Better Is Better? Signaling Paradoxes in Performance-Based Advertising

Abstract

Under performance-based advertising, firms pay only for measurable consumer actions, such as clicks or sales. However, these actions may result from factors other than effective advertising. For example, a high-reputation seller is more likely to generate more actions than a low-reputation seller. If such consumer actions are counted toward advertising performance, a high-quality firm is penalized because it has to pay more than necessary to signal its quality. Without addressing these paradoxes, it becomes increasingly challenging for a high-quality firm to signal its quality under the performance-based advertising scheme. Our research extends advertising signaling theory, which primarily focuses on new products without an established reputation and assumes that the advertising reaches the entire market (e.g., Milgrom and Roberts 1986 , Feng and Xie 2012 ). Instead, we consider products that may have an established reputation (e.g., newer versions of the iPhone) and allow for the scenario that not every market segment can be reached by the advertising. We identify two paradoxes that arise from performance-based advertising and discuss methods to mitigate these paradoxes by proposing different ways of measuring advertising performance.