Price Competition and Endogenous Valuation in Search Advertising

Abstract

This paper studies how to endogenously assess the value of a “superior” advertising position within the price competition and examines the resulting location competition outcomes and price dispersion patterns. We consider a game-theoretic model in which firms compete for advertising positions and then compete in price for customers in a product market. Firms differ in their competence, and positions are differentiated in their prominence, which reflects consumers' online search behavior. We find that when endogenously evaluated within the product market competition, a prominent advertising position might not always be desirable for a firm with competitive advantage, even if it is cost-free. The profitability of a prominent advertising position depends on the trade-off between the extra demand from winning the position and the higher equilibrium prices when the weaker competitor wins it. We also show that the bidding outcome might not align with the relative competitive strength, and an advantaged firm might not be able to win the prominent position even when it does value that position. We derive two-dimensional equilibrium price dispersion, with the realized prices at the same position varying and the expected prices differing across different positions. We find that the expected price in the prominent position might not always be higher, implying that an expensive location does not necessarily lead to expensive products.

Keywords: Price Competition, Endogenous Valuation, Search Advertising, Online Search, Price Dispersion, Bidding Incentive