Price Competition and Endogenous Valuation in Search Advertising

This article studies how to endogenously assess the value of a "superior" advertising position in the price competition and examines the resulting location competition outcomes and price dispersion patterns. The authors consider a game-theoretic model in which firms compete for advertising positions and then compete in price for customers in a product market. Firms differ in their competence, and positions are differentiated in their prominence, which reflects consumers' online search behavior. They find that when endogenously evaluated within the product market competition, a prominent advertising position might not always be desirable for a firm with competitive advantage, even if it is cost-free. The profitability of a prominent advertising position depends on the trade-off between the extra demand from winning the position and the higher equilibrium prices when the weaker competitor wins it. Furthermore, the authors show that the bidding outcome might not align with the relative competitive strength, and an advantaged firm might not be able to win the prominent position even when it values that position. They derive two-dimensional equilibrium price dispersion with the realized prices at the same position varying and the expected prices differing across different positions. They find that the expected price in the prominent position might not always be higher, implying that an expensive location does not necessarily lead to expensive products.