Is bigger better? Customer base expansion through word-of-mouth reputation

A model of gradual reputation formation through a process of continuous investment in product quality is developed. We assume that the ability to produce high-quality products requires continuous investment and that as a consequence of informational frictions, such as search costs, information about firms' past performance diffuses only gradually in the market. This leads to a dual process of growth of a firm's customer base and an increase in the firm's investment in quality. The model predicts, therefore, that the longer its tenure as a high-quality producer, the more a firm invests in quality. We relate this finding to empirical work on online commerce as well as on traditional industries.