INTERNATIONAL ECONOMIC REVIEW

Vol. 42, No. 2, May 2001

WORD-OF-MOUTH COMMUNICATION AND

COMMUNITY ENFORCEMENT∗

By Illtae Ahn and Matti Suominen†
1

Korea Information Society Development Institute, Korea,

INSEAD, France

We study a repeated game where a seller, who has a short-term incentive

to supply low quality, is periodically matched with a randomly selected buyer.
Buyers observe only the outcomes of their neighbors’ games and may receive
signals from them. When the buyer population is large, the seller may sell high
quality even when each buyer observes her action in any given period with an
arbitrarily small probability. When networking among buyers is costly, low qual-
ity is always supplied with a positive probability. For this case, we characterize
an equilibrium where the seller randomizes between high and low quality.

1. introduction
It has long been recognized that community enforcement can make sellers behave
cooperatively even when they meet particular buyers only infrequently and have a
short-term incentive to cheat, e.g., to supply low quality or to shirk in a labor con-
tract. For instance, Klein and Leffler (1981) study the seller’s problem of credibly
committing to offer high quality in a model where a continuum of buyers is ran-
domly matched with a seller who has a short-term incentive to supply low quality at
a lower cost. In their model, community enforcement by the buyers, through a coor-
dinated boycott after observing low quality, provides an incentive for the seller to
produce high quality. The results of Klein and Leffler (1981), along with most of the
existing literature on community enforcement, depend upon the assumption that past
quality choices of the seller are public information.
When the number of sellers and buyers is large, and particular sellers and buyers
meet infrequently or only once, as is the case, for instance, for specialist doctors,
car dealers etc., the assumption of public information seems rather demanding.
Recently, this observation has led to a number of articles looking at community

* Manuscript received March 1999; revised November 1999.

†
E-mail: matti.suominen@insead.fr.
1
We are most grateful to our dissertation advisor George Mailath for much invaluable advice and
encouragement. Special thanks are also due to Aki Matsui for his advice and encouragement since
the very beginning of this project. We also wish to thank Todd Gunther, Jinyong Hahn, Stephen
Morris, Andrew Postlewaite, Juuso Välimäki, an anonymous referee, and the seminar participants at
the University of Pennsylvania, SUNY Stony Brook, and the European and North American meetings
of the Econometric Society for their helpful comments. The second author thanks the Yrjö Jahnsson
Foundation for their financial support. This paper is a revised version of the Caress Working Paper
96-02. All remaining errors are ours.

399
400 AHN AND SUOMINEN

enforcement with less stringent informational assumptions. These papers include

Milgrom et al. (1990), Okuno-Fujiwara and Postlewaite (1995), Kandori (1992),
Ellison (1994), and Harrington (1995). However, partially due to the difficulties of
dealing with private information, all of the above-mentioned articles have made
extreme informational assumptions. They assume either complete anonymity of
players, together with the assumption that players observe only the actions chosen
in their own games, or, alternatively, locally complete information, which allows a
player to perfectly observe the status of his current opponent, which is based on the
opponent’s past behavior.
In this article, we extend this research on community enforcement to a situation
where information among players is transmitted informally and imperfectly through
word-of-mouth communication. We study a seller’s incentive to produce high quality
when the seller has no long-term relationships with buyers and buyers learn about
the seller’s past behavior only through word-of-mouth communication.
More specifically, we study an infinitely repeated game between one seller and
M buyers, where M is a large but finite number. In each period t = 0
1
2
  ,
the seller meets one randomly selected buyer to play a stage game that contains an
opportunity for a mutually beneficial trade. The seller has a short-term incentive to
supply low quality and will supply high quality only if the gains from maintaining a
good reputation outweigh the short-term loss. The buyers have imperfect information
about the seller’s past actions. In particular, we assume that in each period t, in
addition to the matched buyer, only N < M other buyers, called spectators, observe
the outcome of the trade game. We can think of these N spectators as friends of the
matched buyer or just people who happen to pass by. As this greatly simplifies the
analysis without qualitatively affecting any of the results, we assume that the identities
of spectators to any single buyer’s games can change from period to period.
We consider two models of word-of-mouth communication which differ depending
on whether the N spectators are allowed to send signals to the matched buyer or not.
For these two models, we provide the necessary and sufficient conditions on N and
the discount factor for a sequential equilibrium in which high quality is supplied by
the seller in every period. For a high enough discount factor, these conditions can be
stated as N ≥ N ∗ , where N ∗ is a constant determined by the population size, discount
factor, and the payoff matrix. This result verifies our intuition that, as N increases,
information among buyers is transmitted more rapidly, and the seller’s incentive to
provide high quality becomes easier to sustain. This is not, however, a direct impli-
cation of the previous work on the Folk theorem under perfect information. Under
perfect information, high quality can be sustained in a repeated game by the threat
of an immediate reversion to a one-shot Nash equilibrium with low quality, after
observing low quality. When players have imperfect information about other players’
actions, such immediate reversion to the one-shot Nash equilibrium is not possible.
In this case, a seller who once sold low quality cannot be sure whether the buyer,
who is currently matched with her, is aware of her defection or not. In this case, she
may have an incentive to sell high quality in an attempt to slow down the deteriora-
tion of her reputation. Such behavior, on the other hand, can undermine a buyer’s
incentive to punish the seller by not buying.
 WORD-OF-MOUTH COMMUNICATION 401

We then study the effectiveness of information transmission under word-of-mouth

communication by examining how N ∗ , the minimum number of spectators necessary
to support high quality, behaves as we increase the size of the buyer population We
show that, in the absence of signalling, the proportion of N ∗ to the buyer population,
M
is constant. When signalling is allowed, on the other hand, this proportion quickly
approaches zero as we let M go to infinity. This result shows that when the buyer
population is large enough, it can be sufficient that each buyer observes the seller’s
action with an arbitrarily small probability, and yet the seller’s incentive to provide
high quality is maintained.
Finally, we study a model where such “networking,” i.e., setting up N connec-
tions, is costly for the buyers. In this case, we show that when M is large, the seller
produces low quality with a positive probability in any Nash equilibrium. This is a
necessary feature of the equilibrium, as otherwise the buyers do not have an incen-
tive to network. When the costs of networking are below a threshold value, we find
a sequential equilibrium in which the seller initially randomizes between high and
low quality and then continues to produce high quality if and only if she produced
high quality in the first period. This equilibrium has several interesting characteristics:
First, the probability of low quality goods is increasing in the population size M and
the cost of networking Second, even a small increase in the amount of networking
would completely eliminate the supply of low quality and increase the buyers’ utility
discontinuously. Third, when the cost of networking exceeds the threshold value, the
trade collapses, as the buyers no longer have an incentive to experiment with a seller
of unknown history.
In the existing literature on quality provision, the result that high quality is sold
along the equilibrium path is obtained through an assumption that agents instan-
taneously learn about a seller’s defection; see, e.g., Klein and Leffler (1981) and
Allen (1984). In this article, we show that when the population is large and informa-
tion transmission is both costly and imperfect, low quality is produced with a positive
probability in any Nash equilibrium. Historic examples where mechanisms with imper-
fect information have supported trade are described in Greif (1993, 1994) and Greif
et al. (1994). Besides helping to understand how such mechanisms work, our research
can also help explain the role of formal institutions, as in Milgrom et al. (1990), that
have risen to facilitate trade in situations where informal information transmission
is insufficient. We hope that our formalization of word-of-mouth communication has
interest in its own right.
The rest of the article is organized as follows: Section 2 gives a formal description
of the two models that we consider. Section 3 discusses players’ strategies and, for
the two different models of word-of-mouth communication, presents the necessary
and sufficient conditions for sequential equilibria, where high quality is produced by
the seller in every period. Section 4 studies the speed of information transmission
under word-of-mouth communication, while Section 5 considers the case of costly
networking. To clarify the exposition, we have collected most of the proofs in the
Appendix.
402 AHN AND SUOMINEN

2. two models of word-of-mouth communication

In this section, we formally define the two models of word-of-mouth communica-
tion that we are going to study.

2.1. A Model without Signals. There is one seller and M buyers. Throughout
this paper, the seller will be referred to as “female” and the buyers as “male.” We
denote by MB = 1
2
  
M the set of buyers. Let  be the set of all permutations
of MB . In each period t = 0
1
2
  
a permutation θt ∈  is chosen with uniform
probability, independent of previous realizations. The buyer θt 1 ∈ MB is selected
to play with the seller the following simultaneous move “trade” game:

Buyer θt 1
B NB
Seller H 1
1 0
0
L 1 + g
− 0
0

where both g and  are taken to be strictly positive numbers. The seller’s actions,
H and L
refer to providing “high quality” and “low quality” while the buyer’s action
B refers to “buy” and NB to “not buy.” With g and  strictly positive, L is the
dominant strategy for the seller and 0
0 is the only Nash equilibrium outcome of
the trade game. The seller and buyers have a common discount factor δ ∈ 0
1
and
their overall payoffs are the discounted sum of payoffs from the trade games. For
simplicity, it is assumed that the seller cannot recognize the identities of the buyers.2
In each period t = 0
1
2
  
there are N < M other buyers, called period t
spectators, who are neighboring θt 1 and also observe the outcome of the game. We
denote the set of spectators by Nθt  = θt 2
θt 3
   θt N + 1. Note that θt
determines the identities of both the matched buyer and the spectators. In addition,
there exists a public randomization device ft ∈ F ≡ 0
1
which is realized in the
beginning of the each period and drawn from a uniform probability distribution.
The stage game proceeds as follows:
1. θt and ft are realized and observed by all buyers. The seller observes ft .3
2. Seller and buyer θt 1 play the 2 × 2 simultaneous move trade game
described previously, while the spectators Nθt  observe. We denote the
outcome (or the realized action profile) of this game by aSt
aBt θt 1

where aSt ∈ AS = H
L
aBt θt 1 ∈ AB = B
NB. We denote by ot j
the observation of buyer j in period t; i.e., let ot j = aSt
aBt θt 1 ∈
AS × AB if j ∈ θt 1 ∪ Nθt 
and let ot j =  otherwise.
The information that buyer j receives in period t can now be written as
θt
ft
ot j We denote with H t j the set of all possible histories for buyer j
up to, but not including, period t. By convention, let H 0 j = . An element

2
The assumption that the seller could recognize the identities of the buyers would not change
our results. The strategy profiles that we consider would be equilibria of such a game under slightly
different conditions.
3
The assumption that buyers observe θt is made in order to ease the notation.
 WORD-OF-MOUTH COMMUNICATION 403

ht j ∈ H t j includes all past realizations of θs and fs as well as all past observa-
tions of player j
os j
where 0 ≤ s < t. Hence, ht j is
t−1
ht j = θτ
fτ
oτ jτ=0

A pure strategy for buyer j is then a sequence 

j
b t ∞
t=0 , where

j
bt :  × F × H t j → B
NB


Here

j
bt θt
ft
ht j specifies the choice of action for buyer j in period t given θt
ft ,
and j’s private history ht j If j = θt 1
this action is either B or NB; if j = θt 1

the action space for the buyer is merely the empty set.
For the seller, we define the pure strategy as a sequence of maps 
s t ∞
t=0
where

st : F × H
L × B
NBt → H
L

Note that the assumption that a seller does not recognize the identity of a buyer is
implicit in this notation.

2.2. A Model with Signals. This model differs from the previous one in that in
each period t = 0
1
2
  
before the trade game, the spectators j ∈ Nθt  are
allowed to send payoff-irrelevant signals to buyer θt 1
Let us introduce the following notation:
• C = γ
β: the set of possible signals.
j
• mt ∈ γ
β
: the signal from buyer j to buyer θt 1.
• mt j ∈ γ
βN
: the signals received by buyer j in period t
We can interpret the signals γ and β as meaning “Good” and “Bad,” respectively.
The interpretation of mt and mt j is similar to that of

j j
bt : e.g., if j = θt 1
mt j ∈
N
γ
β and if j = θt 1
mt j = . The information that buyer j receives in period t
can now be written as θt
ft
mt j
ot j. As before, we denote by H t j the set of all
possible histories for buyer j up to, but not including, period t and let H 0 j =  An
element ht j ∈ H t j now includes all past realizations of θs and fs
all past messages
to player j, ms j, all past messages from player j, mjs
and all past observations of
player j
os j
where 0 ≤ s < t. Hence, ht j is

ht j = θτ
fτ
mτ j
mjτ
oτ jt−1

τ=0

mt


j j
A pure strategy for buyer j is then a sequence 
bt ∞
t=0 , where

j

t :  × F × H t j → γ
β

m

j
bt :  × F × H t j × γ
βN
 → B
NB

j
Here, m
t θt
ft
ht j specifies the signal that buyer j, with private history ht j

sends to the matched buyer θt 1 in period t, while

j
bt θt
ft
ht j
mt j specifies
the choice of action for buyer j = θt 1 in a period t trade game, given ft , j’s private
history ht j
and signals mt j that he received in the period t communication stage.
For the seller, we define the pure strategies as before.
404 AHN AND SUOMINEN

2.3. Equilibrium Concept. Because of the private histories that players have, the
equilibrium concept that we apply is sequential equilibrium.4 A trivial sequential
equilibrium is one where the seller plays L and the buyers NB after any history:
the repetition of the only pure strategy Nash equilibrium of the trade game. We
are, however, interested in sequential equilibria where H
B is played along the
equilibrium path.

3. exogenous networks and trade

3.1. Strategies. Throughout this paper, we confine our analysis to a particular
class of strategy profiles, which we call either “randomly forgiving” or “unforgiving,”
depending on whether the probability of forgiveness is positive or not. It is convenient
to start by defining the unforgiving strategy profile.
Under the unforgiving strategy profile, the strategy of the seller is:
(i) to sell high quality in period zero (in Section 5 with some probability) and
in the future, provided that the outcome of her past games was always
H
B, and
(ii) to sell low quality, otherwise.
In the second model, the strategy of a neighboring buyer j ∈ Nθt  is to signal β
to the matched buyer θt 1 if he has seen the seller play L or observed some buyer
play NB against her and to signal γ otherwise. In both models, the strategy of buyer
j = θt 1 is to play B unless he is informed about a seller’s past defection, in which
case he plays NB. In the first model, the latter occurs if buyer j = θt 1 has seen
the seller play L or observed some buyer play NB against her. In the second model,
it also occurs if he has ever received a message β from a spectator. When there
is a contradiction between the buyer’s own observations, ot j
and the messages
received, mτ j
in the sense that j = θt 1 has observed H
B in all past periods
τ ≤ t
but received a message β, he disregards this message and plays B.
In both strategy profiles, a buyer effectively assigns the seller one of two different
statuses based on all information that is available to him: he gives the seller bad status
β if he is informed about her defection. Otherwise, he assigns her the good status γ
An equivalent description of the unforgiving strategy for buyer j
when j ∈ Nθt 
is
then to signal θt 1 the status that he assigns to the seller in period t Similarly, when
j = θt 1
his strategy is to play B against a seller with status γ (after the period t
communication stage) and to play NB otherwise.
The strategy profile described above is “unforgiving” in the sense that informed
buyers punish a defected seller whenever they meet her. In the proof of Proposition 2,
we allow for the possibility of an amnesty for the seller which is based on the outcome
of the public randomization device. In this case, the strategy profile that we consider,
the randomly forgiving strategy profile, is similar to the unforgiving strategy profile, except

4
In Kreps and Wilson (1982), the definition of sequential equilibrium requires the specification
of a beliefs system as well as a strategy profile. Because the beliefs system, which is consistent with
our strategy profiles, is simple, we refer only to the strategy profile when describing a sequential
equilibrium.
 WORD-OF-MOUTH COMMUNICATION 405

when ft > f ∈ 0
1
in which case, all players return to the equilibrium path of the
randomly forgiving strategy profile and the game is essentially restarted. The unforgiving
strategy profile is a special case of the randomly forgiving strategy profile with f = 1.
There are two reasons for focusing on these strategy profiles. First, they are simple:
In fact, because of the private information that players have, it is difficult to imagine
other strategies that could support the efficient outcome, where H
B is played in
every period along the equilibrium path, as a sequential equilibrium of this game. For
instance, strategies with finite punishments are difficult to implement because buyers
typically do not know the time of the first defection and therefore cannot synchronize
the last period of a punishment phase.5 Our strategy profiles avoid these problems.
The buyers’ incentives are particularly easily shown to be satisfied.
The second reason for focusing on these strategy profiles is that the unforgiving
strategy profile results in the fastest possible dissemination of information about a
seller’s defection and allows the buyers to implement the maximum punishment. This
is important because the conditions for the efficient outcome that we derive then
give us the minimum N that is necessary for the efficient outcome in any sequential
equilibrium.

3.2. Equilibrium Conditions. In this section, we study the necessary and sufficient
conditions in terms of N for a sequential equilibrium where H
B is played by all
players in every period.
Before proceeding, we introduce some additional notation. Take any two time
periods t  and t, where t  < t. For the first model, we denote by b the probability that
θt 1 was among the N + 1 buyers who observed the seller’s action in period t  . That
is, let b denote the probability

Prθt 1 ∈ θt  1 Nθt  

Correspondingly, for the second model, we denote by b the probability that either
θt 1 or some of his time t spectators, h ∈ Nθt , were among the N + 1 buyers who
observed the seller’s action in period t   In this case, b is therefore the probability
 
Prθt 1 Nθt  ∩ θt  1 Nθt   = 

If the outcome of the game has been H
B in all periods except period t  < t

under the unforgiving strategy profile, for both models, b is the probability that θt 1
assigns the seller a bad status in period t after the possible preplay communication
among buyers. This probability, which we call “the degree of informativeness,” plays
an important role in the analysis below. It is straightforward to show that the degree
of informativeness is

 N+1
M
for the first model
b= M−N−1
N+1 
1 − for the second model
N+1
M


5
It is because of these kinds of difficulties that the existing models on community enforcement
with private information have made such extreme assumptions regarding the observability of players’
actions and identities.
406 AHN AND SUOMINEN

For both models, note that, since θt is i.i.d., b is time independent and does not
depend on t or t   Note also that for both strategies, b increases in the number of
spectators, N.
In the proofs of Propositions 1 and 2, we need the unconditional probability that
θt 1 assigns the seller a good status in period t, given that the seller has defected in
every period t  ∈ tD
  
t − 1 If the buyers follow the unforgiving strategy profile,
this probability is simply 1 − bt−tD . In the analysis below, the constant

g1 − δ
b∗ ≡
δ

also plays a crucial role. Equipped with this notation, we are now ready to state our
first proposition:

Proposition 1. For the two models of word-of-mouth communication, b ≥ b∗ is a

necessary condition for a sequential equilibrium with the efficient outcome, where H
B
is played in every period along the equilibrium path.

Proof of Proposition 1. When buyers play according to the unforgiving strat-

egy profile, the seller has an incentive to play H in every period rather than play L in
every period when
1 1+g
(1) ≥
1−δ 1 − 1 − bδ

The left-hand side is the payoff from playing H in every period, whereas the right-
hand side is the payoff from playing L in every period. This equation can be rewritten
as b ≥ b∗ 
Now, assume that b < b∗  Then, whatever strategy the buyers adopt off the equilib-
rium path, the payoff to the seller from playing L in every period is higher than the
payoff on the right-hand side of Equation (1). Therefore, playing H in every period
cannot be optimal for the seller.
It is easy to show that the unforgiving strategy profile is a sequential equilibrium
when b = b∗ . The seller’s incentive to follow the unforgiving strategy profile is charac-
terized by two conditions: one preventing her from playing L along the equilibrium
path, and one that guarantees that a seller who has defected keeps defecting irrespec-
tive of her private history. To give the seller an incentive to play H along the equilib-
rium path, the short-term gain from cheating, g, must be outweighed by the long-term
loss resulting from the gradual loss of reputation among buyers. As we have seen,
given the buyers’ strategies, this occurs when b ≥ b∗ . On off-the-equilibrium paths,
the unforgiving strategy profile requires the seller to keep defecting rather than play H
in an attempt to slow down the deterioration of her reputation. It can be shown that
indifference to supplying high quality along the equilibrium path, which occurs when
b = b∗ , implies that this off-the-equilibrium path condition always holds The reason
is that the seller has less incentive to protect her reputation on off-the-equilibrium
paths than on the equilibrium path as, in any case, information about her defection
 WORD-OF-MOUTH COMMUNICATION 407

is spreading through the actions of the informed buyers. Given the seller’s strategy,
the buyers’ incentives to follow the unforgiving strategy profile are trivially satisfied.
Somewhat surprisingly, the unforgiving strategy profile is not always a sequential
equilibrium for all b ≥ b∗ . The reason is that when b is larger than b∗ , the seller may
have an incentive to provide high quality in an attempt to slow down the deterioration
of her reputation, thus undermining the buyers’ incentives to punish her by not buy-
ing. As we show in Ahn and Suominen (1996), when δ is large, for both models there
exist bL and bH , such that the unforgiving strategy profile is a sequential equilibrium
of the game if, and only if, b∗ ≤ b ≤ bL or b ≥ bH
where b∗ < bL < bH < 1.
As we have seen, b ≥ b∗ is needed for the seller’s incentive to play H along
the equilibrium path. For the off-the-equilibrium path condition, that a seller who
has defected keeps defecting, when δ is large, it is necessary that either b ≤ bL
or b ≥ bH  If b is large, b ≥ bH , such a seller has an incentive to keep defecting, as
there are many informed buyers who keep playing NB against her, and her reputation
deteriorates quickly irrespective of her current and future actions. On the contrary, if
b is small, b ≤ bL , playing L is preferable simply because the information about her
defections is not spreading very quickly. It can be shown that this off-the-equilibrium
path condition is always satisfied with a strict inequality when b = b∗ , implying that
bL > b∗ .
One way to modify the strategy profile so that it supports the efficient outcome
for all b ≥ b∗ is to make use of the randomly forgiving strategy profile and the public
randomization device to coordinate and adjust the severity of the punishment for
the seller so that she becomes indifferent to supplying high or low quality along the
equilibrium path. As in the case of the unforgiving strategy profile, the indifference to
supplying high quality on the equilibrium path implies that the off-the-equilibrium
path incentives in the randomly forgiving strategy profile are satisfied. In this way, we
can prove the following:

Proposition 2. For both models of word-of-mouth communication, b ≥ b∗ is a

sufficient condition for a sequential equilibrium with the efficient outcome, where H
B
is played in every period along the equilibrium path.

Given that b is a probability, it can only be larger than b∗ if δ ≥ g/1 + g, so that
∗
b ≤ 1. For the remainder of this paper, let us assume that δ ≥ g/1 + g.

4. implications for large populations

How fast must N grow in relation to M in order to sustain H
B as the outcome
of the trade game? If we denote N ∗ M as the smallest integer N that satisfies the
constraint b ≥ b∗ ≡ g1 − δ/δ
then given Propositions 1 and 2, the question can
be reformulated as: How fast does N ∗ M grow in relation to M? In the first model,
given that the degree of informativeness, b, is equal to N + 1/M, it is clear that N ∗
and M must grow at the same rate in the limit as M → ∞. This is not true, however,
for the second model of word-of-mouth communication.
Remember that, for the second model, b is the probability that either θt 1 or
some of his N time t spectators, h ∈ Nθt , were among the N + 1 buyers who
408 AHN AND SUOMINEN

observed the seller’s action in period t  < t. Given this, increasing N will increase
b in two different ways: First, it increases the number of players who observe the
current game and, second, it increases the probability with which each of these players
observed the game in period t  . The presence of these two reinforcing effects, both
order N, suggests that N ∗ may now grow more slowly than M. Indeed, the following √
proposition shows that, in order to sustain trade, N ∗ must grow only at a rate M
in the second model of word-of-mouth communication.

Proposition 3. For the second model of word-of-mouth communication,

N ∗ M2
0 < lim <∞
M→∞ M

Proposition 3 shows that when the buyer population is large enough, it is possible
to provide the seller with an incentive to sell high quality even when each buyer
observes the seller’s action in any given period with an arbitrarily small probability.
This follows from the fact that the proportion N ∗ /M
which is the probability of
observing any given period’s trade game when N = N ∗ , goes to zero, as M goes to
infinity. Indeed, as the proportion shows, it goes to zero quickly. In this sense, when
signalling is allowed, word-of-mouth communication can be a surprisingly efficient
means of transmitting information and thereby an efficient mechanism to facilitate
cooperation.
The reader may wonder whether the fact that, in our model, the identities of
each buyer’s spectators can change from period to period is crucial for the result in
Proposition 3. It is not. The same result would hold even in a setting where each
buyer has N randomly selected spectators, whose identities stay fixed throughout the
game. To understand this, note that, as M increases, the probability that the seller
is matched with the same buyer twice during any finite length of time goes to zero,
and all learning takes place through observing different buyers’ trade games. In this
case, it does not matter whether we randomly select the matched buyer’s spectators
in every period or randomly select a fixed set of spectators for each buyer at the
beginning of the game.

5. endogenous networks
In this section, we complete our previous study of community enforcement under
word-of-mouth communication by making the networking among buyers costly. We
set up a model where the information transmission and b are endogenously deter-
mined. What we find is that the endogenously determined b is equal to b∗  This
is interesting because, as we saw in Section 3, the unforgiving strategy profile, which
apportions the seller the maximum punishment for selling low quality, is always an
equilibrium when b = b∗ . We also show, however, that when the buyer population
M is large, the efficient outcome can never be reached, and low quality is produced
with positive probability in any Nash equilibrium. For simplicity, we will focus on the
first model of word-of-mouth communication. The results for the second model are
similar.
 WORD-OF-MOUTH COMMUNICATION 409

Let us now assume that in period zero, before θ0 is realized, each buyer j ∈ MB can
invest in Nj connections that allow him to observe the outcome of the trade game
whenever θt−1 j ≤ Nj + 1
i.e., if j is the matched player θt 1 or among the Nj
players closest to him in period t. Let us also assume that the cost of this investment
is proportional to Nj . That is, let us assume that in order to obtain Nj connections, j
must pay Nj c, where c > 0, in period zero. This assumption corresponds to the idea
that each buyer, at the beginning of the game, makes an effort to create connections
through which he can later gather information about the actions of the seller against
other buyers. We can now prove the following:

Proposition 4. In any Nash equilibrium of the game with costly networking, low
quality is produced with a positive probability when M > δ/g1 − δ .

Proof of Proposition 4 . The proposition is proved by contradiction. Assume

that there is a Nash equilibrium in which the seller produces high quality with prob-
ability one in every period. Buyers then do not have an incentive to network, and
the optimal Nj must be zero for all buyers. If, however, Nj is zero for all buyers and
M > δ/g1 − δ the seller has an incentive to deviate and produce low quality, a
contradiction.
There clearly exists the equilibrium where Nj = 0 for all buyers, and the seller
produces low quality. More interestingly, we show that, if the costs of networking are
small enough, there exists a sequential equilibrium with trade.
Consider the following modified unforgiving strategy profile. For the seller, in the first
period play H with probability 1 − p∗ and L with probability p∗ . After that, if the
outcome in all the previous trade games was H
B, play H; play L otherwise. For a
buyer j, in period 0, before θ0 is realized, invest in N ∗ − 1 connections with probability
r and in N ∗ connections with probability 1 − r. In all periods t = 0
1
2
  
when
j = θt 1
if j has ever observed the seller play L or someone (including himself)
play NB against her, play NB. Play B otherwise.
Before proceeding, we still need some additional notation. If buyer j invested in
Nj connections, the probability that he observes the seller at any given period t is
Nj + 1/M. We denote this probability by beNj :

beNj ≡ Prθt−1 j ≤ Nj + 1

Similarly, as before, the probability that buyer j has never observed the seller until
period t is simply 1 − beNj t .

Proposition 5. When M > δ/g1 − δ and c ≤ c, the modified unforgiving strat-

egy profile is a sequential equilibrium of the random matching game with
 
1 − δ1 − beN ∗ −1 1 − δ1 − beN ∗ 
(2) p∗ = cM 2
δ
where
 
1 δM1 − δ + δ
c≡
M 2 1 − δ1 − beN ∗ −1 1 − δ1 − beN ∗  + 1M1 − δ + δ
410 AHN AND SUOMINEN

This equilibrium has several interesting characteristics: First, for c > 0, Equation
(2) requires that p∗ is strictly positive, as was shown in Proposition 4. In equilibrium,
L has to be played with positive probability in order to provide the buyers with an
incentive to network. Second, this probability increases in M In the first model of
word-of-mouth communication p∗ is approximately proportional to M 2 , and in the
second model (it can be shown) it is less than proportional to M 2 . A striking result is
also the knife-edge property of our equilibrium: If even one more buyer invested in
one more connection, there would be no low quality at all (increasing the utility of
all buyers discontinuously). However, networking to reduce production of low quality
is a public good, and, as usual, everyone wants to free-ride in its production. Because
of this, the economy is stuck in an inefficient equilibrium.
Another interesting observation is that when c > c, the trade collapses because a
buyer, who is set to trade with an unknown seller, is not willing to experiment, as he
does not take into account the future trading opportunities of the other buyers with
the seller. In the second model of word-of-mouth communication, there would still
be another externality because of the informative signalling by the spectators. When
choosing the number of other buyers’ games to observe, a buyer would not take into
account the other buyers’ learning but would be interested only in his own learning.

appendix

Proof of Proposition 2 . Consider the randomly forgiving strategy profile with

f ∈ 0
1  Let us first check the seller’s incentive to (I) play H along the equilibrium
path and (II) to play L off the equilibrium path when ft ≤ f .
For any ft
a seller has an incentive to follow (I) if, and only if,

1 1+g 
∞
δt
(3) ≥ + f t−1 1 − f 
1−δ 1 − 1 − bfδ t=1 1−δ

1 1+g
⇔ ≥
1 − δf 1 − 1 − bfδ

The left-hand side of the first inequality is the seller’s payoff from following (I),
while the right-hand side is her payoff from deviating and following (II), as long as
fτ ≤ f
and following (I) thereafter. For all b ≥ b∗
there exists f δ ∈ 0
1 such
that Equation (3) holds as an equality when f = f δ. From now on, let us assume
that f = f δ.
A seller who is playing on the equilibrium path is now indifferent to opting between
playing H in every period and deviating. She is also indifferent to either playing H
in the current period and then deviating or deviating right away. By playing H in
the current period and deviating only in the next period, she can keep her good
reputation among N + 1 buyers until they, in some way, learn about her defections
in the future. Now consider a seller off the equilibrium path who is following (II).
If her opponent and all the N spectators to her game happen to assign her a good
status, she also can keep her good reputation among N + 1 buyers by playing H. This
reputation, however, is worth less to her than if she were on the equilibrium path
 WORD-OF-MOUTH COMMUNICATION 411

because, with some buyers already assigning her a bad status, these N + 1 buyers are
now more likely to learn about her bad status before playing against her in the future.
Since the short-term gain from deviating is the same in both cases, we conclude that
playing L is optimal off the equilibrium path.
To consider more formally the seller’s incentive to follow (II) in period t when
ft ≤ f δ, we need some additional notation: Denote by Ps K the probability that
K + s buyers assign the seller a bad status at the end of period t if she plays H in
period t and K players assigned her a bad status at the end of period t − 1. Denote
by us K the associated conditional probability that the seller’s period t + 1 match
θt+1 1 does not assign her a bad status (after the period t + 1 communication stage),
given that K + s buyers assign her a bad status at the end of period t.
Using the principle of dynamic programming, it is sufficient to show that a single-
period deviation to H is unprofitable. Given this, a seller has an incentive to follow
(II) if, and only if,

1 + gu0 
∞
δt
+ f δt−1 1 − f δ
1 − 1 − bf δδ t=1 1−δ
 minN
M−K 

δf δ1 + g Ps us
s=0 
∞
δt
≥ u0 + + f δt−1 1 − f δ
1 − 1 − bf δδ t=1
1−δ
 minN
M−K 

δf δ1 + g Ps u s
1 + gu0 s=0
⇔ ≥ u0 +
1 − 1 − bf δδ 1 − 1 − bf δδ

We can show that this inequality holds as follows:

1 + gu0 u0 1 + gδf δu0

= = u0 +
1 − 1 − bf δδ 1 − δf δ 1 − 1 − bf δδ
 minN
M−K 

1 + gδf δ P s us
s=0
≥ u0 +
1 − 1 − bf δδ

The first two equalities come from the fact that Equation (3) holds as an equality
with f = f δ The inequality follows, since
minN
M−K minN
M−K
 
Ps us ≤ P s u 0 ≤ u0
s=0 s=0

In the second model, when ft ≤ f δ
if a buyer j ∈ Nθt  has ever observed the
seller play L or her opponent play NB against her, j is indifferent to signalling γ or
β to θt 1, since, given (II), he expects the seller to play L in all her future trade
games until fτ > f δ, including those with j himself, irrespective of the signal that
he sends. So, in this case, we may assume that he sends a truthful signal β. If j has
never observed the seller’s game, or if j has observed some games but the outcome
412 AHN AND SUOMINEN

in all those games was always H
B
he strictly prefers to send message γ instead
of β. Sending the message β would result in θt 1 playing NB against the seller,
giving her a bad status and making her play L in the future. This would reduce buyer
j’s future payoffs from games where he is matched with the seller. This establishes
the buyers’ incentives to signal. When ft ≤ f δ, a buyer θt 1 expects a seller with
status γ to play H, in which case, playing B is the best response. Similarly, when
ft ≤ f δ, he expects a seller with status β to play L, in which case, playing NB is
the best response. On the other hand, given that even a defected seller plays H after
ft > f δ, it is optimal for all buyers to assign the seller a good status γ if ft > f δ
and to treat her like a seller who has never defected.
To prove Proposition 3, we need the following lemma:

Lemma 1. Under the unforgiving strategy profile,

N ∗ M
lim =0
M→∞ M

Proof of Lemma 1. By the definition of N ∗ M
we have the following

inequalities:
   
M − N ∗ M − 1 M − N ∗ M
N ∗ M + 1 N ∗ M
(4)   ≤ 1 − b∗  <  
M M
N ∗ M + 1 N ∗ M

First, note that lim supM→∞ N ∗ M/M < 1/2. For the subsequences of N ∗ M/M,
whose limits are 1/2, the numerator of the right-hand side of the strict inequality
in Equation (4) approaches 1, and the denominator goes to infinity, leading to a
contradiction since b∗ is assumed to be strictly less than one.
Using Stirling’s formula,
√ √
2πnnn e−n ≤ n! ≤ 2πnnn e−n e1/12n

the second inequality in Equation (4) implies that

∗
M − N ∗ 2M−N +1 ∗
(5) 1 − b∗  < M+1/2 ∗ e1/6M−N 
M M − 2N ∗ M−2N +1/2

Given that lim supM→∞ N ∗ /M < 1/2
it is clear that the exponential term that
appears at the right-hand side of Equation (5) goes to 1 as M approaches infinity.
The nonexponential term then has to be bounded away from zero for large M. In
what follows, we show that this implies limM→∞ N ∗ /M = 0.
Let q = N ∗ /M. The nonexponential terms in the right-hand side of Equation (5)
can now be written as
 M
1 − q2−2q 1 − q
1 − 2q1−2q 1 − 2q1/2
 WORD-OF-MOUTH COMMUNICATION 413

Since 0 < q < 1/2 and lim supM→∞ q < 1/2 the second term of the above expression
is bounded. Furthermore, we can show that the first term is strictly decreasing with
respect to q for 0 ≤ q ≤ 1/2 and for that range of q it is one iff q = 0 Thus, if
limM→∞ q = 0, the first term is very close to zero for large M, which is a contradiction.
Hence, it must be that limM→∞ N ∗ /M = 0.

Proof of Proposition 3. If we rewrite Equation (4), using Stirling’s formula,

we get
∗  1/2
M − N ∗ − 12M−N  M − 2N ∗ − 23
(6) ∗
M M M − 2N ∗ − 2M−2N MM − N ∗ − 12
 
1 1
× exp − − ≤ 1 − b∗ 
12M − 2N ∗ − 2 12M
∗  1/2
M − N ∗ 2M−N  M − N ∗ 2 ∗
< ∗ e1/6M−N
M M M − 2N ∗ M−2N MM − 2N ∗ 
Since the last two terms of both sides of the inequalities in Equation (6) approach 1
as M → ∞ by Lemma 1, and both the first terms exhibit the same behavior in the
limit, we must have
∗
M − N ∗ 2M−N  ∗
(7) ∗ → 1 − b  as M → ∞
M M M − 2N ∗ M−2N
Next, we show that 0 < limM→∞ N ∗2 /M < ∞ in order for Equation (7) to hold.
First, note that we can write
∗
M − N ∗ 2M−N 
∗
M M M − 2N ∗ M−2N

  2 −M−N ∗ /N ∗ 2 N ∗2 /M−N ∗ 
 −M/2N ∗ −2N ∗2 /M
N∗ 2N ∗
= 1− 1−
M − N∗ M
∗2 /M−N ∗  ∗2 /M
= e + αM N e + βM −2N

where
 2
  2 − M−N ∗ /N ∗
N∗
αM = 1 − −e
M − N∗
 −M/2N ∗
2N ∗
βM = 1 − −e
M
Since limM→∞ N ∗ /M = 0, both sequences αM  and βM  converge to zero from
above. Now, define new sequences aM 
bM  such that eaM = e + αM
ebM = e + βM .
We can then write
∗  
M − N ∗ 2M−N  N ∗2 2N ∗2
(8) ∗ = exp aM − b M
M M M − 2N ∗ M−2N M − N∗ M
414 AHN AND SUOMINEN

Given Equations (7) and (8), all that remains is to show that N ∗2 /M must
converge to some positive number in order for aM N ∗2 /M − N ∗  − bM 2N ∗2 /M
to converge to ln1 − b∗ . If limM→∞ N ∗2 /M = ∞, aM N ∗2 /M − N ∗ − bM 2N ∗2 /M
approaches minus infinity as M goes to infinity. This can be easily shown using the
∗
fact that aM  and bM  converge to 1 from above. If limM→∞ N 2 /M = 0, we
∗2 ∗ ∗2
obtain another contradiction since aM N /M − N  − bM 2N /M → 0 as M → ∞.
Since N ∗2 /M is bounded, it is straightforward to show that limM→∞ N ∗2 /M =
− ln1 − b∗ .

Proof of Proposition 5. For the modified unforgiving strategy profile to be a

sequential equilibrium in this game, the following three conditions must hold:

1 r1 + g 1 − r1 + g
(9) = +
1−δ 1 − 1 − bN ∗ −1 δ 1 − 1 − beN ∗ δ
e

1−p p
(10) N ∗
N ∗ − 1 ∈ arg max − − Nj c
Nj M1 − δ M1 − δ1 − beNj 

δ1 − p
(11) 1 − p + ≥ p
M1 − δ

A seller is willing to randomize in the initial period between providing high quality
goods forever and providing low quality goods forever if, and only if, Equation (9)
holds. The left-hand side of Equation (9) is the payoff from providing high quality
goods, and the right-hand side is the expected payoff from providing low quality
goods forever. To understand this, note that the probability that j = θt 1 has never
observed the seller is 1 − beNj t . Given this indifference on the equilibrium path, the
seller’s incentives to follow the modified unforgiving strategy profile off the equilibrium
path are also satisfied. The proof of this is exactly the same as that for Proposition 2.
Equation (10) requires that buyers be willing to randomize between N ∗ and N ∗ − 1
connections. We can show that the right-hand side of Equation (10) has a single peak
if Nj is treated as a positive real number (or as a continuous variable). Hence, if the
expected payoff to buyer j is the same with N ∗ and N ∗ − 1, then both N ∗ and N ∗ − 1
must solve j’s maximization problem. Equation (10) is therefore satisfied if

p p
+ Mc =
1 − δ1 − be N ∗  1 − δ1 − be N ∗ − 1
or
 
1 − δ1 − be N ∗ − 11 − δ1 − be N ∗ 
(12) p = cM 2
δ

If a buyer has ever observed the seller play L or someone play NB against her,
he should expect the seller to play L, in which case playing NB is the best response.
If the buyer has observed the seller, and the outcomes have always been H
B, he
should expect her to play H, in which case he should play B. If the buyer has never
observed the seller, he should expect her to play H with probability 1 − p. For
 WORD-OF-MOUTH COMMUNICATION 415

such a buyer to play B against her rather than give her a bad status by playing NB,
Equation (11) has to be satisfied. This equation can be rewritten as

M1 − δ + δ
(13) p≤
 + 1M1 − δ + δ

The modified unforgiving strategy profile with p defined by Equation (12) is a sequen-
tial equilibrium if p satisfies Equation (13). This happens when c ≤ c.

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