How does online advertising affect consumer behaviour, product pricing and competition? To analyse this, I develop a theory of digital markets where an intermediary provides a platform for firms to advertise their product and where consumers need to engage in costly search if they want to learn about the product characteristics. First, I show that when prices are observable prior to the costly product inspection, a more prominent (higher in the search order) firm charges a higher price and earns a higher revenue. Second, I augment this model by allowing the intermediary to determine endogenously the order in which products are displayed and the advertising commissions to be paid (per-click), through an auction. I show that the pass-through from these commissions to product prices is higher for a less prominent firm, thus restricting its ability to compete using price. This asymmetry in equilibrium lowers competition, consumer surplus and total transactions in the product market. Third, I show that the pay per-click business model is intermediary-optimal while the pay per-sale and the consumer subscription fee models improve consumer surplus at the expense of the intermediary. Fourth, I provide novel empirical evidence that is consistent with some key predictions of the model. These results inform the ongoing policy discussions on the effect of dominant digital platforms on product market concentration.
This is an online seminar using Cisco Webex. You will receive the login data with the invitation to the talk.