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

Abstract

Performance-based advertising is becoming increasingly popular in the online advertising industry, where the advertiser pays to the publisher only when an "action" (e.g., a click-through) is generated by the advertisement. We study how the performance-based advertising scheme affects one of the fundamental functions of advertising - signaling product quality. We identify two critical factors that affect the signaling function of advertising under performance-based pricing: (1) the demand uncertainty factor, which measures advertisers' uncertainty about their potential market, and (2) the advertising performance over-measure factor, which describes the extent to which product performance accounts for advertising performance. We find that the uncertainty factor facilitates, but the over-measure factor impedes (or even destroys) the signaling function of performance-based advertising. Specifically, our results show that in the presence of the over-measure factor, switching from impression-based to performance-based advertising: (a) reduces the number of situations in which advertising can be used to signal quality, (b) increases the prices charged to consumers, (c) increases the expected advertising expenditure if the cost differentiation between the high- and low-quality firms is sufficiently high, but decreases the expected advertising expenditure otherwise, and (d) increases the advertiser's profit if the over-measure factor is low but the uncertainty factor is high, and decreases the profit otherwise.

Keywords: Advertising, E-commerce, Internet Marketing, Signaling