Adverse selection induces economic limits to market substitution. If quality uncertainty persists in both internet and traditional marketplaces, a second-best equilibrium with parallel market segments may arise. Positive trade in parallel segments implies that the information cost advantage of one marketplace is exactly offset by a more severe adverse selection problem associated with non-observable quality variables. The electronic marketplace providing dominant search means contains all segments, while the traditional market may lack some segments. These missing segments are characterized by low quality expectations given the vector of advertised quality signals. The analytic results are confirmed by an empirical investigation of used-car trade. Thus, the study also provides an estimate of the price differential between the electronic and the traditional marketplace.
E-Commerce market substitution adverse selection efficient search and learning