Vertical differentiation and a comparison of online advertising models

Abstract

Designing business models that take into consideration the role of advertising support is critical to the success of online services. In this paper, we address the challenges of these business model strategies and compare different ad revenue models. We use game theory to model vertical differentiation in both monopoly and duopoly settings, in which online service providers may offer an ad-free service, an ad-supported service, or a combination of these services. Offering both ad-free and ad-supported services is the optimal strategy for a monopolist because ad revenues compensate for the cannibalistic effect of vertical differentiation. In a duopoly equilibrium, exactly one firm offers both services when the ad revenue rate is sufficiently high. Furthermore, we find that a higher ad revenue rate may lead to lower service prices. Consistently across both monopoly and duopoly settings, such price reductions are more severe in the cost-per-thousand-impressions model than in the cost-per-click model. Our findings emphasize the role of advertising revenues in vertical differentiation and offer strategic guidance for monetizing online services. © 2012 M.E. Sharpe, Inc. All rights reserved.