Quality differentiation and firms’ choices between online and physical markets

We study firms’ choices between online and physical markets with respect to product quality and competition, and exam- ine consequences of transparency policies on price competition and market structure. We investigate two contrasting forces. First, since consumers cannot fully inspect an online prod- uct’s quality prior to purchase, conventional wisdom and some of the literature suggest that this attracts low-quality prod- ucts to the online market (a p o oling effect). On the other hand, the literature on vertical product differentiation indi- cates that a firm with a lower-quality product may prefer to reveal its product quality in the physical market because qual- ity differentiation helps alleviate price competition (a differ- entiation effect). We show that an entrant firm with product quality lower than that of the offline incumbent may choose the physical market, whereas the entrant with a quality higher than the incumbent’s may sell online. More generally the two contrasting forces can give rise to a wide range of product quality—from low-end to high-end—in both markets