# Competing for Consumers Online: The Advertising Strategies of. Vertically Di erentiated Firms

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1 Competing for Consumers Online: The Advertising Strategies of Vertically Di erentiated Firms Taylan Yalcin Harvard Business School, Harvard University Elie Ofek Harvard Business School, Harvard University June, 011 The authors thank seminar participants at the Marketing Science Conference (Cologne, 010) for valuable comments. The authors also thank Thomas Steenburgh, Rohit Deshpande and Sunil Gupta for their insightful suggestions.

12 Figure : Benchmark Case Demand Structure not. For instance the valuation of the marginal consumer for product i, i, satis es U i = i v i p i = U 0 = 0. Thus, all consumers who have a higher valuation, > i = p i v i, derive positive utility from product i. The valuation of the marginal consumer between products 1 and, b, satis es U 1 = b v 1 p 1 = U = b p. Thus, consumers that have valuation greater than b = p 1 p v 1 prefer product 1, and the rest of the consumers prefer product, as long as they get positive utility from purchase. Firm 1 s demand is x 1 = [1 b ] and rm s demand is x = [ b ] (see Figure ). Note that this demand structure is realized if 1 >. If this were not true, rm s product would be dominated because any consumer who derives positive utility from product would get greater utility from product 1. Hence rm never selects a price that is too high in equilibrium and this ensures that = p < 1 holds. The corresponding pro t functions are: B 1 = (1 b )p1 (1) B = (1 b )p () The equilibrium prices and pro ts are given in Table 1 under the heading Benchmark. 10

18 Figure 5: Display Advertising Outcome the low-quality rm does not advertise per Proposition 1, the low-quality rm s pro t may actually increase in advertising e ectiveness (See Figure 5). 8 This is surprising because in this region only the high-quality rm advertises and a greater advertising e ectiveness means that the proportion of consumers that only consider the high-quality product is larger, while the proportion of consumers that also consider the low-quality product is smaller. That is, the low-quality rm might be better-o if more consumers have only the high-quality product in their consideration sets. This result is due to the impact of informational disparity on price competition. When quality di erentiation is small, prices are very close to marginal costs and the pro ts are very low. In such a case, an increase in advertising e ectiveness leads to a greater level of informational disparity and alleviates price competition because it prompts the high-quality rm to raise price. This allows the low-quality rm to raise price as well, and consequently its equilibrium pro t increases. In other words, the low-quality rm might be better-o if fewer consumers have its product in their consideration sets. 8 Note that 1 + 3(1 ) p 1. 16

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