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

Performance-based advertising is becoming increasingly popular in the online advertising industry, where advertisers pay the publisher only when an "action" (e.g., a click-through or a purchase) is generated by the advertisement. This paper examines how the performance-based scheme affects one of the fundamental functions of advertising—signaling product quality. We show that switching to performance-based advertising will disable the signaling function of advertising unless the publisher can effectively convey crucial information to consumers (i.e., the advertising scheme as well as the per-unit advertising expenditure of the merchant). We discuss some possible mechanisms to communicate such information. Our analysis also reveals that two critical factors significantly affect the signaling function of performance-based advertising: (1) The demand uncertainty factor, which measures advertisers' uncertainty about their potential market through advertising, and (2) the advertising performance over-measure factor, which describes the extent to which product performance accounts for advertising performance. Adopting the performance-based advertising scheme (a) increases (reduces) the number of situations in which advertising can be used to signal quality when the over-measure factor is sufficiently small (large); (b) leads to a shared interest for the merchant and the publisher (i.e., a win-win or loss-loss situation) in the presence of either a weak or a strong over-measure factor, but a conflict of interest (i.e., a lose-win situation) in the presence of a middle-range over-measure factor; and (c) is more likely to benefit the publisher than the merchant, and is more likely to be advantageous in markets with high demand uncertainty and for merchants with strong concern about risk.