Written by Dhruvi Dedhia
Would you rather watch a movie rated 8/10 on IMDb or one rated 4/10? Or want to stay at a 5-star hotel as opposed to a 2-star one? Several studies have shown that consumers tend to be heavily affected by user reviews (i.e., ratings and feedback by consumers who have purchased the good or service previously)—one survey of over 8000 U.S. shoppers found that 98% of shoppers claimed reviews were an important factor in purchasing decisions, and 77% explicitly look for websites with ratings and reviews (Survey: The Ever-Growing Power of Reviews); another study found that 70% of consumers view online reviews as an important source of information (Lackermair et al., 2013). This has been linked to behavioral economics, particularly a phenomenon called “social proof”, wherein consumers “might make a decision based on social norms in order to gain acceptance by others”, which includes basing purchases on reviews/ratings by other people (8 Marketing Takeaways from Behavioral Economics).
However, another way to look at how online reviews play a role in economic transactions is in terms of information asymmetry, which “occurs when one party to an economic transaction possesses greater material knowledge than the other party” (Bloomenthal, 2021). Generally, sellers tend to have more information about what they sell than buyers, and might choose not to disclose certain information for obvious reasons—a used-car seller might not reveal all of a car’s defects to a potential buyer for fear they might get discouraged from purchasing it, for instance. This is an example of adverse selection, where “sellers have information that buyers do not have, or vice versa, about some aspect of product quality” (Hayes, 2023), which puts the party with less information at a disadvantage. In many cases, therefore, online reviews and ratings work to reduce information asymmetry; a study found that “electronic word-of-mouth” diminishes information asymmetry significantly in the hotel industry (Manes & Tchetchik, 2018). Online reviews and ratings thus are a medium for “screening”, which the party with less knowledge uses to reduce the information gap—i.e. when the “less informed party initiates steps or creates mechanisms to decipher or extract hidden information about the other party to make a more informed decision” (tutorchase.com, 2023).
In economic terms, this potential reduction of asymmetry theoretically means greater social welfare (Jiang and Chen, 2007), in that greater asymmetry would lead to a “welfare loss” as consumers might make purchasing decisions or economic transactions that are not in their/society’s best interests due to limited information. Asymmetric information is therefore an example of market failure, as the knowledge gap between agents means that transactions are no longer determined by the market forces of supply and demand (Tarver, 2022). However, online reviews may not always work to reduce asymmetry. A study found that online reviews contribute to making markets more efficient, increase competition, and reduce adverse selection, but these effects are often diminished by fake customer reviews, often generated by sellers to potentially boost sales (Malbon, 2013). Therefore, the possibility of promoting social welfare in online markets through reviews depends largely upon their authenticity.
While the impact of customer reviews on consumer spending and purchasing decisions may seem evident, in that people are more likely to buy a product with positive reviews, this also implies an effect on producer behavior and firm strategies. Firms generally seek to maximize profit, and thus any factor that affects consumer spending behavior is likely to be of interest to sellers. A study by researchers Rezvani and Rojas (2022) found that “…hotels’ public responsiveness to consumer reviews on online platforms can cause an increase [in] average customer ratings (a measure of firms’ online reputation)”, suggesting that firms should take into account customer feedback when strategizing. Indeed, research has shown that low ratings—and specifically, the way these ratings are displayed—encourage auto repair firms to take expensive short-term steps to improve their ratings (Hunter, 2022). Why might sellers take such costly measures to boost their ratings? The simple answer is that online reviews and ratings affect product sales—both numerical and written reviews were found to affect the sales performance of electronic products (Li et al., 2019). Particularly, studies have shown that new product sales were specifically affected by the “volume” of reviews, and such influence diminished over time (Cui et al., 2012). The same study also discusses another interesting phenomenon: negative feedback has more influence than positive feedback, which the research describes as the “negativity bias” (the tendency to “attend to, learn from, and use negative information far more than positive information” (Vaish et al., 2008)). Given that research findings suggest that negative reviews work to direct potential customers away from a product (Huang & Pape, 2020), it follows that it is likely in firms’ interests to try to improve their overall ratings and reviews, particularly given the role that the negativity bias plays in consumer behavior, as discussed above. This indicates not only that online sellers should take steps to incentivize consumers to leave reviews, but also that seller responsiveness to existing reviews could work to improve their overall rating and reputation.
Online reviews and ratings have become an integral part of the online marketplace, and directly affect the market mechanisms of demand and supply. Not only do they work to diminish market failure in the form of asymmetric information, but they also have important implications for producer revenue and sales. However, the links between online reviews/ratings and economic outcomes are not as straightforward as they may seem. There are a multitude of factors that must be considered, such as the number of reviews, consumers’ belief of the reviews’ authenticity, the effects of positive vs. negative reviews, and even the format of the review itself, given the multimodal rating system prevalent today. Thus, it is evident that the economics of online reviews relies on a complex interplay between multiple factors, even though we, as consumers, can be unaware of the connections and decisions we make based on online reviews. Looking at the (number of) stars before watching a movie, booking a hotel, or buying something may seem almost instinctive, but ratings and reviews have become an intricate mechanism in the economic and psychological aspects of transactions.
References
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