August 5, 2019 Reading Time: 4 minutes

Out of the corner of my eye, I saw my phone flash with a notification from the social media app Nextdoor. I cursed myself for having failed to turn off the auto-notification feature. But I saw the title of the post and decided that since I was between tasks, I would investigate further. It was a post from a neighbor detailing a bad experience with a local company and suggesting that we look elsewhere should we need air conditioning repair. 

It was an example of how people in a free society provide quality assurance. Brand names matter, and in this case the AC company’s shoddy service and shady dealing sullied their name in the eyes of everyone who read the post and who will now go to a competitor as a result. Free minds and free speech on free social media platforms mean rapid and sometimes ruthless dissemination of information.

Reputation solves some of the problems transaction costs create. Transaction costs include the costs of establishing trust. It’s hard to know that you will actually get what is promised, when it is promised. Platform services, banks, and retailers are ultimately in the business of reducing transaction costs, including the cost of establishing trust. When you see some brand names, you know you’re getting high-quality products (and probably paying premium prices). When you see other brand names, you know you’re probably not paying more, because what you’re getting isn’t quite as good as the leading brand.

For many firms, their reputation is their most valuable asset. They will go to great lengths to protect it. My freshman year of college, several of my friends got shigella. The restaurant that gave it to them didn’t last much longer. Even when the offenders don’t go bankrupt, the damage to their reputation and their bottom line can be long-lasting and substantial.  When I was in sixth grade or so, I remember reading about an e. coli outbreak at a fast food restaurant in another state. It made quite an impression, I still think about that every time I see one of them, and I’ve still never eaten there. 

When I mentioned this to an audience of high schoolers, they all mentioned another restaurant that was ground zero for an e. coli outbreak a few years ago. The hit to their reputation also means a likely hit to their ability to charge higher prices and definitely a hit to their ability to sell more meals. All else equal, I will make fewer visits to this place over my lifetime than I would have without the e. coli outbreak and vote with my dollars for places that haven’t been the source of e. coli outbreaks.

Does it work perfectly in every instance? Of course it doesn’t, but it works pretty well. Adam Smith said there is “a great deal of ruin in a nation” and was under no illusion about flawed and fallen people creating a utopia as a consequence of what he called “the obvious and simple system of natural liberty.” As social media shows us all too regularly, the line separating a community from a mob can be thin indeed. On net, services like Yelp, TripAdvisor, Nextdoor, and others help keep businesses on their best behavior — and they work tolerably, even surprisingly well. There was even an episode of South Park dedicated to the power Yelp reviewers wielded — or tried to wield.

That might seem to damn the market process with faint praise. We all have stories about bad customer service or some way we were wronged by a restaurant, an employer, or a retailer. Isn’t it simply naive to say, “Just leave it to the market”?

I don’t think so. When we compare them to the very best world we can imagine populated by the very best people we can imagine, actually existing markets look pretty bad. They cater to our least beautiful instincts of self-love, self-preservation, and self-advancement, and when Yelp hosts reviews they aren’t doing so because they really want to help me the way I would help a child tie her shoes. They’re only helping me because I help them — in this case, by providing content and data. 

We get strangers to help us by helping them because we can’t be friends and family with everyone. Maybe it would be nice if the people at Yelp, Waffle House, and Amazon loved me and thought about me the way I love and think about my children and my friends, but they have their own children and their own friends to worry about. Market exchange makes cooperation easier, and being able to cooperate with strangers makes it easier for me to love my friends and family well.

When we say, “Leave it to the market,” we’re engaging in an explicitly comparative exercise. There are a lot of relevant and possible alternatives, each with their own costs and benefits. As Don Boudreaux reminds us, “The State Is Not a Transcendental Being” — nor is it likely to have the knowledge of what Friedrich Hayek called “the particular circumstances of time and place” that would make it a wise steward of the fruits of our labor

Unlike licensing boards and elected officials, firms like Yelp get indispensable profit-and-loss signals that can tell them whether people think they are doing a good job relative to the alternatives — and in such a case, people tell them this by parting with their time and occasionally their hard-earned money. Network effects and switching costs are important, but a platform’s ability to abuse its users is constrained by the fact that there’s usually another platform in the app store.

There are all sorts of potential problems in markets where people don’t share the same information. At first glance, it looks like someone following his most narrowly conceived self-interest has an almost-overwhelming incentive to lie, cheat, steal, dissemble, break promises, and act in a whole host of antisocial ways. The problem with this strategy? People talk — and if you don’t manage your firm’s reputation carefully, it will hurt your bottom line in the long run.

Art Carden

Art Carden

Art Carden is a Senior Fellow at the American Institute for Economic Research. He is also an Associate Professor of Economics at Samford University in Birmingham, Alabama and a Research Fellow at the Independent Institute.

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