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

This paper studies the impact of quality disclosure on the entry and exit dynamics of firms in an industry with many firms. We develop a novel theoretical model that elucidates two key forces through which quality disclosure drives market dynamics: (1) the direct effect, which pertains to changes in consumers' preference for a firm upon learning its quality, and (2) the competition effect, which relates to changes in a firm's competitive environment once consumers learn its competitors' qualities. Depending on which force dominates, several scenarios can emerge. In some instances, quality information intensifies competition to the extent that high-quality firms are discouraged from entry, while in some cases, it reduces competition so significantly that even low-quality firms are encouraged to enter. We empirically test these model predictions using a unique dataset that tracks the entry and exit of restaurants and consumers' online review activities in Texas from 1995 to 2015. Our results show that different market types in Texas give rise to different scenarios. In college-town markets, all firms are discouraged from entry including high-quality firms, whereas in highway-exit markets, all firms are encouraged to enter including low-quality firms. In other markets, high-quality firms are encouraged to enter but low-quality firms are deterred. On the exit side, the effect is consistent across all market types: young high-quality independent firms are encouraged to stay longer, whereas young low-quality independent firms are driven out of the market sooner. No significant impact is found for either chain or established independent restaurants.