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The Effect of Quality Disclosure on Firm Entry and Exit Dynamics: Evidence from Online Review Platforms

This paper develops a theoretical model that studies the impact of quality disclosure on the entry and exit dynamics of firms in an industry with many firms. We employ a novel dynamic oligopoly game framework and use the oblivious equilibrium concept to solve the game. We unravel two key forces through which quality disclosure drives market dynamics: (1) the direct effect, which is the change in consumers’ preference for a product once they know the true quality, and (2) the competition effect, which is the change in the competitive environment due to quality disclosure. Depending on which force dominates, several scenarios are possible. In some cases, quality disclosure can drive competition to such a fierce level that high-quality firms are discouraged from entry. To test our model predictions, we use as a case study the impact of online reviews on the market dynamics of the restaurant industry in Texas. Using a unique dataset that tracks the entry and exit of restaurants and consumers’ online review activities, we empirically test the effect of quality disclosure through online reviews. Results confirm the most common predictions of our model, where the direct effect dominates the competition effect: the penetration of online review platforms encourages the entry of high-quality independent restaurants and speeds up the exit of young low-quality independent restaurants. No significant impact is found for either chains or established independent restaurants.