We consider the strategies of online advertising providers, firms, and consumers in the context of ad listings assigned by a generalized second price auction. The first part of the paper develops a model of consumer responses to ad listings and product offerings from the included firms and uses this behavioral model to derive optimal bidding functions for the firms. We show that the relationship between per-sale margins and product-consumer match probabilities (“relevances”) must meet certain conditions to rationalize this equilibrium for consumers and firms; in particular, we give the conditions for consumers to rationally search from the top of the listing downward. Next, we turn to the incentives facing the ad server to alter the relevances and margins of the firms and the search costs and valuations of the consumer pool. While these incentives align with the desires of consumers, they may conflict with those for firms. We calculate the optimal number of slots for the ad server to offer, which is less than that desired by firms and consumers. We also show that the ad server has an incentive to subsidize its own competitor in the product market. These results have important implications for competition policy, innovation, and online content provision.
Available at: http://works.bepress.com/cgibbons/2/