Information, Quality Sorting, and the Value of Online Reviews

Abstract

This article studies the impacts of online reviews on firm dynamics and consumer welfare in the context of the restaurant industry. Preliminary evidence suggests that restaurants that get reviews early are likely to survive, while entrants with few reviews exit early. To explore a potential explanation, I build a model featuring firms of heterogeneous quality facing static pricing decisions and dynamic entry and exit choices. Imperfectly informed consumers are modeled under the rational inattention framework. They use aggregate information provided by online reviews to form priors regarding quality but can also process additional information at a cost. If the cost to process information is high enough, young firms have to operate at very low profits even if they have high quality. The model highlights that the overall impact of online review websites depends on their effect on consumers’ prior beliefs and on the cost of obtaining information from other sources.