individual and institutional reputation · individual and institutional reputation ... (1990), we...

Individual and Institutional Reputation∗

Zhaohui Chen,McIntire School of Commerce,

University of Virginia.

Alan D. Morrison,Saıd Business School,University of Oxford.

William J. Wilhelm, Jr.,†

William G. Shenkir Eminent Scholar,McIntire School of Commerce,

University of Virginia.

October 1, 2012

∗Chen and Wilhelm received support from McIntire Foundation’s King Fund for Excellence and the Walker Fund;Morrison received support from the Oxford University Centre for Corporate Reputation. We thank Patrick Bolton, JeffGordon, Steven Tadelis and seminar participants at the Helsinki School of Economics, University of Iowa, and theUniversity of Connecticut School of Law, the University of Leicester and the Oxford University Centre for CorporateReputation for their comments and suggestions.†Corresponding author. McIntire School of Commerce, University of Virginia, Rouss & Robertson Halls, East

Lawn, P.O. Box 400173, U.S.A. email:[email protected]; tel: 434-924-7666; fax: 434-924-7074

Individual and Institutional Reputation

Abstract

We develop a simple model in which individual reputation concerns give rise to the bad

reputation problem identified by Ely and Valimaki (2003). In the spirit of Kreps (1990),

we consider whether the problem is more efficiently resolved within a hierarchical firm.

The only asset of the firm is its institutional reputation for curbing individual reputation

concerns. Thus our model frames a conflict between individual and institutional reputation

concerns. That conflict is more likely to resolve in favor of institutional reputation when

firms recruit only the most talented people, and more difficult to sustain when unique ability

is especially valuable. We apply the model to the provision of professional services.

JEL Codes: L14, G20

Keywords: Trust, reputation, professional services firms, star culture

INDIVIDUAL AND INSTITUTIONAL REPUTATION

1. Introduction

Reputation is important because it tells economic actors what to expect of their counterparties

in situations where actions are hard to observe or to contract upon. For example, Fudenberg,

Levine and Maskin (1994) show that an infinitely repeated game can admit equilibria in which high

reputation agents operate non-opportunistically because they are expected to do so and hence are

rewarded accordingly. Ely and Valimaki (2003)1 show that bad reputation concerns can arise when

talented individuals have incentives to take actions that damage their short-lived counterparties

because, in doing so, they can separate themselves from their less talented or trustworthy peers. In

the extreme, the bad reputation effect can lead to market failure.

In this paper we ask whether institutional reputation concerns could mitigate the bad effects

of individual reputation management. For an institutional reputation to be meaningful, it must be

more than an aggregation of individual reputations. An institutional reputation exists when agents

expect the members of the institution to behave differently than they would were they operating

outside the institution. We obtain conditions under which high-reputation institutions succeed in

restraining individual actors’ own reputational concerns in favor of their clients’ needs. Although

we identify the long-lived organizations in our analysis as firms, the insights we derive could

apply to any institution that fosters what might be thought of as professional, ethical, or altruistic

behavior: for example, through the Hypocratic oath, or via religious or community affiliations.

In our model, organizations can maintain reputations for curbing the undesirable reputation-

building of junior employees. Strong organizational reputations are economically valuable be-

cause they are transferred between generations of firm owners. Following Kreps (1990), we study

a hierarchical firm in which short-lived owners have an economic stake in the firm’s long-term

reputation. Because they capture some of the surplus generated by employees and will ultimately

1See also Ely, Fudenberg and Levine (2008). Morris (2001) develops a model in which an informed advisor’sconcern for maintaining a reputation for unbiasedness in the provision of information can lead to the perverse outcomewhere she provides no information to her client in equilbrium. Scharfstein and Stein (1990) identify a very differentproblem of inefficient personal reputation management. In their model, managers who act apart from a generallyinformed herd may signal that they have inferior information. As a result, they suppress private information thatwould be socially useful in order to protect their own reputations. In contrast to our model, the agents in Scharfsteinand Stein’s model have neither opportunity nor incentive to separate themselves from their peers.

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sell the firm to the next owner, current owners have an incentive to monitor junior agents’ actions.2

Our focus on the tension between individual and institutional reputation reflects an interest in

the hiearchical structure and performance of professional services firms.3 This interest motivates a

modeling strategy that differs in important ways from standard models in which long-lived, strate-

gic agents build reputation with short-lived agents by mimicking the behavior of a (non-strategic)

“commitment” or “Stackelberg” type.4 In these models, if a short-lived agent assigns even a small

probability to encountering a commitment type, then a sufficiently patient strategic agent mimics

the commitment type most of the time. However, at some point the strategic agent will have incen-

tive to cheat on the commitment strategy, thereby revealing his type and destroying his reputation.5

At the highest levels of law, consulting, and investment banking, “up or out” promotion poli-

cies provide incentive for talented young agents to prove their ability quickly and the rewards from

doing so can be immense. Absent effective monitoring, opportunities arise for young agents to

free ride on the firm’s client relationships, reputation for fair dealing, technology, and capital to

showcase and even amplify their skills.6 Assuming the presence of a non-strategic agent is cer-

tainly less natural in this setting.7 More importantly, a model in which reputation is not persistent

2We could treat the organization as a partnership with senior advisors having the sole interest in protecting theorganization’s reputation. As we discuss in section 3, separating the owner’s monitoring function from the provisionof client service sheds light on the role of the division of surplus in resolving the bad reputation problem. Talentedadvisors capture surplus only in the second stage of their careers when they have no incentive to violate client trustwhile part of the owner’s surplus derives from monitoring. Ely and Valimaki (2003) identify the source of the badreputation problem as an informational externality arising from the short-lived client’s inability to benefit from infor-mation revealed to future prospective clients by her current hiring decision. In our model, this benefit is internalizedby the owner as beliefs about the firm are preserved when it is sold.

3Although it is perhaps less applicable, the analysis is not restricted to professional services firms. In firms wheretechnical expertise is concentrated in specific employees whose knowledge is not shared by senior management wemight expect to observe similar patterns. For example, a junior programmer in a software firm might be able to enhanceher own reputation by adopting an untried technology, even when doing so is against the interests of customers whoseprimary concern is for software stability.

4See Kreps, Milgrom, Roberts and Wilson (1982),Kreps and Wilson (1982), and Milgrom and Roberts (1982) forthe origins of this approach.

5See Fudenberg and Levine (1992).6Risk-taking functions within large, complex banks appear to represent the extreme case of incentive distortions

coupled with monitoring failures. Relatively junior bankers are able to gain considerable financial and technologicalleverage and both organizational and transactional complexity have contributed to monitoring failures that our modelwould treat as failures to curb their self interest. Perhaps the extreme case involved Nick Leeson who, in 1992 atthe age of 25, began carrying out unauthorized trades from the Singapore office of Barings Bank (the U.K.’s oldestmerchant bank) that led to its insolvency in February 1995. In 1993, Leeson earned a bonus of £130,000 in additionto a £50,000 salary (BBC News, June 22, 1999).

7In general, the analysis of Ely and Valimaki (2003) suggests wide scope for bad reputation effects. See Elyet al. (2008) for a detailed analysis of the conditions under which the bad reputation effect persists in the presence ofcommitment types.

3


does not rest comfortably with the fact that the most prominent professional services firms have

existed for decades or longer.8 Persistence in reputation can be achieved with replenishment of

type uncertainty and this is a feature of our model. But existing models that follow this path do

not consider the tension between individual and institutional reputation concerns at the heart of our

model.9

In short, the central coordinating device in our model is a long-lived institutional reputation of

a hierarchical firm or similar institution, rather than a commitment type. We are therefore able to

shed light on the reasons that individuals elect to join forces to provide professional services when

they seemingly could deliver the same services independently.10 Firm owners have an incentive to

build and preserve a corporate reputation for enforcing client-centric behavior. Granted the choice,

talented agents would prefer to join a firm because they otherwise suffer the full burden of the bad

reputation problem. For talented agents, the firm’s monitoring function complements their ability.

By accepting firm-imposed limits on their ability to develop individual reputation, talented agents

benefit from a level of client trust that would be impossible to achieve independently.

In addition to providing a reputational motivation for the firm, our model yields predictions

that correspond with features common to professional services firms. In monitoring equilibria

compensation is heavily skewed in favor of senior agents and owners of the firm. Preventing junior

agents from signaling their type is consistent with an emphasis on team rather than individual

accomplishment.11 The primacy of institutional reputation concerns is consistent with both the

long-lived organizations and client relationships observed in professional services.12

8Barings, for example, was founded in 1762. Goldman Sachs was a relative latecomer to investment bankinghaving been founded in 1869 and was the last of the major investment banks to leave behind the partnerhsip with its1999 initial public offering. The law firm Cravath, Swaine and Moore was founded in 1819. Cravath is noteworthyfor introducing the “Cravath System” around the turn of the 20th century. The “system” included hiring the bestcandidates from the top law schools and an “up or out” policy with a hurdle that few candidates were expected to clear.Marvin Bower introduced the system in the early 1950s to the McKinsey consulting firm (The firm was founded in1926. See McKenna (2006)).

9See Mailath and Samuelson (2001) as well as the discussion in Mailath and Samuelson (2006, p. 462), and thecitations therein.

10See Gilson and Mnookin (1985, p. 316) for discussion of scale considerations in law firms.11Gilson and Mnookin (1985, p. 365, fn. 89) argue that, when law firms organize seminars for potential clients,

they feature “a number of the firm’s lawyers as opposed to a single star. Similarly, Endlich (1999, p. 21) stresses thecultural tendency within the investment banking firm Goldman Sachs to downplay individual accomplishment.

12See Morrison and Wilhelm (2008) for data on the longevity of investment-banking partners and long-lived, ex-clusive relationships between banks and their clients. Gilson and Mnookin (1985, p. 358-364) discuss the foundationsfor law firms’ client relationships.

4


Our model also enables us to identify forces that might upset the monitoring equilibrium. For

example, technological changes that reduce the costs of type signalling by junior agents reduce

the value of institutional relative to individual reputation, and, hence mitigate against professional

standards. This type of effect is identified by Baker, Gibbons and Murphy (1994, 2002), who argue

that, because technological advances that increase the precision of formal contracts lower the costs

of reneging on more efficient reputational contracts, they could render reputational contracting

impossible.13

We also show that institutions that extract a greater proportion of the rent that high-reputation

individuals generate have weaker incentives to maintain their own reputations. This result is sug-

gestive of Horner’s (2002) observation that heightened competition might encourage reputation-

building behavior: in Horner’s model this is because disappointed consumers have better outside

options in competitive markets; in ours, because heightened competition in the labor market might

allow senior agents to retain a higher fraction of their earnings.14

Finally, when talent is rare or hard to identify there is little point in preventing signalling by

junior agents and, hence, institutional reputation is of less importance. In other words, institutional

reputation is easier to sustain when the average quality of all of the agents in the firm is high. It

is therefore unsurprising that successful professional services firms devote significant resources to

identifying and recruiting the best talent, and that they do so in such a visible way.15

Our work employs Cremer’s (1986) classic OLG framework with overlapping generations of

junior and senior advisors. The advisors provide a service whose utility can be observed by their

clients, but not contracted upon. The relationship between advisors and their clients therefore rests

upon trust, and a conflict between individual and institutional reputation emerges naturally within

our model.

13If better codification allows firms to realize sufficient economies of scale, it may actually be efficient to sacrificereputational contracting. We discuss this point in the Conclusion.

14A related argument is advanced by Bolton, Freixas and Shapiro (2007), who present a model in which reputationalincentives can ameliorate conflicts of interest in advisory businesses, and show that these incentives are stronger inthe presence of competition. This effect obtains in Bolton et. al.’s model both because customers have better outsideoptions when there is competition, and because competition increases the relative value of the higher margins that canbe derived from giving good advice to customers who trust that advice.

15Levin and Tadelis (2005) argue that, as a result of the profit-sharing arrangements that underpin partnershipfirms, partnerships impose higher quality thresholds upon new recruits; their model therefore predicts the prevalenceof partnership firms in industries where employee quality is hard for clients to assess.

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Several papers share our focus on reputation in teams, especially as it applies to professional

services firms. In Morrison and Wilhelm’s (2004) OLG model of partnership firms, senior agents

own the firm and create a market for their stake by mentoring the junior agents who will replace

them. Mentoring is costly and subject to free-riding among senior agents but it is the means by

which the firm develops a reputation for an ability to provide high-quality service. The firm’s only

asset is its reputation and so the intergenerational transfer of ownership is simply a transfer of its

reputation for developing human capital. Thus the internal market for reputation is similar to that

in our model if we assume that senior agents own the firm. But in their model there is no means

by which junior agents can signal their type and so there is no tension between individual and

institutional reputation concerns.

Bar-Isaac (2007) develops an OLG model of a professional services firm in which junior agents

are motivated by concern for their own reputations, while senior agents are concerned for the rep-

utation of the firm which they own. Once senior agents establish their own reputation, they have

nothing more to prove and thus little incentive to exert further effort. Entering joint production

agreements with a junior agent of unproven quality motivates costly effort by the senior agent and

enhances the junior agent’s reputation because individual contributions to output are unobservable.

In Bar-Isaac’s model junior agents’ reputation concerns are desirable because they generate effort

incentives, and are not distortive because junior agents will one day inherit the firm and its reputa-

tion. This is in contrast to our model, in which bad reputation effects are a first order concern.

From a theoretical perspective, our analysis also is related to a small body of recent work that

focuses on the conditions under which reputation is a tradeable asset. Also in an OLG setting,

Tadelis (1999, 2002) studies conditions under which a firm’s reputation is a tradeable asset. In his

models reputations are tradeable when ownership changes are hidden from potential clients of the

firm. With this assumption he is able to prove the novel result that reputations must be actively

traded in all equilibria. Moreover, Tadelis’ work does not admit an equilbrium in which good

agents fully separate themselves from bad types by buying good names. Unobservable firm types

and hidden ownership changes are also central to Mailath and Samuelson’s (2001) analysis, which

yields similar results on reputation trades, while shedding considerable new light on the dynamics

6


of firm reputation.

In our model we allow clients to observe ownership changes. Although it is reasonable to

assume that ownership changes are hard to observe in many settings, it is a less plausible assump-

tion in markets for professional services where agents have repeated personal dealings with their

clients, often in circumstances involving high stakes. As Tadelis points out with respect to Kreps

(1990), the price of our repeated game modelling approach is the existence of multiple equilibria.

Nevertheless, we demonstrate that in any monitoring equilibrium of our model the bad reputation

effect is dampened, and there is trade in institutional reputation. Moreover, prospective owners

with superior monitoring capacity always place a higher value upon a strong institutional reputa-

tion than do less capable owners.

The remainder of the paper is set out as follows. In Section 2 we develop a simple two-period

model that generates the bad reputation effect identified by Ely and Valimaki (2003). In Section

3 we embed this model in an OLG framework to illustrate how bad reputation effects can be

mitigated when agents deliver services from within a long-lived firm. For expository purposes, we

focus on a single equilibrium that illustrates important elements that are common to any monitoring

equilibrium; the full equilibrium analysis is provided in the appendix. Section 4 concludes with

a further discussion of the model’s applicability to professional services firms and outlines an

extension of the model that is capable of generating a rich set of dynamics for both individual and

institutional reputation.

2. Base Case

2.1 Model

We consider the interaction between two players, a client and an advisor, who interact over two

periods. Both players are risk-neutral and each has a per-period discount factor of δ . In each

period, the advisor takes one of two actions A ∈ {1,2} on behalf of the client. The action can

be thought of as the delivery of an advisory service or, more generally, as an experience good.

The cost of either action to the advisor is zero, but the action that maximizes the client’s welfare

7


Nature selects

state of nature

ω ∈ {1,2}

and reveals it

to fiduciary

Fiduciary

and customer

sign contract

and customer

pays fiduciary

Fiduciary

takes action

A ∈ {1,2}; A

is observed by

the customer

Customer

receives payoff

Figure 1: Time line for the stage game.

depends upon the state of nature ω ∈ {1,2} in the period when the action is taken. The distribution

of ω is i.i.d. across periods, with state 1 occurring with probability p in each period. Action ω is

optimal in state ω , for ω = 1,2: when state 1 realizes, the client receives utility 1 from action 1

and x ∈ (0,1) from action 2; when state 2 realizes, the client receives utility X > 0, where X 6= x,

from action 2 and utility 0 from action 1.

Advisors know the state of nature ω when they select their action, but clients do not and, as a

result, it is impossible to contract upon ω . Advisors can be of two possible types: competent (C)

and inept (I). Competent advisors are able to take either action on behalf of their client, but inept

agents can only take action 1. The prior probability that a advisor is competent is θ0, and θ0 is

common knowledge. The advisor knows its type, but this information is private and non-verifiable.

Although neither A nor ω is observable, the mapping from actions and states to payoffs is

invertible, so that the client can infer the state of the world and the advisor’s action from her

payoff. However, the client’s payoff is not verifiable in court, and, hence, cannot be the basis of a

contract between the client and the advisor. The only contract possible between the client and the

advisor in each period is therefore a straightforward fixed client payment in exchange for an action

by the advisor. We assume that this payment occurs at the start of the period. Moreover, we assume

that the advisor has all of the bargaining power when the contract is signed, so that it extracts all

of the expected surplus from the game. We normalize the client’s outside option to zero.

The timeline for each stage game is illustrated in Figure 1.

At any time, both players select their moves to maximize their expected income over the re-

8


mainder of the game. If the advisor is indifferent between two moves then we assume that it selects

the move that generates the highest income for its client.

2.2 Game Solution

We seek Bayesian Nash Equilibria of this game. Every node in the extensive form for the final

stage starts a subgame, so we can solve the final stage by backward induction. After the client has

paid the advisor, the advisor’s payoff is independent of his actions. Competent advisors set their

action A equal to the state ω; inept advisors set A = 1, irrespective of the state. Suppose that the

client assesses a probability θ1 that the advisor is competent at the start of the second period. Then

her expected surplus at the start of the second period is

φ1 = p+(1− p)θ1X . (1)

The advisor receives the whole of this surplus as his second-period fee.

We now consider the advisor’s first-period action. This move has no effect upon his first period

payment, which has already been made when he moves, and hence he selects his action in order to

maximize his second period income, φ1; in other words, he selects A so as to maximize his second

period reputation, θ1.

The advisor is able to manage his reputation because the client can infer from her payoff the

state of the world and the advisor’s action. The client can distinguish between four information

sets at the end of the first period, as illustrated in the extensive form of Figure 2. Since only a

competent advisor can take action 2, the client sets the posterior reputation θ1 = 1 when she infers

that this action was taken. On the other hand, the client cannot distinguish between competent and

inept actions after action 1, and hence will assign θ1 in information sets 1 and 2 in the Figure by

applying Bayes’ Law to the advisor’s equilibrium strategy. For any competent advisor strategy, the

posterior θ1 in information sets 1 and 2 is below 1. Since the advisor aims in period 1 to maximize

θ1, it follows that competent advisors select action 2 in period 1, irrespective of the state of the

world.

We have therefore proved the following:

9


N

N

F

A = 1

ω=

1p

F

A = 1

ω=

2

1−p

Dumb

1−θ0 N

F

A = 1

A = 2

ω=

1p

F

A = 1

A = 2

ω=

2

1−p

Smartθ0

Set 1

Set 2

Figure 2: First stage extensive form for the base case.

Lemma 1. In the first period of the base game, competent advisors select action 2 and inept advi-

sors select action 1, irrespective of the state of the world.

2.3 Discussion

Our base model captures two essential features of advisory relationships. First, the advisor in our

model knows better than its client what action is best for the client, and it is impossible to write a

contract that stipulates that this action be taken. Clients therefore have to trust their advisor to take

this action.

Second, there is conflict between the objectives of the advisor and the client. In our model, this

conflict is a consequence of adverse selection over advisor type. Because clients will pay more

to deal with an advisor whom they believe to be competent, competent advisors select socially

suboptimal actions if doing so signals their quality, and so increases their future revenue stream.

In short, in some circumstances, an advisor’s concern for its own reputation may lead it to harm

its clients.

This result is easy to derive in our model because a single client experience of action 2 is

10


sufficient to establish that the advisor is competent. But the result is robust to a relaxation of this

condition. If the inept advisor was able to select action 2 with small probability q then full type

revelation would never occur, but a first-period experience of action 2 would result in a higher

posterior assessment of θ1 than an experience of action 1. Hence, as before, the competent advisor

would always select action 2. The inept advisor would attempt to pool with the competent advisor

by selecting action 2 whenever possible.

Similarly, our conclusions are robust to a multiple-period extension of the model. This is

trivially the case when the inept advisor cannot take action 2. In the case where inept advisors can

take action 2 with small probability q, the per-period expected customer income from a competent

advisor that always took action 2 would be px+(1− p)X , while the per-period expected client

income from a inept advisor that always attempted to act in the client’s best interests would be

p+(1− p)qX . Hence, provided

p+(1− p)qX < px+(1− p)X , (2)

the competent advisor is preferred, even if it always takes action 2. Since the client increases her

assessment of θ1 every time she experiences action 2, it follows that when condition (2) is satisfied,

competent advisors select action 2 in every stage prior to the final one, and inept advisors select

action 2 whenever they are able to.

3. A Professional Services Firm

Conflict between the advisor and the client in Section 2 leads the advisor to take second-best

actions. Moreover, because none of the important variables in this game is observable by third

parties, direct regulation of the advisor’s actions will not be effective. In this Section, we identify a

market solution to the agency problem. We show that a professional services firm that is concerned

with its own reputation has the right incentives to monitor the advisor, and so to ensure that it takes

the best action for the client whenever it is capable of doing so.

11


3.1 Model

We consider a model of an infinitely lived professional services firm that employs advisors. As

in Section 2, advisors live for two periods, and are assigned type C or I by nature when they are

born. The firm hires one advisor each period; at any time, it therefore has one junior and one

senior advisory employee. Nature determines the state of nature in each period according to the

distribution of Section 2. Advisor capabilities and client preferences are precisely as in Section 2.

Once again, neither the state of nature nor the advisor’s action is verifiable in court. However, we

assume that clients are able to communicate their experiences to each other, so that at any time the

firm’s clients can condition their expectations upon prior clients’ experiences.

At any time, the firm employs two advisors and has one owner. In line with Section 2, we

assume that the professional services firm captures all of the client’s expected surplus, which is

split between the owner and the advisors. The outside option for a junior advisor is 0, so the owner

captures all of the surplus that he generates; senior advisors have better outside options, so we

assume that the owner captures a fraction ρ > 0 of the surplus that they generate.16

Owners retain their stake in the firm for one period, after which they sell their ownership of the

firm and retire. Owners can be effective or ineffective; the prior probability that a new owner will

be effective is γ > 0. γ is common knowledge. Effective owners are able to monitor advisors. If

competent advisors are monitored then they always select action ω in state ω; monitoring has no

effect upon inept advisors.

Owners and advisors aim to maximize their lifetime expected discounted income. When an

advisor is indifferent between actions, he selects the one that maximizes his client’s welfare: hence,

as in Section 2, a competent advisor takes action ω in state ω in the last period of his career.

16In practice, there is no reason why the firm should not be owned by the senior advisor. We adopt our modelingstrategy for two reasons. First, many professional services firms, particularly in investment banking, are now publiclyowned. Second, separating ownership of the firm from the advisors allows us to examine the significance of thedivision of surplus, ρ , between the advisors and the owners.

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N

1−θ0

N

E

π1−1

A = 1

ω=

1p

E

π2−1

A = 1

ω=

2

1−p

Mon

itor

µN

E

π1−2

A = 1

ω=

1p

E

π2−2

A = 1

ω=

2

1−p

Not m

onitor

1−µ

Dumbθ0

N

E

π1−3

A = 1γ

π3−1

A = 21− γ

ω=

1p

E

π2−3

A = 1

π4−1

A = 2ω=

2

1−p

Mon

itor

µ

N

E

π1−5

A = 1

π3−2

A = 2

ω=

1p

E

π2−4

A = 1

π4−2

A = 2

ω=

2

1−p

Not m

onitor

1−µ

SmartOwner

Set I1

Set I2

Set I3

Set I4

Figure 3: Extensive form for the stage game with professional services firms.

3.2 Model equilibrium

The extensive form for one period of the model of Section 3.1 is illustrated in Figure 3, where we

denote by µ the probability with which the professional services firm’s owner elects to monitor

the firm’s advisory employees. As in Section 2, the client can infer the state of nature and the

advisor’s action from her end-of-period return. Hence, she can distinguish between the following

four information sets, which are illustrated in Figure 3:

I1 : {ω = 1,A = 1} ; I2 : {ω = 2,A = 1} ;

I3 : {ω = 1,A = 2} ; I4 : {ω = 2,A = 2} .

We seek a Perfect Bayesian Equilibrium of this model.

13


Definition 1. An equilibrium of the OLG game comprises the following for each period t:

1. R-1: For each information set Ii and each node j within Ii, a client assessment πi− j of the

probability that node j obtains;

2. R-2: Fees R j and Rs for junior and senior advisors;

3. R-3: A monitoring probability µt for owners;

4. R-4: Action choices for unmonitored competent advisors,

with the following properties:

1. E-1: The client assessments πi− j are derived from the advisors’ action choices and the

owner’s monitoring choice µ via Bayes’ Law;

2. E-2: The fees R j and Rs are equal to the respective expected client surplus (using the appro-

priate measure{

πi− j}

j) that junior and senior advisors generate;

3. E-3: The advisor’s action choices are an optimal response to the fee structure;

4. E-4: The owner’s monitoring choice µt is an optimal response to the fees R j and Rs and the

advisors’ action choices.

Of the requirements for an equilibrium, R-4, comprising the action choices for unmonitored

competent advisors, is the easiest to characterize:

R4∗: As in Section 2, senior competent advisor select action ω in state ω (ω = 1,2),

and junior competent advisor select ω = 2 whenever they are not monitored, so as to

distinguish themselves from inept junior advisors.

When competent advisor use rule R4∗ to select their actions, they will never select action 1 in state

2. It follows that

π1−5 = π2−3 = π2−4 = 0 (3)

We now define µ∗ to be the probability with which the client believes that monitoring occurs;

any client assessment πi− j that satisfies condition E-1 must correspond to some µ∗. Given any

probability µ∗ of monitoring, we write Πi (µ∗) for the probability that information set Ii is at-

tained. The following expressions follow immediately from equation (3) and inspection of Figure

14


3:

Π1 (µ∗) = p(1−θ0 (1−µ

∗γ)) ; (4)

Π2 (µ∗) = (1−θ0)(1− p) ; (5)

Π3 (µ∗) = θ0 p(µ∗ (1− γ)+(1−µ

∗)) ; (6)

Π4 (µ∗) = θ0 (1− p) . (7)

We can now derive the following client assessments by applying Bayes’ Law to Figure 3:

π1−1 =(1−θ0)µ∗p

Π1 (µ∗); π1−2 =

(1−θ0)(1−µ∗) pΠ1 (µ∗)

; π1−3 =θ0µ∗pγ

Π1 (µ∗);

π2−1 =(1−θ0)µ∗ (1− p)

Π2 (µ∗); π2−2 =

(1−θ0)(1−µ∗)(1− p)Π2 (µ∗)

;

π3−1 =θ0µ∗p(1− γ)

Π3 (µ∗); π3−2 =

θ0 (1−µ∗) pΠ3 (µ∗)

;

π4−1 =θ0µ (1− p)

Π4 (µ∗); π4−2 =

θ0 (1−µ)(1− p)Π4 (µ∗)

.

(R1∗)

The expected surplus that the period t + 1 client derives from dealing with the senior advisor

depends upon his assessment of the probability θ1 that the advisor is competent. This can be

derived immediately from equation (R1∗):

Lemma 2. Denote by θ t1 (i,µ

∗) the probability that the client assigns in information set Ii to the

event that the period-t junior advisor is competent. Then θ1 (2,µ∗) = 0, θ t1 (3,µ

∗) = 1, θ t1 (4,µ

∗) =

1, and

θt1 (1,µ

∗) =θ0µ∗γ

1−θ0 (1−µ∗γ). (8)

The intuition for Lemma 2 is straightforward. Information sets I3 and I4 can only arise if the

advisor takes action 2, and the advisor must therefore be competent if either obtains. A competent

junior advisor never takes action 1 if it is able to take action 2; nodes 3 and 4 of information set I2

arise only if a competent junior advisor takes the action 1 and, as this action is socially suboptimal

in state 2, the advisor will never be compelled by the owner to take it. Hence, only nodes 1 and 2 of

information set I2 occur with positive probability, so this information set can only realize with an

inept advisor. Only information set I1 could arise with both competent and inept advisors. Since

15


node 4 of this set arises when the competent advisor selects action 1 against the interests of the

client it will never arise. Node 3 arises when the owner is effective (probability γ) and monitors

the advisor (probability µ); its likelihood, and hence the posterior reputation of the advisor in

information set I1, is therefore increasing in γ and µ .

We say that a professional services firm has a reputation for being well-governed if none of

its junior advisors has ever selected an action not equal to the state of nature, ω; if it is not well-

governed then we say that it has a reputation for being poorly governed. A firm could therefore

lose its reputation for good governance either because of a failure to monitor a competent junior

advisor in state of nature 1, or because it has an inept junior advisor in state 2. For t ∈N, we define

φt = 1 if the firm is well-governed at time t, and φt = 0 otherwise.

Define reputationally motivated client beliefs as follows:

µ∗t = φt . (9)

Hence, a client with reputationally motivated beliefs assumes that owners monitor junior advisors

when the firm has never acted against the interests of its clients. After a single incidence of sub-

optimal junior advisor choice, the client assumes that owners do not monitor junior advisors.

When customers have reputationally motivated beliefs, at time t they will pay R j (φt) for the

services of a junior advisor, and Rs(θ t

1)

for the services of a senior advisor, where

R j (φ) = θ0 (p(x+ γφ (1− x))+(1− p)X)+(1−θ0) p;

Rs(θ

t1)= θ

t1 (p+(1− p)X)+

(1−θ

t1)

p.

(R2∗)

We now examine the owner’s decisions when clients have reputationally motivated beliefs.

The owner derives income from two sources: from fees paid for junior and senior advisory

services during the period that he owns the firm, and from the sale of the firm at the end of the

period in which he owns it. He cannot affect the fees paid to the advisors that he acquires when he

buys the firm. He therefore works to maximize the fees that will accrue to advisors in the period

after he sells the firm; in doing so, he maximizes the sale price of the firm. We consider the cases

with φt =±1 separately.

First, suppose that the firm has a reputation for being poorly governed, so that φt = 0. It will not

lose this reputation, so φt+s = 0 for all s > 0. The fee income R j (φ) that the firm will derive from

16


junior advisors in subsequent periods is therefore independent of the information set that realizes

at the end of period t. The owner therefore picks his monitoring intensity µ so as to maximize

the return that the next owner derives from senior advisors. The posterior advisor reputation is

0 in information sets I1 and I2, and is 1 in I3 and I4. Hence, the owner selects µ in order

to maximize the probability that information set I3 or I4 obtains. Since Π′1 (µ) = pθ0γ > 0,

Π′3 (µ) =−pθ0γ < 0, and Π′2 (µ) = Π′4 (µ) = 0, the owner sets µ = φt = 0.

Now suppose that the firm has a reputation for being well-governed, so that φt = 1. Once again,

because he has no influence over the fees that he receives during his ownership period, the current

owner maximizes his own lifetime expected discounted income by maximizing the sale value of

the firm. He does this by taking actions aimed at maximizing fee income realized by the next

period’s owner. The fee income that accrues to the firm in the next period is given by equation

(10):

Eµ

t[R j (φt+1)+ρRs

(θ

t+11)]

= Π1 (µ)R j (1)+ρRs (θ1 (1,2))+Π2 (µ)(R j (0)+ρRs (1)

)+

Π3 (µ)(R j (0)+ρRs (1)

)+Π4 (µ)

(R j (1)+ρRs (1)

)(10)

Equation (11) follows immediately from Equation (10):

ddµ

Eµ

t[R j (φt+1)+ρRs

(θ

t+11)]

= pθ0γ

[θ0γ (1− x)−ρ

((1− p)(1−θ0)X

1−θ0 (1− γ)

)](11)

Let

B = θ0γ (1− x)−ρ

((1− p)(1−θ0)X

1−θ0 (1− γ)

). (12)

When B ≥ 0 it follows from equation (11) that owners of well-governed firms whose clients

hold reputationally motivated beliefs will employ the following monitoring strategy:

µt = φt . (R3∗)

Proposition 1 is now immediate:

17


Proposition 1. When B ≥ 0, rules (R1∗), (R2∗), (R3∗) and (R4∗) constitute an equilibrium of the

game. When B < 0, the only equilibrium of the game in which firms lose their reputations upon

taking action 1 in state 2 is one in which the owner never monitors the advisors.17

Proof Suppose that B ≥ 0. We argue above that advisor actions (R4∗) are an optimal re-

sponse to any owner actions, and, hence, that they satisfy requirement E-3. Given these actions,

the assessments (R1∗) are derived from µ∗ using Bayes’ Law. When beliefs are reputationally

motivated and condition (R3∗) is satisfied, the assessments (R1∗) therefore satisfy condition E-1.

With reputationally motivated beliefs, fees set using rule (R2∗) satisfy condition E-2. Finally, we

have demonstrated that the monitoring rule (R3∗) is the optimal response to the assessments (R1∗)

precisely when B ≥ 0.

When B < 0 equation (11) implies that the owner will not monitor when clients have reputa-

tionally motivated beliefs.

3.3 Discussion

In this Section, we identify and discuss some simple corollaries to Proposition 1.

Monitoring junior advisors increases the likelihood that the firm retains its reputation for good

governance, and, hence raises the expected income that the firm will derive from junior advisors in

the following period. On the other hand, monitoring prevents junior advisors from signaling that

they are competent, and, hence, lowers the expected income that the firm will derive from senior

advisors in the following period. We interpret B as a measurement of the net benefit that the

owner derives from monitoring junior advisors; Proposition 1 demonstrates that monitoring occurs

precisely when B is positive.

Corollary 1. The net benefit B of monitoring is smaller, and, hence, a monitoring equilibrium is

harder to sustain when:

17Other equilibria exist in which the firm’s loss of reputation is temporary. In this case, the costs of deviationare lower, but the gains of maintaining a reputation are also higher. For certain parameterizations, it is possible thatthe second effect outweighs the first, and, hence, that a monitoring equilibrium can be sustained with a temporarypunishment phase for a wider parameter range. When it is possible, this effect alters the critical B value from 0, butit does not change the intuition that drives our results, nor the effects that we identify in Corollaries 1 and 2 below.

18


1. The opportunity cost (1− x) to clients of allowing junior advisors to signal that they are

competent in state 1 is small;

2. Clients perceive that owners are ineffective (low γ);

3. Clients perceive that most advisors are inept (low θ0).

We argue in the Conclusion that the opportunity cost (1− x) of part 1 of this corollary may have

shrunk as a consequence of innovations in accounting and risk management. These innovations

have improved formal contracting to a level where informal, reputational, contracting is squeezed

out, even though such contracting would generate more efficient outcomes if it were possible. Parts

2 and 3 are straightforward: when owners or advisors are perceived to be of low quality, clients will

pay little for monitoring, because it is unlikely to work, and hence monitoring will be unlikely to

occur. Conversely, if the firm is able to demonstrate that it takes great care over recruitment policy

the rewards to monitoring, and the likelihood that a monitoring equilibrium will be sustained, is

greater.

Corollary 2. The net benefit B of monitoring is greater, and, hence, a monitoring equilibrium is

easier to sustain when:

1. The probability p that state 1 obtains is high;

2. The benefit X that clients derive from competent advisors in state 2 is small;

3. The fraction ρ that the owner extracts of the senior advisor’s fee income drops.

Part 2 of this Corollary implies that economies of scale that allow competent advisors to gen-

erate much higher payoffs in favorable states of the world render monitoring equilibria harder to

sustain, because the owner anticipates a share of these payoffs. Recent advances in information

technology have greatly increased the amount of financial capital that a talented agent can control

and, hence may have served to raise X and so undermine institutional reputational incentives in

professional services firms.

Finally, professional services firms exist in our model because they can resolve a reputation trap

between advisors and clients. They are most effective when the owners of the firms benefit from a

19


reputation for monitoring junior advisors, and when they share least in rents that accrue to junior

advisors who fall into the reputation trap by taking sub-optimal actions in order to signal their type.

Part 3 of Corollary 2 demonstrates that this is best achieved by ensuring that senior advisors extract

most of the rent that they generate, while leaving all of the rent generated by junior advisors to the

owners. This observation is in line with traditional remuneration schemes in professional services

firms, under which junior agents are paid little, and work for a chance to extract high rents later in

their careers.

4. Conclusion

Advisory relationships are complicated by the client’s inability to measure or contract upon the

activities of their advisor. When the most able advisors have incentive to separate themselves

from their less talented peers, they may take actions that are damaging to their clients’ interests.

Any transaction involving experience goods could be subject to this bad reputation problem. The

standard framework for modeling reputation suggests that the problem will not exist if there is a

sufficiently high probability that the client will encounter a Stackelberg type who always acts in

the client’s best interest.18 By contrast, our model is a first step toward understanding potential

institutional responses to the bad reputation problem.

We take the bad reputation problem as given and, in the spirit of Kreps (1990), we consider

whether economic activity subject to this problem can be carried out more efficiently within a

hierarchical firm. The only asset of the firm is its reputation for curbing individual reputation con-

cerns. Thus our model frames a conflict between individual and institutional reputation concerns.

Analysis of the model yields conditions under which a second-best response to the bad reputation

problem involves a balance struck between individual and institutional reputation concerns.

In (monitoring) equilibria where these conditions are met firm characteristics are consistent

with those observed among professional services firms. Namely, monitoring equilibria are easier to

sustain when the firm recruits only the most talented people who share little in the surplus generated

by the firm during the early stages of their careers. Monitoring equilibria are more difficult to

18See Ely and Valimaki (2003) and Ely et al. (2008).

20


sustain when, among other things, clients derive a large benefit from the unique abilities of the

most talented agents. We contend that this condition is especially descriptive of the high end of

professional services where advice or service can have enormous positive or negative consequences

for the client.

The model also suggests that advances in information technology that generate economies

of scale in, and increased the transparency of, professional services firms, amplify the unique

abilities of talented agents. In doing so, they alter the nature of the firm’s client relationships

by making it more difficult to curb the negative effects of individual reputation concerns. The

increasing mobility of stars in professional services firms is consistent with this analysis, as would

be increasing violations of client trust.19

Of course, a diminished role for institutional reputation need not be a problem. Institutional

reputation is ineffective when the cost (1− x) of individual reputation formation is reduced. Codi-

fication of professional services, for example through better measurement and accounting systems,

that lowers this cost and facilitates direct contracting on the actions of agents obviates the need for

institutional reputation. If this codification also generates economies of scale, a culture in which

stars dominate may even be desirable, because it allows resources to be concentrated in the most

efficient hands.

In its current state, our model has little to say about the dynamics of individual and institutional

reputation and their interaction. However, the modeling approach of associating beliefs regarding

ability with individual reputation and those regarding client-centric behavior with institutional rep-

utation can also be used to study reputation dynamics. Chen, Morrison, and Wilhelm (2012) derive

an equilibirum in which good types signal through their actions for an endogenously determined

period of time regardless of the state of nature and the associated consequences for the client.

Thereafter, although the firm’s type is never fully revealed (i.e., individual reputation is persis-

19The possibility that key staff might defect was identified as a key risk factor in the flotation of the investment bank-ing firms Greenhill & Co. and Lazard (Morrison and Wilhelm, 2007, p. 308). More recently, see for example “UBSTechnology Bankers Join Centerview”, Dana Cimilluca, Wall Street Journal, June 18, 2008, page C3, stating that “Foryears, bankers have been decamping from Wall Street’s biggest firms,” and “A Once-Tight Flock at Goldman, NowScattered’,” Susanne Craig, New York Times, May 16, 2011 (accessed at http://dealbook.nytimes.com/2011/05/16/a-once-tight-flock-at-goldman-now-scattered/). Some commentators have pointed to the $550 mn fine that the S.E.C.recently imposed upon Goldman Sachs as evidence of a violation of client trust: see “S.E.C. Accuses Goldman ofFraud in Housing Deal,” Louise Story and Gretchen Morgenson, New York Times, April 17, 2010, A1

21


tent), incentives shift the firm’s concern to maintaining client beliefs that it will no longer take

actions against their interests. In the presence of technological shocks that essentially replenish

type uncertainty, firms can go through cycles of individual reputation development, preservation

of institutional reputation for trustworthiness, and destruction of trust.

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