Online Reputation and Litigation as Mechanisms for Quality Assurance: Strategic Implications for Profits and Efficiency

Recent advances in information technology have dramatically reduced the cost of collecting, processing and disseminating consumer feedback, thus enabling low-cost online reputation mechanisms with global reach. This paper identifies certain settings in which the ability of such mechanisms to economically aggregate feedback across a large number of different buyers and disjoint transactions can be used to facilitate new markets and to increase profits in existing ones. First, we show that when legal costs are high relative to consumer valuations, the cost of quality assurance mechanisms relying on the legal system may prevent market participation by buyers and/or sellers, whereas reputation-based mechanisms may enable transactions resulting in positive seller profits and buyer surplus. Second, we show that when the legal system provides incentives below their optimal level, introducing a reputation mechanism on top of an existing legal regime can increase performance incentives for sellers and result in more efficient outcomes. Third, we show that firms can use reputation mechanisms in conjunction with the legal system to implement a form of product versioning; for instance, when legal costs are high, offering a lower-priced product version that requires buyers to waive their legal rights and rely instead on providing seller feedback through the reputation mechanism, can increase firm profits and total surplus.