Google Economics. A Model of Leadership in Search Advertising

1. Google Economics.A Model of Leadership in Search Advertising by Federico Etro University of Venice, Ca’ Foscari Saint Petersburg, October 2012 HSE Center of Market Studies and Spatial Economics

2. Main questions: What are the incentives of leaders in multisided markets to adopt potentially abusive strategies against followers? Are there potential abuses of dominance in online advertising (think of EU, US,… investigations)?

3. Literature: Theory of multisided markets: Rochet-Tirole (2003, Rand) Armstrong (2006, Rand), Weyl (2010, Aer), Belleflamme-Peitz (2010, EER) Theory of leadership: Fudenberg-Tirole (1984, Aer); Whinston (1990, Aer); Bonanno-Vickers (1987, JIE) maybe with entry: Etro (2006, Rand; 2008, EJ), Tesoriere (2008, IJIO), Kovac et al (2010, JEDC), Etro (2011, EER)

4. The Market for Online Advertising a two sided market with a leader (typically Google, but Baidu in China) search advertising is aimed at online transactions (text ads, CPC), a key difference compared to traditional advertising (> complementarity) display advertising is aimed at brand awareness (graphic ads, CPM) but behavioral advertising leads again to demand fullfillment (Etro, 2012, Ch. 11 in “Advances in the Analysis of Competition Policy and Regulation”, Katsoulacos and Harrington Eds, Elgar)

5. The Market for Online Advertising Goldfarb and Tucker (2011, Management Science) look at US personal injury lawyers: prices for ads on Google are 5-7% higher in States where clients cannot be contacted by (e)mail (> substitutability) but: this applies mainly to email advertising (still online) forbidding mail is equivalent to an infinite price increase, not a small increase (as in the SSNIP test) this evidence hardly applies to a EU context too weak evidence against the separability of the markets for on and off line ads

6. The Market for Online Advertising in search advertising the platforms compete to conquer the largest number of visitors (and an auction sets a price per click), i.e.: close to competition in quantities in display advertising the platforms compete in prices per impression, i.e.: close to competition in prices

7. The Market for Online Advertising in search advertising network effects are peculiar for two reasons: scale in search (N visitors improves search algorithms) >> RPS has S shape >> role of the leader crucial - exclusivity (or privileged) agreement between the dominant firm and hardware or software distributors to install only its search-related services (Google toolbar? agreements with Adobe, iPhone, Firefox?) or websites (Youtube?) and advertisers to rely only on its platform multihoming on both sides: web visitors (search “one click away”) and advertisers (comparing ROIs) >> role of the leader crucial - limiting multihoming or simply at raising its costs (contracts with which Google prohibits advertisers from using competing platforms, and for the exclusive use by Google of the data on its clients which prevents them to perform data analysis to compare ROIs.

8. The Market for Online Advertising click-weighted auctions (to manipulate the willingness to pay) other peculiarities: vertical search (search platforms focus on specific issues, as news, travel information, academic works, videos, maps..): if a dominant platform gives priority to its own vertical services and diverts traffic away from its competitors, it is destined to reach leadership independently from the consumers' preferences search intermediation: multihoming should be the rule - but exclusivity agreements limit catch up (Amazon, eBay, Ask, AOL, CNN, Friendster, MySpace..) barriers to entry due to scale in search (Argenton and Prufer, 2011, suggest to require search engines to share their data on previous searches) and to the current costs of adopting multiple ads system

9. Theory of leadership: in duopolies (Fudenberg and Tirole, 1984, AER) the commitment of the leader depends on the form of competition and on the impact on marginal profitability with endogenous market structures (Etro, 2006, Rand; 2008, EJ) it depends only on the impact on marginal profitability (on vertical restraints, bundling and other antitrust apps see Etro, 2011, EER) what happens in multisided markets?

10. Modeling search advertising: Platform profits Microfoundation under competition in quantities (search ads): - n platforms, one advertiser (equalizing ROIs on different platforms):

11. Modeling search advertising: NC consumers: Rochet-Tirole rules for symmetric competition: pA - pC – c = pA /eA = pC / eC ……

12. Modeling search advertising: Network effects > modified Rochet-Tirole rules: pA - pC – c = pA /eAA = pC /eCC +pA / eAC Endogenous market structures: pA - pC – c = …=F/AC

13. Modeling search advertising: Commitments Quantity (Ci) leadership > modified Rochet-Tirole rule > (small network effects) lean & hungry look: reduce services and pC to be aggressive on ads prices > (large network effects) top dog: overinvest to increase willingness to pay of advertisers Scale in search (more visitors reduce the cost per transaction) > overinvestment to increase Ci and lock in the market into a monopoly (as in Argenton & Prufer, 2011) Click-weighted auctions (overinvestment to manipulate the willingness to pay pA(..)) Exclusivity agreements

14. Leadership: Fixed entry, no network effects > Lean and hungry look: Scale in search > Top dog, dominance Click-weighted auctions > Top dog: EMS: same results

15. Modeling display advertising: Microfoundation under competition in prices (display ads, see Etro, 2012, Ch. 11 in Katsoulacos and Harrington Eds): Commitments: Price leadership (pC) > modified Rochet-Tirole rule > Puppy dog: increase pc(reward to content providers) to accommodate on pA Mergers (Doubleclick?) Exclusivity agreements

16. Conclusions: A deeper theory of leadership in multisided markets is needed to understand abuse of dominance issues Online advertising is an extremely complex market in which multiple potential abuses by the leader are possible - Promote endogenous entry of competitors is always the priority