Reputation and litigation: Why costly legal sanctions can work better than reputational sanctions

The paper analyzes the optimal incentive system when reputational sanctions can be supplemented with legal sanctions. A firm sells a good to a sequence of consumers where the firm’s unobservable effort affects the good’s quality. To solve the moral-hazard problem, the firm can promise to pay damages (offer a warranty), consumers can impose reputational sanctions, or both. Both types of sanctions are costly, but legal sanctions have an advantage over reputational sanctions. Raising damages creates both marginal (additional lawsuits) and inframarginal (bigger recovery to existing lawsuits) effects, but increasing reputational sanctions lacks the inframarginal effect. Various extensions, such as litigation’s informational role and the interaction with one long-term buyer, are also analyzed.