In online marketplaces, a critical objective of the platform’s intermediation is ensuring the sellers’ quality. This is particularly challenging in large marketplaces, where it’s infeasible to pre-screen all sellers, and the platform uses feedback from previous transactions to infer the sellers’ quality. However, this process matches existing buyers to new, untrusted sellers, potentially leading to a poor buyer experience. This raises a natural exploration-exploitation tradeoff in online marketplaces. Here, the authors suggest that the exploration-exploitation tradeoff is closely linked to the nature of externalities in the marketplace. Using a stylized model, they uncover a qualitative difference between exploration and exploitation, based on the underlying network externalities between buyers and sellers in the market. In particular, in many settings, they show that by focusing on exploration, the platform can achieve a higher overall rate of successful matches.
Invited article based on Banerjee 2014