1. Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Market Intermediation Part IX. Market Intermediation Information and reputation in intermediated product markets Chapter 23. Information and reputation in intermediated product markets

2. © Cambridge University Press 2010 2 Objectives Chapter 23 - Objectives Learning objectives Chapter 23. Learning objectives Understand how consumers can access and process information more efficiently if they use the service of an intermediary Information overload and information gatekeeper Gatekeepers who provide price information in search markets Recommender systems Analyze asymmetric information problems Intermediary can act as a certifier Reputation systems Learning objectives Chapter 23. Learning objectives Understand how consumers can access and process information more efficiently if they use the service of an intermediary Information overload and information gatekeeper Gatekeepers who provide price information in search markets Recommender systems Analyze asymmetric information problems Intermediary can act as a certifier Reputation systems

3. © Cambridge University Press 2010 3 Information overload Advertisers compete for the limited attention span of consumers Consumers select randomly and adjust their attention span to the expected quality of the match Firms are assumed not to be competitors in the marketplace Due to the limited attention span they compete with each other for the consumers’ attention ntermediation and information Chapter 23 –Intermediation and information Lesson: When consumers incur costs when sampling and processing, there is overload in equilibrium: consumers sample fewer messages than they have received.

4. © Cambridge University Press 2010 4 Information overload (cont’d) Higher cost of sending messages  unwanted messages never make it into the mailbox of the consumer Beneficial role of an information gatekeeper in this market Sets price in such a way that the information overload is avoided ntermediation and information Chapter 23 –Intermediation and information Lesson: An information gatekeeper who increases the cost of sending messages can avoid the information overload in the market.

5. © Cambridge University Press 2010 5 ‘Infomediaries’ and competition in search markets Information acquisition and diffusion process is mediated by a profit-maximizing information gatekeeper Virtual marketplace eliminates geographic boundaries between (two) local markets Timing of the Game: Stage 1: intermediary announces Access fee to firms which post their prices on the website Subscription fee to consumers who access price information from the website Stage 2: consumers decide whether or not to subscribe Stage 3: firms choose their price for the product and decide whether or not to post it on the website Stage 4: consumers shop ntermediation and information Chapter 23 –Intermediation and information

6. © Cambridge University Press 2010 6 ‘Infomediaries’ and competition in search markets (cont’d) Optimal shopping by consumers Nonsubscribing consumers visit and purchase from their local firm Subscribing consumers First visit the website Purchase at the lowest price available there If no price is listed, they visit and purchase from their local firm ntermediation and information Chapter 23 –Intermediation and information

7. © Cambridge University Press 2010 7 ‘Infomediaries’ and competition in search markets (cont’d) Firms’ pricing and posting decisions Symmetric Nash equilibrium When access fees are not to high firms are indifferent between posting and not posting their price Posted prices are always lower than nonposted prices Virtual marketplace eliminates geographical distance Each firm can use it to steal business from its rival Price dispersion is observed at equilibrium ntermediation and information Chapter 23 –Intermediation and information

8. © Cambridge University Press 2010 8 ‘Infomediaries’ and competition in search markets (cont’d) At stage 2: three equilibria are possible i.Inactive market for information No consumer subscribes No firm posts its price ii.Active market for information with partial consumer participation iii.Active market for information with full consumer participation Equilibria ii. and iii. exhibit price dispersion Intermediary finds it profitable to reduce the subscription fee so as to induce full consumer participation ntermediation and information Chapter 23 –Intermediation and information

9. © Cambridge University Press 2010 9 ‘Infomediaries’ and competition in search markets (cont’d) ntermediation and information Chapter 23 –Intermediation and information Lesson: Equilibrium price dispersion persists in an environment with optimizing consumers, firms and a monopoly infomediary organizing a virtual marketplace, because it is costly for firms to advertise prices on the website. All consumers choose to subscribe and are ‘fully informed’ in the sense that they buy form the cheapest firm on the virtual marketplace. Despite this fact, firms earn positive profits at equilibrium. The creation of the marketplace results in lower average prices, greater surplus for consumers and lower profits for firms. Lesson: Equilibrium price dispersion persists in an environment with optimizing consumers, firms and a monopoly infomediary organizing a virtual marketplace, because it is costly for firms to advertise prices on the website. All consumers choose to subscribe and are ‘fully informed’ in the sense that they buy form the cheapest firm on the virtual marketplace. Despite this fact, firms earn positive profits at equilibrium. The creation of the marketplace results in lower average prices, greater surplus for consumers and lower profits for firms.

10. © Cambridge University Press 2010 10 Information and recommendation networks Hypothesis: niche products are doing relatively better in the digital worlds the tail of the sales distribution becomes thicker (‘long tail’) Recommender systems similar to ‘word-of-mouth’ in the traditional world ‘community content’: reviews become a public good for the community Has the online retailer an incentive to establish a recommender system? – Loses control of the content created BUT Retailer who offers a wide selection of different products has little to fear from negative reviews for particular products Better manage warehouse stocks – Other retailers may be able to free-ride on the content that is provided BUT No evidence that large retailers use reviews from rival retailers, but consumers may not shop at the website that offers no information ntermediation and information Chapter 23 –Intermediation and information

11. © Cambridge University Press 2010 11 Case 23.2 Case 23.2 Book review in Amazon and Barnes & Noble in the US Does an additional negative report on e.g. Amazon lead to a fall of sales at Amazon relative to the sales at Barnes & Noble? Data: random selection of book titles in three short periods (two-day periods in May and August 2003 and May 2004) Additional positive review for a particular book at one retailer leads to an increase in the sales of this book at that retailer relative to the other An additional negative review is more powerful in decreasing book sales than an additional positive review is in increasing sales Case 23.2 Case 23.2 Book review in Amazon and Barnes & Noble in the US Does an additional negative report on e.g. Amazon lead to a fall of sales at Amazon relative to the sales at Barnes & Noble? Data: random selection of book titles in three short periods (two-day periods in May and August 2003 and May 2004) Additional positive review for a particular book at one retailer leads to an increase in the sales of this book at that retailer relative to the other An additional negative review is more powerful in decreasing book sales than an additional positive review is in increasing sales ntermediation and information Chapter 23 –Intermediation and information

12. © Cambridge University Press 2010 12 Information and recommendation networks (cont’d) Subjective product valuations Other recommenders use historic click and purchasing data that document actual choices of other consumers Popularity information Consumers know in advance whether some product features fit their taste but are not fully informed about a quality dimension A recommender system reporting popularity of a product my provide valuable information to consumers ntermediation and information Chapter 23 –Intermediation and information Lesson: A recommender system based on product popularity often affects mass markets and niche products differently. Niche sellers compared to mass market sellers tend to benefit more from the information released through the recommender system.

13. © Cambridge University Press 2010 13 Certifying intermediaries Model with two product qualities A continuum of buyers of mass n b Buyers have unit demand for each product Each seller has high or low quality Cost of high and low quality c H and c L, c H > c L Consumers do not observe the product quality Willingness to pay v H for high quality v L for low quality Suppose that firms can certify or brand their products No incentive to deviate to low quality Cost per buyer ψ > 0 ntermediation and reputation Chapter 23 –Intermediation and reputation

14. © Cambridge University Press 2010 14 Certifying intermediaries (cont’d) Basic certification game: Stage 1: firm chooses its quality Decides whether or not to certify quality If it certifies, it incurs a cost ψ at this point Stage 2: Consumers observe whether a product has been certified, otherwise do not observe the quality Consumers form beliefs about the product quality and decide whether to purchase Profit of a low-quality firm v L – c L Profit of a certifying high-quality firm v H – c H – ψ A firm produces high quality and certifies its product if v H – c H – ψ > v L – c L ntermediation and reputation Chapter 23 –Intermediation and reputation

15. © Cambridge University Press 2010 15 Certifying intermediaries (cont’d) Introduce an intermediary who perfectly observes the quality of each product Efforts required to obtain information on the product quality small for the intermediary but prohibitive for individual buyers Stage 1:Commission P for providing certification announced at the beginning of the game Stage 2: firms choose product quality Stage 3: intermediary then decides which products to take in Stage 4: consumers sequentially decide whether to buy the products Products arrive at random order Consumers learn the quality of each product immediately after purchase ntermediation and reputation Chapter 23 –Intermediation and reputation

16. © Cambridge University Press 2010 16 Certifying intermediaries (cont’d) Not only the seller but also the intermediary will be blamed for any deficiencies in product quality Intermediary repeatedly interacts with consumers  has strong incentive to preserve his reputation Perfect Bayesian equilibrium in which all firms provide high quality and sell through the intermediary  Intermediary bearer of reputation Rejects low-quality applicants (off equilibrium) Any product sold through the intermediary is believed to be of high quality by a consumer unless she previously experienced low quality of some other product sold trough the intermediary Suppose that v L – c L > v H – c H – ψ low quality in the absence of an intermediary incentive for a seller to produce high quality if v H – c H – P ≥ v L – c L Maximal commission compatible with seller incentives is P ≡ (v H – c H ) – ( v L – c L ) ntermediation and reputation Chapter 23 –Intermediation and reputation

17. © Cambridge University Press 2010 17 Certifying intermediaries (cont’d) Critical argument: intermediary would reject low quality An additional seller profit n b P On average, consumers will still have to make half their purchases after buying one particular product By accepting low-quality product, intermediary would lose half of its revenues If v H – c H – ψ > v L – c L intermediary can set the commission at a level up to P = ψ ntermediation and reputation Chapter 23 –Intermediation and reputation Lesson: In the presence of asymmetric information about product quality, intermediaries can become bearer of reputation. Consumers buy through a trusted intermediary, who effectively certifies quality to consumers.

18. © Cambridge University Press 2010 18 Certifying intermediaries and adverse selection Continuum of product qualities valuations All costs equal to zero Some seller types do not sell through the intermediary  are the rather low quality types Intermediary may only disclose that the true type belongs to some interval Make the interval with lower types smaller and smaller Expected quality of sellers who sell independently converges to zero  firms who sell independently obtain zero profit Intermediary can set P = Ev Intermediary can extract all the surplus from the market without any information being disclosed ntermediation and reputation Chapter 23 –Intermediation and reputation

19. © Cambridge University Press 2010 19 Certifying intermediaries and adverse selection (cont’d) If unit costs are higher than the valuation for the lowest type Rediscover a positive role for the certifying intermediary Intermediary certifies that a product is in accordance with a minumum quality standard ntermediation and reputation Chapter 23 –Intermediation and reputation Lesson: A certifying monopoly intermediary may disclose essentially no information on product quality and still extract all expected rents from the market.

20. © Cambridge University Press 2010 20 Reputation systems Facilitate communication between consumers Digitization of word-of-mouth about a seller‘s quality characteristics Amazon marketplace Buyers can rate retailers after a transaction is completed Model Two populations of consumers A period-1 population that is only active in period 1 A period-2 population that is only active in period 2 Firm commits to its quality at the beginning of the game ntermediation and reputation Chapter 23 –Intermediation and reputation

21. © Cambridge University Press 2010 21 Reputation systems (cont’d) Reputation system allows period-1 consumers to report observed quality to period-2 consumers Postulate that consumers want it to be known how the product has performed fellow period-2 consumers can make informed decisions ntermediation and reputation Chapter 23 –Intermediation and reputation Lesson: Reputation systems can solve asymmetric information problems between firms and consumers and are thus valuable for firms.

22. © Cambridge University Press 2010 22 Reputation systems (cont’d) Markets such as eBay on which price is determined through auction Role for reputation systems even if all consumers are informed before purchase Guide consumers to the more valuable products Consumers have to select the auction they want to participate in Quality uncertainty at the ex ante stage In the auction itself all asymmetric information has disappeared so that consumers pay their true valuation if not alone in the auction If consumers knew the product quality ex ante, more would go to high-quality firms because they lead to a higher surplus in case no other bidder shows up ntermediation and reputation Chapter 23 –Intermediation and reputation

23. © Cambridge University Press 2010 23 Reputation systems (cont’d) With a reputation system that reports types, seller with a low-quality product in period 1 acquires a bad reputation in the second period Reputation system may allow the intermediary to charge for its services Make a profit from resolving asymmetric information problems ntermediation and reputation Chapter 23 –Intermediation and reputation Lesson: Reputation systems that reveal information (about product quality or the honesty of previous claims) help consumers to identify which seller type they will visit in an auction. This leads to a partial separation of firm types: high-quality firms tend to receive more visits than firms with low quality. The introduction of a reputation system is welfare-increasing.

24. © Cambridge University Press 2010 24 Review questions Chapter 22 - Review questions Review questions How can consumers react to information overload? What is the role of an information gatekeeper in a search market? How do recommendation networks affect sales? In which situations are intermediaries bearers of reputation? Do seller benefit from the presence of a reputation system on Amazon MarketPlace? Provide a detailed answer. Review questions How can consumers react to information overload? What is the role of an information gatekeeper in a search market? How do recommendation networks affect sales? In which situations are intermediaries bearers of reputation? Do seller benefit from the presence of a reputation system on Amazon MarketPlace? Provide a detailed answer.