Performance-based Advertising: Price and Advertising as Signals of Product Quality

Juan Feng and Jinhong Xie University of Florida

Performance-based advertising

  the advertiser pays the publisher only when an “action” is generated by the ad;

  action:   click-through, purchase, download,

registration…   traditional impression-based pricing model:

  advertisers are charged for exposure, independent upon the actual performance of advertising

Major Benefits

  Internet makes it possible to   measure the performance of ads   Provide links to the specific web sites

 Pay only for results!  Advertisers are charged only if someone

clicks their ads, not when the ads are displayed.

Popular Practice

  Led by   Yahoo! (Overture),   Google (AdWords and Adsense),   MSN (AdCenter),   eBay (AdContext)

 more aggressive performance-based measures   the “cost-per-action” model ( Snap.com),   ZiXXo (pay-per-print)   Ingenio (pay-per-call),

Research Questions:

 What is the impact of performance advertising on one of advertising’s fundamental functions --- SIGNALING product quality?

Why Important?

  Internet lowers the barriers of advertising   Quality uncertainty increases.

  Is “signaling” possible?   In traditional advertising, consumer may learn

the advertising expenditure from advertising exposure.

  Consumer may not be aware of the pricing scheme;

  Advertising expenditure is NOT directly observable.

Information Policies

 Should the publisher reveal the pricing scheme?

 Should the publisher reveal advertiser’s per-unit advertising expenditure?

Literature

 Keyword auctions   Feng et al. (2007), Liu and Chen (forthcoming),

Weber and Zheng (forthcoming), Balachander and Kannan (2006), and Animesh (forthcoming), Feng (2008), Chen and He (2006),Ghose and Yang (2007), Viswanathan et al (2008)

 Publisher’s incentive to promote advertising   Hu (2004), Zhao (2005), Sundararajan (2003)

Literature (cont.)

 Advertising spending and quality of the product/service   Gerstner (1985), Shoemaker et al. (2000),

Zhao (2000), Zhang (2001), Horstmann and Moorthy (2003)

 Advertising and Signaling:   Phillip (1974), Kihlstrom and Riordan (1984),

Milgrom and Roberts (1986), Kirmani and Rao (2000) and Bagwell (2005)

Model Framework

 A monopolist advertiser with uncertain quality level (H or L)   Decides its product price (P), as well as per-

unit advertising expenditure (a)  Consumers decide

  whether to purchase,   Whether to repurchase (with probability q=H,L)

 Publisher decides   whether to announce the pricing scheme, as

well as per-unit advertising expenditure

Model Features (I)

 Advertiser is risk-averse about the performance of advertising.   Risk-aversion factor r   Performance of advertising

An Illustrative Model (cont.)   First period demand is: , where

  Assume advertisers are risk-averse with risk-aversion factor and :

  Mean-variance representation:

Impression-based Advertising (Benchmark)

 Advertising CAN signal high quality if and only if:

 The optimal advertising expenditure is:

Model Features (II)

  Assume a proportion of consumers repurchase the product through the same link provided by the publisher

  The advertisers are charged for this proportion of consumers   Over-charge factor

I. Full Information

 Advertising CAN signal if and only if:

 The H type advertiser needs to pay in order to prevent the L advertiser from mimicking

II. Only price-scheme information

 The exposure of advertising does not tie with advertising expenditure,

 when consumer observe positive advertising, they believe the advertiser to be an H type with probability 0.5,

 No separating equilibrium in which one advertiser advertises and the other does not

III. No information

 Consumers mistake the performance-based advertising as traditional impression-based advertising,

 Consumer uses advertising exposure to infer advertising expenditure,

 No separating Eq.  Consumer may misbelieve the H advertiser

as an L one.

Equilibrium---Performance-based Advertising

Condition for Equivalence

Full Informaion Case

Conditions for advertising to signal

  When full information is revealed to consumers, switching from impression-based to performance-based advertising:   Destroys advertising’s signaling function if ;   Make it easier for advertising to signal quality

if , and vice versa.   decreases in .

Advertiser’s Profit

Advertising Expenditure

What do we learn?

  Performance-based advertising benefits advertisers by reducing risk

  For publisher   Communication of the pricing scheme   Communication of advertising prices   Reduce

  For advertisers   Attract repeat purchase directly

  Combination of impression-based and performance-based pricing?

A Full Model

 Price and advertising can both serve as signals, and are endogenizely determined.

 Examine the impact of performance advertising on   The conditions for advertising to serve as a

signal   Price in a separating equilibrium   Advertising expenditure in a separating

equilibrium   H type advertiser’s welfare

Conditions Required for Price to Signal

Proposition 3 (Equilibrium Price)

Proposition 4 (Advertising Expenditure)

Proposition 5 (Advertiser's Profit)