New study indicates customer reviews are effective in regulating businesses

Proponents of licensing — and other forms of regulation –– proclaim that customers usually lack sufficient information to measure the quality or safety of products. In this case, licensing signals a seller’s ability to offer safe and high-quality goods and services. Lawmakers and other groups have used this reasoning to expand licensing to cover multitudes of occupations and workers.

Research supporting this information asymmetry is, however, scant. According to evidence, licensing rarely improves the quality or safety of products. On the other hand, licensing restricts supply, thereby raising prices, and deters low-income individuals from entering lucrative professions.

The idea that licensing improves quality has been debunked, especially by research showing that licensing has little to no effect on consumer choices. In fact, evidence from one study indicates that private regulation through online reviews plays a much more significant role in influencing consumer choices than does licensing.

The extent to which reviews reflect overall safety and quality is unknown. However, reviews are more likely to reflect things that consumers do care about, and are therefore useful. This is supported by a new study that analyzed how Yelp reviews affect restaurants in New York.

Researchers Chiara Farronato and Georgios Zervas, who used Yelp data to ascertain how reviews affect consumer choices, found that “restaurants are significantly less likely to sell out” following a bad hygiene review. Moreover, restaurants take Yelp reviews into account when formulating their hygienic practices.

One important thing the researchers note is that reviews are more reflective of hygiene dimensions that customers can easily observe, such as food temperature. Reviews, however, do not offer information on other hygiene dimensions like facilities maintenance, which regulators can easily measure. So, for that reason, online reviews cannot entirely replace regulation.

Regardless of that fact, this study shows that there is a role for the market to play when it comes to regulating goods and services. In an era when customers have easier access to information (through the internet and other means), online reviews offer a role for customers to control some dimensions of safety and quality –– especially those affecting them –– without imposing significant costs on businesses.

Unlike licensing, online reviews do not deter individuals from entering certain occupations or offering certain goods. Neither do they restrict supply. Instead, reviews allow all types of suppliers to come into the market and be judged on the basis of the quality and prices of their goods and services.

Online reviews can reduce the regulatory burden that businesses incur while providing high-quality and safe products –– especially if they are used as a substitute for government regulations that measure safety and quality indicators that consumers can easily observe.