When a Bad Reputation is Just Fine

For a couple of weeks, I've been following a debate on the importance of reputation.

In this entry on his NY Times blog, Paul Krugman argued that insurance companies don't give a rat's rear about their reputation or the satisfaction of their customers. He didn't say, but clearly was saying that he'd found yet another need for a governmental white knight. He explicitly launched snark at a series of Bryan Caplan Econlog posts which placed great importance on reputation in economic decisions. Bryan responded with this post, entertainingly including pirates and VDs in his case. At the end, he asked his audience:

What is your favorite example where reputation doesn't make voluntary
interaction work well? Is the problem demand, supply, or what?

As moths drawn to fire, many responders couldn't help but focus on the pirates and sex. Others have thought up niche examples such as the "fall forward" effect of bad bosses with good employees. They needn't. His question can be answered with common real-world examples. My contribution to the debate is as follows:

When doesn't it work? When there is:
1. A very large, fragmented population of consumers, most making infrequent purchases
2. A largely standardized product (ie: highly regulated or commoditized), leading to high inelasticity of demand to price ... causing price to be the major differentiator
3. And a highly transparent market in terms of price

Airlines, credit card companies, and banks are all great examples. Major players make little investment in customer retention, preferring instead to counter attrition with new customer acquisition, based largely on price, combined with creation of monopoly/oligopoly power (usually only local or short-lived). Any marketer in these industries will tell you that their key metric is the ratio of attrition to acquisition.

Said concretely, an airline can sell confirmed seats to someone else, strand 300 customers in a layover airport overnight, make us stand in line for hours to get re-booked, pack each of us between sumo wrestlers on a tiny aircraft, over-charge us for a bottle of water, and then wreck your luggage. All the while, their demoralized, unionized employees will make scant few attempts to pay attention to, much less accomodate us customers to retain our business. The airline knows it can lure most of us back next time by simply offering the cheapest fare for the route and time of our next trip.

Unsurprisingly, the story is much different in the international market where they have far less ability to secure those temporary monopolies and thus must compete on something other than price alone. Fly the same carrier domestically and internationally. You'll find it hard to believe it's the same company.

Gee, I wonder if therein lie the seeds of a real answer for both Paul and Bryan.