We propose a basic theoretical model of eBay's reputation mechanism, derive a series
of implications and empirically test their validity. Our theoretical model features
both adverse selection and moral hazard. We show that when a seller receives a negative
rating for the first time his reputation decreases and so does his effort level.
This implies a decline in sales and price; and an increase in the rate of arrival
of subsequent negative feedback. Our model also suggests that sellers with worse
records are more likely to exit (and possibly re-enter under a new identity), whereas
better sellers have more to gain from buying a reputation' by building up a record
of favorable feedback through purchases rather than sales. Our empirical evidence,
based on a panel data set of seller feedback histories and cross-sectional data on
transaction prices collected from eBay is broadly consistent with all of these predictions.
An important conclusion of our results is that eBay's reputation system gives way
to strategic responses from both buyers and sellers.