Stretching Firm and Brand Reputation

Abstract

I consider an adverse selection model of ¯rm reputation. Each firm is characterized by an exogenously given quality level, which is the firm's private information and applies to any product it sells. Consumers observe the performance of the firm's products, which is positively related to the firm's quality level. The firm's reputation is given by the consumers' posterior on the firm's quality level given the firm's performance history. I address the following question: if a firm is to launch a new product, should it use the same name as its base product (reputation stretching), or should it create a new name (and start a new reputation history)? I show that, for a given level of reputation, firms stretch if and only if quality is sufficiently high. As a consequence, stretching signals high quality. If the new product is relatively profitable compared to the base product, then, for a given level of quality, firms stretch if and only if reputation is high (i.e., firms exploit good reputations). Conversely, if the new product is relatively unprofitable compared to the base product, then, for a given level of quality, firms stretch if and only if reputation is low (i.e., firms protect good reputations).