The Dynamics of Reputation and Status on Virtual Marketplaces

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1 The Dynamics of Reputation and Status on Virtual Marketplaces Morten Thanning Vendelø Copenhagen Business School Department of Informatics Howitzvej 60, 4. DK-2000 Frederiksberg Denmark tlph: Presented at the Symposium on: The Role of Reputation in a Globalizing Economy, at The 43rd Western Academy of Management Conference, in Santa Fe, New Mexico, March

2 The Dynamics of Reputation and Status on Virtual Marketplaces Morten Thanning Vendelø Copenhagen Business School Key words: Reputation, status, virtuality Recent decades have witnessed a dramatic growth in the number of information technology applications used by firms. More recently they began to use the Internet for transactions with suppliers and customers, and thus, the phenomenon of electronic commerce emerged. When firms use the Internet for transactions with suppliers and customers they enter virtual marketplaces. Among Internet gurus, Internet consultants and in the popular press virtual marketplaces have got a lot of attention. Especially, it has been argued that virtual marketplaces are far more efficient than physical marketplaces, as on virtual marketplace customers' search cost goes down, and thus, customers can consider many more suppliers and products than previously. Hence, it has been predicted that the "old fashioned" physical marketplaces would soon dry out (Hamel and Sampler, 1998). A central assumption in this presentation is that if we want to understand the dynamics of virtual marketplaces we must investigate the dynamics of reputation and status on virtual marketplaces. For this purpose the presentation draws on economic models of reputation and sociological mo-dels of status, as these models suggest that expectations to the future performance of a firm re-sult from different market dynamics. The presentation examines possible changes in search costs and information richness on virtual marketplaces, and some consequences of these chan-ges for different types of products. It discusses dynamics of reputation and status on virtual marketplaces, and some implications regarding reputation and reputation formation on virtual marketplaces. Finally, building on the insights from these discussions the presentation will look at possible strategies for firms globalizing by entering virtual marketplaces. Why is Reputation Important on Virtual Marketplaces? The risks associated with acting on virtual marketplaces are higher, regarding payment, distribution and seller opportunism (Shapiro and Varian, 1999), and thus, trading on virtual market-places makes buying decisions more complex. Also, customers might be concerned if a seller will provide the ordered product on time and can fulfill his promises about its quality 2

3 (Strader and Shaw, 1997). As noted by Hoffman et al. (2000, p. 3):... the recent introduction of the Internet, computer and communication technologies allow potential trading partners to be anywhere. Trades can take place at any time, and almost any degree of anonymity can be guaranteed. But this anonymity has increased the potential for opportunistic behavior, and has created a public outcry for solutions. An important reason for the increased anonymity is that electronic commerce relies on non- F2F interaction between the buyer and the seller, and this increases the buyer's vulnerability (Ambro-se and Johnson, 1998). The reputation of the seller remedies this problem, as it provides infor-mation about what to be expected from the seller in the future. Thereby, reputation is a valuable input to customers' decision making concerning which product to buy and where to buy it. Hen-ce, reputation facilitates economic transactions in an uncertain world, as it helps minimizing costs and maximizing rewards associated with a transaction (Salem et al., 1998). Economic Models of Reputation Economic models of reputation assume that the quality produced in past periods is a source of information about current quality (Allen, 1984; Shapiro, 1983; Wilson, 1985), and thus, it is assumed that there is a tight connection between the reputation of a producer and the quality produced by that producer. Hence, when the quality of the products produced by a firm goes down, so does the reputation of that firm. In economics the concept of reputation exist because of imperfect or asymmetric information. If all actors had full information about their counterparts resources, skills, abilities, etc. they could easily decide with whom to exchange and at what price. Because with perfect information it is possible to have markets in which prices reflect all the necessary information, and therefore, re-flect the economic value of the goods. In contrast when imperfect information exists, prices are an imperfect indicator of the economic value of goods and markets can be described as imper-fectly competitive. Consequently, actors must to rely on additional information, such as reputa-tion, when assessing the value of goods. Sociological Models of Status Sociological models do not assume a connection between produced quality and status. 3

4 Instead, status is connected to the hierarchical ranking of positions in a social structure (Ossowski, 1963). Hence, expectations about current quality produced by a firm develops from the position of that firm in a status hierarchy and from the affiliations it develops with other organizations through exchange relations. Ergo, the status of a firm depends on both its position within those networks of which it is a part and on which networks it participates in (White, 1981, cf. Podolny, 1993). Studying the relationship between status, performance and age of firms Ager and Piskorski (2000) found that when controlling for various performance factors (excess returns, growth and positive changes in expectations about future performance) firms of higher age are accorded higher status than are younger organizations. Also, they found that the dynamics of status vary significantly with the age of the firm. When a firm is young, the dynamics of status closely trace the economic conception of reputation. In contrast, as firms' ages, the dynamics of status in-creasingly resemble that of the sociological conception of status. Hence, young firms gain status through the quality produced in past periods, whereas older firms gain and loose status through other factors than quality produced. Search Costs and Information Richness on Virtual Marketplaces When trading on virtual marketplaces customers typically experience that more information is available faster and that search costs are lower. Also, as search costs are lower, product prices are likely to be so (Strader and Shaw, 1997). Yet, doing business on the Internet limits the richness of the information exchanged between firms and customers. Hence, although more information is available to customers on virtual marketplaces, the richness of this information is lower, and thus, less useful for building up of trust between firms and customers (Zmud et al., 1990). From above it follows that foremost customers benefit from the lower search costs on virtual marketplaces when buying search products, as the quality of these products is known or easily observable prior to purchase. Because with low search costs consumers can easily, quickly and cheaply compare larger number of prices and get the best price. Thus, with search products cu-stomers mainly have to be concerned with the risks associated with the transaction itself. In contrast, experience products have characteristics that make reputation more critical. First, as the product quality is unobservable prior to purchase, then information asymmetry concerning pro-duct quality is a problem for the customers (Akerlof, 1970), and therefore, they find it difficult to compare products offered by different firms. Hence, for firms selling experience products their reputation provides information about the quality of 4

5 their products. Second, experience products are produced and consumed some time after being purchased, and thus, the customer must put resources at risk before receiving anything in return. When combining the product type with the frequency of purchase the situation becomes a little more complicated. It has long been known that the problems related to opportunism in trading increases as the frequency of interaction goes down. As noted by Smith (1997, p. 17): Where people seldom deal with one another, we find that they are somewhat disposed to cheat, because they can gain more by a smart trick than they can lose by the injury which it does their character. Furthermore, the lower the frequency of purchase, the fewer opportunities exists to observe pro-duct quality (Rao and Ruekert, 1994), and thereby, reputation builds up slowly. Whereas the op-posite is true when frequency of purchase is high. Some Dynamics of Reputation and Status on Virtual and Global Marketplaces Having examined the changes in search costs and information richness on virtual marketplaces, as well as the consequences of these changes for different types of products we now return to the question regarding the dynamics of virtual marketplaces. Using the product characteristics described above, we first look at the situation where firms sell experience products with low frequency of purchase. In this situation there are few opportunities for evaluation of product quality and firm reliability, and the process of reputation building is slow. As a result, customers must rely on other sources of information when predicting future product quality and judging firm reliability. The status of a firm provides information useful for such predictions. Consequently, in this situation older and established firms, whether present on virtual marketplaces or not, hold a competitive advantage over younger firms trading on virtual marketplaces. Hence, young firms selling experience products with low frequency of purchase must be innovative in their sales process in order to overcome the barriers of existing status hierarchies. Looking at the opposite situation, when firms sell search products with high fre-quency of purchase, we learn that there are many opportunities for evaluation of product quality and firm reliability, and thus, markets become less imperfect and reputation builds up fast. As a result young firms trading on virtual marketplaces may provide tough competition to older and established firms, even when these are present on virtual marketplaces. 5

6 From above it follows that economic models of reputation best explains the dynamics of virtual marketplaces for search products with high frequency of purchase, whereas sociological models of status better captures the dynamics of virtual marketplaces for experience products with low frequency of purchase. Consequently, as frequency of purchase increases and as products be-come more search based, then the usefulness of economic models of reputation increases, whe-reas when the opposite happens then the usefulness of sociological models of status increases. Now focusing on the issue of becoming global by going virtual, what strategies should firms consider? Transfer of reputation seems solely likely to happen when strong brand names, such as Coca Cola, Levis Strauss or Chanel, exist. Other firms will be rather anonymous when ente-ring new marketplaces, as both reputations and status hierarchies tend to be local. Consequently, these firms must consider other ways for acquisition of reputation. A quick glance suggests that like on the local virtual marketplace the reputation problem seems smaller to firms providing search products, as they can quickly build-up reputation from repeated sales. In contrast, firms selling experience product can solely get a slow take off by relying on repeated sales. Hence, they are likely to benefit from establishing alliances with firms already present on the new mar-ketplaces. However, in both cases the situation is likely to be more complicated than this, as differences in norms and cultures regarding business relationships as well as good conduct on the marketplace can make the processes troublesome. References Ager, D. L., and Piskorski, M. J. (2000) Age Dependence in Organizational Status Hierarchies. Presented at the 4 th International Conference on Corporate Reputation, Identity and Competitiveness. May Copenhagen, Denmark, pp Akerlof, G. A. (1970) The Market for Lemons: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 84, pp Allen, F. (1984) Reputation and Product Quality. Rand Journal of Economics, 13, pp Ambrose, P. J., and Johnson, G. J. (1998) A Trust Based Model of Buying Behavior in Electronic Retailing. Proceedings of the Association of Information Systems 1998 Americas Conference, pp

7 Hamel, G., and Sampler, J. (1998) The E-Corporation. Fortune, 138, pp Hoffman, E., McCabe, K., and Smith, V. (2000) What Makes Trade Possible? Paper presented at Second KNEXUS Research Symposium On Institutionalization of Knowledge: How Institutions Develop and Spread Knowledge, July August 2. Stanford University, California, pp Ossowski, S. (1963) Class Structure in the Social Consciousness. New York, NY: Free Press. Podolny, J. M. (1993) A Status-Based Model of Market Competition. American Journal of Sociology, 98, pp Rao, A. R., and Ruekert, R. (1994) Brand Alliances as Signals of Product Quality. Sloan Management Review, 36, 1, pp Salem, A. F., Rao, H. R., and Pegels, C. C. (1998) An Investigation of Consumer-perceived Risk on Electronic Commerce Transactions: The Role of Institutional Trust and Economic Incentive in a Social Exchange Framework. Paper presented at the Association of Information Systems 1998 Americas Conference, pp Shapiro, C. (1983) Premiums for High Quality Products as Returns to Reputations. The Quar-terly Journal of Economics, 98, pp Shapiro, C., and Varian, H. (1999) Information Rules. Boston, MA: Harvard Business School. Smith, A. (1997) Lecture on the Influence of Commerce on Manners. In: D. B. Klein (ed.) Re-putation - Studies in the Voluntary Elicitation of Good Conduct. The University of Mi-chigan Press, pp Strader, T. J. and Shaw, M. J. (1997) Differentiating Between Traditional and Electronic Markets: Toward a Consumer Cost-Based Model. Paper presented at the Association of Information Systems 1997 Americas Conference, pp

8 White, H. C. (1981) Where do Markets Come From? American Journal of Sociology, 87, pp Wilson, R. (1985) Reputation in Games and Markets. In: A. E. Roth (ed.) Game-Theoretic Models of Bargaining. Cambridge, UK: Cambridge University Press, pp Zmud, R. W., Lind, M. L., and Young, F. W. (1990) An Attribute Space for Organizational Communication Channels. Information Systems Research, 1, pp

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