to buy a car because they are sick of buying garbage. Of course, with their budget they can only afford used cars, so it looks like American car companies will still see their reputations suffer for some time yet.