Abstract: I study the impact of consumer reviews on the incentives for firms to enter and participate in the marketplace. Firms produce goods of heterogeneous, unknown quality that is gradually revealed through user-generated feedback, and face both entry and exit decisions. For each firm, the platform constructs a rating based on previous consumer feedback that provides the market with information regarding product quality. Under full transparency, consumers' equilibrium choices exhibit wasteful congestion at high-rated firms, inducing low entry rates as well as negative selection effects - high-quality firms exit early. This benchmark also offers several novel theoretical predictions, some of which echo existing empirical findings.
I then turn to the design of such ratings systems. These platforms must balance the need to provide consumers with accurate information and high-quality experiences against the need to encourage firms to participate in the marketplace. The optimal ratings system is a tenure policy that involves maximal feedback for struggling and young firms, and a ratings freeze for high-quality firms. In particular, full transparency is never optimal, and exhibits completely the reverse profile of ratings dynamics.
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