Research Note–Performance-Based Advertising: Advertising as Signals of Product Quality

Performance‐based advertising is becoming increasingly popular in the online advertising industry, where advertisers pay the publisher only when the advertisement generates an ‘action’ (e.g., a click‐through or a purchase). This paper illustrates that adopting this emerging advertising scheme has profound impacts on one fundamental function of advertising–signaling product quality. We identify several important dimensions that affect the signaling function of performance‐based advertising relative to its traditional counterpart (impression‐based advertising). These include: (1) information–total advertising expenditure is determined after the demand is realized, so it is unobservable to consumers when making purchase decisions; (2) ad performance–the measured ‘performance’ (e.g., recorded click‐throughs) includes actions generated by first‐time buyers (i.e., advertising performance) and actions generated by repeat buyers (i.e., product performance), which increases the cost of signaling through advertising; (3) demand uncertainty–the merchant pays only when a response to the advertisement is generated, which reduces the merchant's advertising uncertainty. We build a model of performance‐based advertising by explicitly incorporating these factors, and we derive the conditions under which switching to performance‐based advertising will (a) disable or strengthen the signaling function of advertising, (b) help or hurt the merchant, and (c) lead to a higher or lower advertising expenditure.