Cooperation Without Enforcement? A Comparative Analysis of Litigation and Online Reputation as Quality Assurance Mechanisms

Commerce depends on buyers and sellers fulfilling their contractual obligations; mechanisms inducing such performance are essential to well‐functioning markets. Internet‐enabled reputation mechanisms that collect and disseminate consumer feedback have emerged as prominent means for inducing seller performance in online and offline markets. This paper compares the ability of reputation and more traditional litigation‐like mechanisms for dispute resolution to induce efficient economic outcomes. We use a game‐theoretic formulation and derive results for their relative efficiency and effectiveness individually or as complements. We find that the popular view of reputation as an efficient and relatively costless way to induce seller effort under all circumstances is incorrect; reputation is less efficient than litigation in inducing any given level of effort. Thus, reputation improves efficiency only in settings where the high cost of litigation, insufficient damage levels, or low court accuracy induce suboptimal effort or cause market failure. When adverse selection is important, reputation helps reveal the true types of market participants, which may offset its higher cost of inducing effort. Finally, adding reputation to existing litigation mechanisms increases seller effort and may require adjusting damage awards to avoid inducing excessive effort that reduces economic efficiency.