THE BEHAVIOR OF INEXPERIENCED BIDDERS IN INTERNET AUCTIONS

I. INTRODUCTION As has now been documented in many studies, the Internet auction market has quickly become a thriving marketplace. In the United States, the market is dominated by eBay. In the second quarter of 2007 alone, eBay users posted a total of 559 million listings, resulting in gross merchandise value (the total amount that all goods sold for) of $14.46 billion. (1) This impressive success has occurred despite the fact that bidders face substantial risks because of the nature of the market. Sellers by convention do not send goods to winning bidders until after they have received payment. The seller can then simply pocket the money or send an item of poor quality. A widespread and widely publicized example of this behavior occurred in 2002 when a seller with a history of over 6,000 properly conducted transactions sold hundreds of porcelain collectibles on 4 January 2002 but did not send the winners anything after receiving payments of about $300,000. (2) A consumer who is defrauded by a seller has little recourse because the identity of a seller is known only through an e-mail address, which can be anonymously obtained. (3) To solve this problem, rather than formally enforcing contracts, eBay has established an innovative reputation system, which allows winning bidders to post ratings of sellers' actions that are publicly viewable (and vice versa). The ratings are classified as positive, neutral, or negative. This information is also presented as a feedback rating that is equal to the number of positive reports received from unique trading partners minus the number of negative reports received from unique trading partners. (4) Potential bidders can use this information to form expectations about how the seller will behave in the future and reward sellers who develop good reputations by bidding more and more often in their auctions. The seller's benefits to a good reputation can come in two forms: an auction can be more likely to attract bidders and thus result in a sale and bidders can be willing to bid larger amounts. Most studies do find that auctions are more likely to end in a sale if the seller is more reputable; however, the results regarding the amount by which bids increase as the seller's reputation improves have been quite mixed: some find that bid amounts increase substantially as the seller's reputation improves, some find extremely small increases in bid amounts, and some find no increase in bid amounts at all. (5) The prevalence of studies that show very small changes in bidder behavior as the seller's reputation improves has led to an apparent consensus that the returns to reputation in Internet auctions are indeed quite small. For example, in the September 2007 issue of the Journal of Economic Literature, MacLeod (2007) refers to Bajari and Hortacsu's survey and notes that "the results are rather consistent. Mikhail I. Melnik and James Alto (2002), Paul Resnick and Richard Zeckhauser (2002), and Luis Cabral and Hortacsu (2004) all find that there is a positive relationship between price and quality (of the seller's reputation). However, the overall effect appears to be small." Despite this consensus, recent studies favor the hypothesis that there is a significant increase in bid amounts as the seller's reputation improves. Melnik and Aim (2005) find that the returns to an improved seller reputation increase when there is more uncertainty about product quality. Livingston (2005) shows that sellers are strongly rewarded for the first few reports that they have behaved honestly, but marginal returns to additional reports are severely decreasing. He notes that other studies may have found small increases in bid amounts because they typically assume that the relationship between the price and the number of positive reports received by the seller is linear or log linear. If marginal returns to reputation are severely decreasing, these functional forms may only pick up the small returns that occur after an initial reputation is established. …