Abstract
We study a firm's choice between online and physical markets with respect to product quality. We analyze two contrasting driving forces: On the one hand, online consumers cannot physically inspect the products prior to purchase. This provides the firm with the incentive to hide low-quality products online. On the other hand, consumer reviews and the larger market size may attract higher qualities to the online market. Using a simple yet flexible framework, we show that the firm's choice of a marketplace can disclose or hide product quality. If marginal cost is convex in quality, the firm's choice will be characterized by a cut-off quality level, below which the firm will choose the online market. If marginal cost is concave in quality, both high-end and low-end qualities may choose the online market, leaving the physical market to intermediate qualities. Overall, we show that consumer reviews can alleviate, but do not eliminate, the “lemons problem”. The pooling result in the case of concave-in-quality marginal cost provides a caveat for empirically testing the effectiveness of online consumer-review mechanisms.
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