Research Note ---Quality Uncertainty and the Performance of Online Sponsored Search Markets: An Empirical Investigation

Online sponsored search advertising has emerged as the dominant online advertising format largely because of their pay-for-performance nature, wherein advertising expenditures are closely tied to outcomes. While the pay-for-performance format substantially reduces the wastage incurred by advertisers compared to traditional pay-per-exposure advertising formats, the reduction of such wastage also carries the risk of reducing the signaling properties of advertising. Lacking a separating equilibrium, low-quality firms in these markets may be able to mimic the advertising strategies of high-quality firms. This study examines this issue in the context of online sponsored search markets. Using data gathered from sponsored search auctions for keywords in a market without intervention by the intermediary, we find evidence of adverse selection for products/services characterized by high uncertainty. On the other hand, there is no evidence of adverse selection for similar products in a regulated sponsored search market, suggesting that intervention by the search intermediary can have a significant impact on market outcomes and consumer welfare.