Pay to Lose: A Theory of Digital Co-op

Abstract

Under the practice of “digital co-op”, manufacturers subsidize the online advertising expenditures of retailers that they sell their products through, even though retailers typically compete with manufacturers in the advertising market and appropriate a share of the manufacturers' channel margins. In this paper, we use a game theory model with two competing manufacturers and a single retailer to study the incentives of manufacturers to participate in digital co-op. Focusing the model on search advertising in which an ad slot is sold through a second-price auction, we obtain the key insight that a manufacturer subsidizes the advertising expenditure of the retailer to lose the auction to the retailer rather than compete with the other manufacturer for the ad slot. Furthermore, the promise of subsidizing the retailer's advertising expenditure acts as a commitment device for a manufacturer to not bid too high in the ad auction, therefore reducing the amount it has to subsidize. For a category keyword sponsorship softens competition between manufacturers, and for brand keywords it enables more effective indirect poaching of the competing manufacturer's customers. We determine the subsidy rates and bids that manufacturers should use under different conditions, and the competitive responses and outcomes that they can expect. Our insights hold for digital co-op in display advertising as well, where consumers can be targeted based on their inferred interest in the category or in a particular brand.

Keywords: search advertising, cooperative advertising, game theory, category keyword, brand keyword

JEL Classification: M31, M37, L86, D44