Reputation as a Public Good: Externalities in Corporate Communications Markets

Economists use two questions when determining whether something belongs to a particular class of goods: "Can the good be excluded from use by people if it is being consumed by someone else?" and "Does a person's consumption affect how much consumption is available to other people?" Most public goods are classified as both non-exclusionary and non-rival. As a result, public goods do not limit how many people can use them. Corporate reputation is a prime example of how corporate reputations also fit these two defining characteristics, and thus create large amounts of distortion in the market place.

An industry as a whole is also exposed to these effects through the collective reputation of that industry with consumers. When Boeing lost approximately $34 billion in market value as a result of two 737 Max crashes in 2018 and 2019, that effect did not just impact Boeing and its shareholders. Other organisations who had a relationship with Boeing were also negatively impacted by the loss of the collective reputation of the airline sector. Suppliers, regional airlines and the aerospace workforce in the Midwest, for example, suffered reputational losses due to decisions made by one manufacturer that negatively affected the collective reputation of that sector. The overall decline in passenger confidence in air travel was also a measurable result of one organisation's failure to communicate effectively. In this case, the failure of one firm to adequately communicate created an externality for all firms involved with that sector and created an overall lack of confidence in the air travel sector as a whole.

Underinvestment and over-transparency resulting in suboptimal market outcomes

From an economic perspective, the above-mentioned concepts can be easily explained through a basic understanding of externalities. When a corporation makes a reputational investment that produces a positive spillover effect for its sector, that corporation will always underinvest in that type of reputational investment. The reason is that the corporation will not receive the complete social return on its investment. In contrast, if a corporation engages in those activities where it has cut corners with respect to transparency (e.g., burying negative findings in supplemental filings), then that corporation privatises the cost savings derived from cutting corners and simultaneously socialises the negative credibility cost of that action.

This asymmetric externality structure is precisely what creates the conditions for market failure. There exists substantial empirical data illustrating this phenomenon. For example, a 2023 survey conducted by the Edelman Trust Barometer of 32,000 survey respondents, located across 28 countries, revealed that people have much greater variance in trust in business as an institution than they do in trust in specific companies. Collectively, all of the companies in an entire industry or country can experience trust being significantly decreased by the existence of one huge scandal, yet it is very uncommon for individual firms to produce an increase in total aggregate trust for their respective industries or countries on their own. An illustrative example of this point is found in the pharmaceutical sector. By 2021, after all the lawsuits related to the opioid crisis, the amount of trust that the general public has in the pharmaceutical sector fell to only 32 per cent, and consequently, all of the firms in that sector, including those who spent a lot of time and money investing in transparency of their clinical communication practices, suffered because of this decrease in consumer trust.

Strategic behaviour and free-riding

Due to the structure of the incentive systems, rational firms have created incentives that are individually rational, but collectively undermine the overall social behaviours of firms within the industry. When one firm hires a PR agency with a good reputation to provide consulting services during a time of crisis, it enhances the reputation of that firm. However, by repairing its reputation through investments in the face of a crisis, that firm has also aided in repairing the reputation of competitors (who did not invest) following the crisis. Competitors with low levels of transparency effectively are free-riding on the benefits of the industry repairing the reputation it had lost during the crises without contributing to repairing the reputation. This creates a downward spiral as firms would eventually converge on the lowest defensible level of disclosure instead of the socially acceptable or optimal level of disclosure.

An excellent example of this dynamic is illustrated in the financial services industry from 2010-2015. After the 2008 financial crisis, many of the large banks in the U.S. invested billions of dollars to regain public confidence. The large banks used transparency, new community lending programmes, and improved governance communications to earn back public trust. However, because the environment for regaining public trust was very favourable, it provided the same benefits to the smaller regional banks and new fintechs that were also in the marketplace, but without spending anywhere near the same amount of money to do so. According to the 2015 Capgemini World Retail Banking Report, customer trust was restored to pre-crisis levels in retail banking in all areas of the world, benefiting the entire industry, not just those firms that had made investments to enhance their reputations.

Government action and limits

To address this issue of free-riding and internalise the externalities, governments have implemented mandatory disclosure regimes (in an effort to encourage investment in repairing reputational damage). One example is the EU's Corporate Sustainability Reporting Directive (CSRD) that will go into effect on January 1, 2024, and will apply to about 50,000 companies. The CSRD creates a tax on "opacity" by requiring companies to produce standardised reports for investors and other stakeholders. Similarly, the recently proposed SEC (United States) climate disclosure rules follow this reasoning. The idea behind mandating uniform records of disclosure is to avoid the free-riding problem.

However, the mandatory disclosure regulations are a "blunt" instrument. They specifically focus on the lowest level of disclosure and do not motivate the proactive trust-building communications that provide the opportunity for a positive externality for an entire industry. Whether or not voluntary mechanisms (i.e., industry association, reputation compacts, third-party verification programmes) can substitute for internalising externalities is a question that remains to be answered in the economic literature regarding corporate communications.