A working paper by Frankel and Schwarz (2009) looks at the economic environment where uninformed customers rely on experts to both diagnose and treat their problems. If experts can earn more money doing high margin procedures, then customers may not receive appropriate treatment. However, experts must also take into account how doing unnecessary treatments will affect their reputation.
“In the 1950s, Bower was summoned to Los Angeles by billionaire Howard Hughes, who wanted him to study Paramount Pictures…. But Bower sensed that nothing good could come of working for Hughes. He found the entrepreneur’s approach to business ‘so unorthodox and so unusual’ that he felt he would never be able to help Paramount. Instead of taking the assignment and reaping a big fee, he walked away. The move was classic Bower. He built McKinsey into a global consulting powerhouse by insisting that values mattered more than money” (Byrne (2003)). In other words, by publicly rejecting a proﬁtable action, McKinsey increased its future business.
Because of reputational concerns within a in a repeated game framework, the authors show a truthful equilibrium will emerge. “The promise of future business removes the incentive to play major treatments over minor ones. Customers only need to look at the most recent action taken. If it was a minor treatment, they return to the last period’s expert with high probability. If it was a major treatment, they return with a low probability.”
- Frankel and Schwarz (2009) “Experts and Their Records” NBER Working Paper #14921.