Performance-Based Pricing : Advertising as a Signal 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 illustrates that adopting this emerging advertising scheme has profound impacts on one of the fundamental functions of advertising - signaling product quality. We identify several important dimensions that affect the signaling function of performance-based advertising relative to its traditional counterpart (impression-based advertising). These include: (1) Information - total advertising expenditure is determined after the demand is realized, so it is unobservable to consumers when making purchase decisions; (2) Ad performance - the measured “performance” (e.g., recorded click-throughs) includes actions generated by first-time buyers (i.e., advertising performance) and actions generated by repeat buyers (i.e., product performance), which increases the cost of signaling through advertising; (3) Demand uncertainty - the merchant pays only when a response to the advertisement is generated, which reduces the merchant’s advertising uncertainty. We build a model of performance-based advertising by explicitly incorporating these factors and derive the conditions under which switching to performance-based advertising will (a) disable or strengthen the signaling function of advertising, (b) help or hurt the merchant, and (c) lead to a shared interest (win-win or lose-lose) or a conflicting interest (win-lose) for the the publisher and the merchant