Chances are that if you are a member of the internet age you have in recent years either given out or received a rating. Maybe as product reviewer on Amazon, an avid seller on eBay, a food critique on Yelp, a holiday specialist on TripAdvisor, or a travel aficionado on Uber you have been in some way been confronted by the innovative reality of rating systems or more specifically reputational feedback mechanisms. Presented in a variety of forms these modern technology enabled mechanisms have liberated economic transactions from the information-based chains under which they were once imprisoned, to allow us to enter a new age of economic efficiency.
Trust has always been a foundational aspect of functioning markets. We place trust in the sellers we engage in everyday often without realising it. We trust Coles not to sell us food that will make us sick or we trust Doctors to give us the right medication. Not without good reason of course – in civilised societies we have legal frameworks, and civil standards to rely on when simple faith is not enough. But legal precedents do not outdate economic transactions and so other mechanisms must have been in place to ease our commercial concerns. John McMillan’s ‘Reinventing the Bazaar; A Natural History of Markets’ points to the rules and customs that emerged to satisfy our need for trust, the early remnants of reputational feedback mechanisms.
Ostentation appears to be an early favourite. In the absence of being unable to establish a reputation for quality through experience, showing off seemed an acceptable substitute. Likened to ‘peacocking’ in the animal kingdom prolificacy sent a signal of brash confidence to consumers conveying that their product had to be good. Other mechanisms sought to impose sanctions rather than signals to create trust. Market agents who were dishonest and did not adhere to market rules were admonished by being banned from organisations or involvement, meaning it paid off to stay honest. This was present everywhere from New York diamond dealings to the Mexico shoe trade.
Closer analysis reveals that these mechanisms we’ve come to depend on can take two forms; they can be sanctioning and hence provide an incentive for buyers and sellers to adopt an honest policy, or they can be signalling providing insight on issues of quality. From an economics perspective there are differing circumstances under which either mechanism is necessary.
The first – sanctioning – is most appropriate in the case of moral hazard. In markets that lack credibility mechanisms, sanctions that deter dishonest market behaviour provide stability to the market, and evoke confidence in market consumers. A commonly cited example is that of eBay’s famous marketplace. Since eBay agents can operate under a high degree of anonymity having agents engage at just face value would likely see no transactions completed at all. The seller who is able to receive the money prior to the goods arriving with the buyer has an incentive to keep the money and the goods rather than fulfilling the honest transaction. However, by establishing a two-way public feedback system eBay creates a self-regulating marketplace that is able to build its own trust; rewarding sellers with high ratings with more sales, and sellers with low ratings with less. Thus while under regular circumstances an anonymised transaction may be impeded by a lack of mutual confidence, online tools have broken down information barriers to enable permitting such transaction to take place.
The second case – signalling – caters to circumstances where there is a risk of adverse selection. A 2015 Mercatus Working Paper endeavours to reveal how reputational mechanisms have come to address adverse selection issues like the ‘lemons problem’. In essence the central argument of the lemons theory is that consumers when faced with incomplete information will tend to produce suboptimal outcomes. In the second hand rental car market as buyers face information barriers they only offer low prices, causing higher quality second hand cars to exit the market knowing they can’t get a good price – hence your only left with lemons. Signalling information offered by services like Amazon through their reviewing system can ameliorate quality concerns by allowing consumers to establish a better sense of a seller’s reputation. Whether or not it overcomes the lemons problem remains to be seen but undoubted advances have been made in breaking down informational constraints that would have previously impeded economic activity.
To be sure these mechanisms are far from perfect. Online anything presents a myriad of issues, but of most importance is the question of whether people use these mechanisms as they were intended. Interestingly economic considerations of these issues often leads to game theory analysis – figuring out the how buyers and sellers optimise their behaviour often points towards how to design mechanisms to ensure they’re being used right.
Ultimately therein lies the incredibly powerful impact of an innocuous (and well-designed) online rating/feedback systems. By partaking in mechanisms that strengthen marketplace interactions a new era of economic cooperation has in place founded on the age old adage that ‘honesty is the best policy.’
Reputation Mechanisms – Chrysanthos Dellarocas: http://www.mv.helsinki.fi/home/aula/Top20/dellarocas-reputation-mechanisms.pdf
How the Internet, the Sharing Economy, and Reputational Feedback Mechanisms Solve the “Lemons Problem” – Adam Thierer, Christopher Koopman, Anne Hobson, and Chris Kuiper: http://mercatus.org/sites/default/files/Thierer-Lemons-Problem.pdf
The Economics of Trust and Reputation: A Primer – Lu ́ıs M B Cabral: http://pages.stern.nyu.edu/~lcabral/reputation/Reputation_June05.pdf’
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