Abstract:

Online consumer product reviews have become very popular and influential in consumers’ purchase decisions. I study how competing firms choose advertising and prices when customer reviews are available and when firms may build up loyal customer bases. The model predicts that higher-rated firms are more likely to be dominant in advertising. In other words, online reviews complement firms’ advertising. I also analyze an extreme case of the model: an entry game in which an entrant and an incumbent interact. I find that the availability of customer reviews undoes the “fat-cat” effect of a big incumbent with a lot of loyal customers. An incumbent with a high enough ratio of good reviews can successfully deter entry and maintain a high profit. Comparative statics of the theory model can explain the pattern of advertising response to Yelp ratings found in the empirical RDD paper. Intuitively, when the capacity limit of a local business becomes binding, a jump in the display rating will reduce the complementary effect of online reviews on advertising.

Your participation is warmly welcomed!