Online Reputation and Market Power: Evidence from the Cannabis Retail Market

Abstract

The contribution of online reputation - customarily hosted by third-party digital platforms - to a firm's competitive advantage is yet to be measured and characterized. Because this quality signal is driven by the crowd, questions arise about the characteristics necessary for other consumers to trust and act on the online reputation of a firm: arguably, the impact depends not only on the valence (average rating) of reviews, but also on their volume (number of reviews received). Does valence or volume matter more in affecting a firm's market power, i.e., its ability to charge supracompetitive prices or shield profits from new entrants' competition? In this paper, using data from the cannabis market in Washington State, we examine the relationship between online reputations and firms' market power. We estimate a structural demand-supply model where consumers update store quality beliefs using online reviews and find that stores enjoy a boost in their market power because of online reputation, particularly, the volume of reviews, while consumers benefit from their informational value. Quantitatively, online reputation allows stores entering early in the market to increase margins (1.4%) and profits (105%), contributing to about 30% of the additional profits due to early entry, compared to late entrants. However, stores entered later can also obtain similar profits in a relatively short period; thus, the review hosting platform contributes to the overall profitability of the industry. Our analysis shows that volume matters more than valence in the early periods after entry, when stores benefit even from reviews with lower rating. Overall, online reputation increases consumer welfare, despite its anti-competitive effect.

Keywords: Online reputation, Market Power, Review Platforms, Pricing, Structural Models, Consumer Welfare