Two-sided service markets: Effects of quality differentiation on market efficiency

Determining the effects of quality differentiation on the efficiency of two-sided service markets is challenging. The presence of private information on both market sides and the heterogeneity of sellers can lead to substantial economic inefficiencies. Hence, this paper investigates how quality-differentiated sellers affect market efficiency from the perspective of mechanism design theory. First, we characterize second-best mechanisms for matching buyers and sellers. We then propose a heuristic algorithm for approximating the welfare-maximizing match outcomes. Based on empirical data, our simulation study suggests that an increased quality differentiation can reduce market efficiency; however, this inefficiency vanishes as the market size increases.