Price and advertising competition in an online marketplace: The tradeoff between quality and cost

Abstract

We investigate how two sellers selling products of different qualities and costs compete in an online marketplace wherein advertising is the only means to attract customers. We build a one-stage competition model, in which each seller decides the product price and advertising intensity simultaneously. With mild assumptions, this model is reduced to a one-dimensional competition model on advertising intensities, which exhibits advertising spillover that drives one seller’s demand by its rival’s advertising effort. By characterizing the competition equilibrium in four possible forms, we find that if the cost-quality difference ratio between the two sellers takes a certain value, then they advertise equally, price at the same profit margin and obtain the same profitability, reaching a symmetric competition result. This ratio determines which seller makes more profit, whereas the expensiveness of advertising determines the form of equilibrium. We further find that if one seller has private cost information, it may alter the result of who makes more profit.