DP11543 Reputation Cycles
This paper shows that endogenous cycles can arise when contracts between firms and their customers are incomplete and when products are experience goods. Then firms invest in the quality of their output in order to establish a good reputation. Cycles arise because investment in reputation causes self-fulfilling changes in the discount factor. Cycles are more likely to occur when information diffuses slowly and consumers exhibit high risk aversion. A rise in idiosyncratic uncertainty is of two kinds that work in opposite ways: Noise in observing effort is contractionary as it generally is in agency models. But a rise in the variance of the distribution of abilities is expansionary. A calibrated version produces realistic fluctuations in terms of peak-to-trough movements in consumption and the spacing of time between recessions.