Quality Uncertainty and the Performance of Online Sponsored Search Markets: An Empirical Investigation

Abstract

Online sponsored search advertising has emerged as the dominant online advertising format largely due to their "pay-for-performance" nature, wherein advertising expenditures are closely tied to outcomes. While the pay-for-performance format substantially reduces the "wastage" incurred by advertisers compared to traditional "pay-per-exposure" advertising formats, the reduction of such wastage also carries the risk of reducing the signaling properties of advertising. Lacking a separating equilibrium, low quality firms in these markets may be able to mimic the advertising strategies of high quality firms. This study examines this issue in the context of online sponsored search markets. Using data gathered from sponsored search auctions for keywords in an unregulated market we find evidence of adverse selection for products/services characterized by high uncertainty. On the other hand, there is no evidence of adverse selection for similar products in a regulated sponsored search market, suggesting that intervention by the search intermediary can have a significant impact on the market outcomes and consumer welfare.

Keywords: Sponsored search, Online Advertising, Adverse Selection, Quality Uncertainty