Firm reputation and horizontal integration

We study effects of horizontal integration on firm reputation in an environment where customers observe only imperfect signals about firms' effort/quality choices. Horizontal integration leads to a larger market base for the merged firm, and thus helps reputation building with more effective punishments and better monitoring by eliminating idiosyncratic shocks of individual markets. But it allows the merged firm to deviate only in a subset of markets, which hinders reputation building by making it more difficult for consumers to monitor its quality. We show that these effects give rise to a reputation‐based theory of the optimal firm size and derive its comparative statics.