In class we discussed the characteristics of the market for lemons. In this case there is asymmetric information between the buyer and seller. While presumably the seller knows whether the car is good or not, the buyer cannot tell. This situation is very similar to the online market of buyers and sellers found in online auctions.

Several online auction sites, including eBay, rely on feedback systems in order to help minimize the risk involved in a transaction between two people who have had no previous interaction with one another. A paper by Daniel Houser and John Wooders provides an interesting analysis of these systems and their economic effects. As in the market for lemons, buyers experience risk due to the uncertainty of the transaction. The seller may not deliver the item and its quality cannot be guaranteed. However, unlike the market for lemons the seller also experiences risk since the buyer may fail to pay for good. Houser and Wooders examined the effects of eBay users feedbacks scores to determine if the reputations of buyers, sellers, or both have a statistically significant effect on selling price.

In order for these feedback systems to be effective, positive feedback profiles should allow sellers to obtain higher prices for the items they sell, providing an economic incentive for establishing and maintaining a good reputation. In such systems, a seller’s feedback score essentially represents the probability that he will deliver the item as described. This is analogous to the fraction of cars that are good in the market for lemons. As we saw with the market for lemons, this suggests that the buyer’s expected value for the item should increase as feedback score improves. This produces the desired reinforcement of seller’s reputations. However, we know that in second price sealed bid auctions that the each persons equilibrium bid is their expected value of winning. This suggests that the bidders reputations does not have an effect on price.

These assumptions were consistent with the results observed in the Houser and Wooders study. It was found that the seller’s reputations based on the numbers of positive and non-positive comments left have a statistically significant impact on selling price. As expected, positive comments increase selling price and and negative comments decrease price. It was also shown that bidder reputation has little effect on price. Based on the principles of the market for lemons, if the probability that buyers would fail to deliver the item was too high buyers would assume that all sellers would default on the transaction or their offer price would be so low that only bad sellers would use the site. This situation would cause the market to collapse and eBay would fail. Thus, the feedback system helps provide buyers with a reasonable estimate of a probability of a good transaction and ensures that these probabilities are high enough that eBay’s market prospers.