Quality Sorting, Adverse Selection, and Pricing in Electronic and Physical Markets

Abstract

Markets can yield significant economic benefits by improving transaction efficiency, but effective design is necessary to achieve these benefits. We compare a physical market to a discrete electronic market in the wholesale used vehicle industry to evaluate how their different designs work for different types of transactions. We find that buyers and sellers balance adverse selection costs and other transaction costs when using the two markets, with the physical market serving as the general exchange and the electronic market serving as a spot market for vehicles with low adverse selection risk. These findings increase our understanding of how sellers and buyers distribute supply and demand between physical and electronic markets in industries in which they co-exist. They also increase our understanding of how information technology can improve market function in wholesale environments.