Firm Reputation and Horizontal Integration∗

We study effects of horizontal integration on firm reputation. In an environment where customers observe only imperfect signals about firms’ effort/quality choices, firms cannot maintain reputations of high quality and earn quality premia forever. Even when firms are choosing high quality/effort, there is always a possibility that a bad signal is observed. In this case, firms must give up their quality premium, at least temporarily, as punishment. A firm’s integration decision is based on the extent to which integration attenuates this necessary cost of maintaining a good reputation. Horizontal integration leads to a larger market base for the merged firm and may allow better monitoring of the firm’s choices, hence improving the punishment scheme for deviations. On the other hand, it gives the merged firm more room for sophisticated deviations. We characterize the optimal level of integration and provide sufficient conditions under which nonintegration dominates integration. Then we show that the optimal size of the firm is smaller when (1) trades are more frequent and information is disseminated more rapidly; or (2) the deviation gain is smaller than the honesty benefit; or (3) customer information about firm choices is more precise.