Reputational Economies of Scale, with Application to Law Firms

In some circumstances, increasing the number of products it sells improves a firm's incentives to maintain a reputation for high quality. There is a trade-off from increasing scale that must be accounted for in any theory of firm size and reputation. The more products sold, all things equal, the more the firm has to gain in the long run from preserving a reputation for high quality. On the other hand, the more products sold, the greater the potential short-run gain from providing low quality. This article focuses on a natural assumption to explain why in many cases the longer run considerations dominate: asymmetric performance. If, for example, the products a firm sells are sold nonsimultaneously, then the entire reputation of the firm is on the line from the sale of only a subset of its products. This article explains the importance of asymmetric performance for reputational economies of scale. The logic applies to law firm structure, suggesting that larger law firms have reputational advantages. It also helps to explain why partners tend to share profits among themselves. Existing empirical evidence about firm reputation and profit sharing is consistent with the theory. Copyright 2012, Oxford University Press.