Peer Learning, Enforcement, and Reputation

ABSTRACT

We study a two‐period learning model where a sequentially rational regulator builds a reputation for strict enforcement and self‐interested firms test the regulator's enforcement propensity through their misconduct. In the transparent setting, where misconduct and enforcement are observable between the firms, the regulator's reputation concern endogenously creates positive or negative enforcement externalities between the firms. When the reputation concern is strong, the enforcement externalities are negative and dominate the information externalities, encouraging misconduct. Otherwise, both externalities are positive and deter misconduct. Although a strong reputation always benefits the regulator in the opaque setting, it often backfires in a transparent setting.