Paul Krugman can’t believe how much I trust in the power of reputation to keep health insurers honest.  He’s right about one thing: I think reputation works wonders – not just in insurance, but throughout modern economies.  I could talk about the miracle of the credit card, and how it has enabled hundreds of millions of strangers to trade via computer.  I could talk about the miracle that is CostCo – if they stock it, you know you’re getting quality on the cheap.  Or consider a random example from my own experience:

When we wanted a new house built, we gave 10% of the purchase price to the builder upfront.  The builder gave us a contract almost devoid of legal remedies – practically everything was at the builder’s “sole and absolute discretion.”  A few months later, we moved into our house.  99% of the details were exactly right, and they fixed the rest for free.  Why would the builder treat us so well?  Altruism?  Ha.  Legal remedies?  Ha.  Even repeat business is a stretch.  What are the odds we’ll ever ask them to build a second house for us?  The only answer that makes sense is reputation.

Reputation is so mighty a force, it makes me wonder: When doesn’t it work well?   Reputation obviously fails for involuntary interaction; pirates and dictators often deliberately seek reputations for ruthlessness because it makes their job easier.  So let’s refine the question: If interaction is voluntary, when doesn’t reputation work well?

To me, venereal disease is the most striking response.  Unlike other disease, V.D. is simple to prevent: Only have sex with people who credibly show that they aren’t infected.  How hard is that?  But according to Wikipedia, AIDS alone kills over 2 million people per year. 

What’s going on?  I see one big problem with demand, and another with supply. 

The demand problem: Reputation can’t protect those who ignore its importance.  Yet lots of people are strangely willing to gamble their lives by having sex with people they (a) barely know, and (b) who are themselves willing to have sex with people they barely know.  If people bought cars this recklessly, they really would be “unsafe at any speed.” 

The supply problem: Reputable people – unlike reputable firms – cannot readily expand to take over the whole market.  (No puns please).  In the business world, one trusted supplier can ably serve all your friends and family.  The local singles bar doesn’t work that way.

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