International Think-Tank on Innovation and Competition
SEARCH ADVERTISING AND ANTITRUST
May 1st, 2011
In November 2010 the European Commission started an investigation on potential abuses concerning the preferential treatment for Google services in its free search engine, the manipulation of the pricing system for the sponsored links, and exclusivity clauses or other restrictions for advertisers using Google services. In particular, the potential abuse is about 1) "allegedly lowering the ranking of unpaid search results of competing services which are specialised in providing users with specific online content such as price comparisons (so-called vertical search services) and by according preferential placement to the results of its own vertical search services in order to shut out competing service", 2) lowering the `Quality Score' for sponsored links of competing vertical search services, 3) imposing "exclusivity obligations on advertising partners, preventing them from placing certain types of competing ads on their web sites, as well as on computer and software vendors, with the aim of shutting out competing search tools", and 4) imposing "suspected restrictions on the portability of online advertising campaign data to competing online advertising platforms". The investigation started with the complaints of some European companies in February 2010. Other complaints have been also filed in front of the US, German and Italian authorities, mainly regarding unfair competition with publishers and other content providers.
Online advertising is a multisided market in which platforms as Google, Yahoo! and others attract at the same time Internet users and companies willing to advertise their products to these users. The more Internet users reach a platform, the more effective is an advertising campaign on the same platform. Since Internet users often join the platform with a commercial purpose in mind and use it to find information on products and offers, advertising can be tailored on them in a much more effective way than with other means. Moreover, continuous technological innovations open new ways for advertisers to be always more effective on a platform online. This generates a very limited substitutability between online and traditional advertising. In spite of this, Ratliff and Rubinfield (2010) have advanced the hypothesis that some substitutability between online and traditional advertising could exist because they both serve broad advertising goals. However they have not provided any empirical argument in support of this and have neglected a key difference: traditional advertising is aimed at building a general brand-awareness usually without a specific target audience, while search advertising is largely aimed at generating market transactions online. From this perspective, traditional and online advertising are almost always complements rather than substitutes.
Goldfarb and Tucker (2011) have provided an interesting analysis of susbtitutability between search advertising and a very particular form of offline advertising, marketing through mail and email. They used data on prices paid by U.S. personal injury lawyers in search advertising (on the Google platform) comparing states where they can and they cannot directly contact potential clients by mail or email. Their econometric analysis convincingly argues that advertising prices per click are 5-7% higher when state regulations forbid this form of offline advertising, suggesting that online and offline advertising would be substitutes. However, also this conclusion can be criticized on multiple grounds:
- it does not really apply to the substitutability between online search advertising and traditional offline advertising, but mainly to the substitutability between search advertising and a marginal part of online advertising which is e-mail advertising;
- it is not clear how to evaluate such a limited percentage change of prices in search advertising as a response to a huge change of the price of mail advertising, since forbidding snail-mail marketing is equivalent to a prohibitive increase of its price (the traditional test of market definition of a reaction to a small price increase would probably give raise to a smaller or an insignificant change in price for search advertising, suggesting that the markets would be separate).
- this natural experiment is very specific to U.S. legal marketing and hardly extends to other countries or markets (there are no similar studies for the European Union).
Search advertising is aimed at direct demand fullfillment, as witnessed by the "text-only" composition and the payments on a Cost per click (CPC) basis; moreover, platforms compete to conquer the largest number of visitors (that is they compete in quantities) and charge advertisers for the clicks they receive on their ads. As well known, Google is the leading search engine in the world, with a global share of search traffic around 85 %, against 7 % for Yahoo! and 4 % for Bing, but with even higher market shares in Europe. Google reached this position through constant innovations that have provided a wide array of services to Internet users. Beyond this, Google dominates the lucrative business of placing text ads next to search engine results. Google AdWords accounts for more than 70 % of search advertising revenue worldwide, leaving Yahoo! and Microsoft far behind.
Understanding search advertising requires first of all understanding its payment system. All the search engine platforms choose a number of advertisements to be made available in a specific order for any search query. Given the space allocated to these sponsored links, an auction pins down the market clearing price for these advertisements. Charges are typically for each click on the ad, and the highest bid for each keyword association wins, with the price given by the second highest bid: as shown by the Nobel prize Vickrey, this tends to force bidders to reveal their true evaluation of the click, which allows the auctioneer to choose the profit maximizing auction mechanism. Contrary what is usually claimed (see again Ratliff and Rubinfleld, 2010) these auctions do not necessarily add a competitive element to online advertising, but allow a dominant firm to adopt complex forms of price discrimination aimed at excluding competitors in search advertising or at extracting all the surplus from the bidders (or even both aims at the same time). Moreover, the auction process is made more complex by the different places where the ad can appear on the search page, and remains largely obscure to advertisers and competitors. Finally, most platforms have recently introduced forms of click-weighted auctions that weight bids to give priority to advertisements with a larger chance to be clicked on: this mechanism is aimed at increasing the effective willingness to pay (see Athey and Ellison, 2011, for the most complete theoretical treatment of this issue).
Scale in search
The structure of the market for search advertising depends on a particular form of network externality which is quite different from the one emerging in other markets of the New Economy. This is due to two main reasons, one related to technological issues and one related to the role of multihoming by advertisers. Let us start from the first issue, scale in search. Network effects in search are combined with a form of learning by doing (or learning by searching). This is due to technological reasons: search engines find more relevant results for each query when there are more queries and the subsequent clicks of the users provide information on what were the most relevant websites associated with particular keywords. Through this feedback mechanism, the same users improve the algorithms that govern the search engine, and the impact is relatively bigger on tail queries (compared to the most common queries on which all search engines reach a relatively large scale of queries). Therefore, not only more search generates more demand for advertising (as in any market with network effects), but more search generates also the scale needed to improve the search technology and provide more relevant results and ads, which in turn generates more search. This is a key difference compared to other markets with network externalities, as those of other software platforms: on one side in traditional platforms the number of consumers determines the demand of application developers but does not affect the quality of the software platform for a given number of applications, on the other side the number of visitors of a search engine determines not only the demand of advertisers but also the (future) quality of the search engine (in terms of ability to reach the most relevant results). This combination of network effects and learning by doing induces initial increasing returns to scale in this market, that are reflected in the pattern of the "revenue per search" (RPS), which has a typical S shape in the size of the web visitors.
As a consequence of the importance of scale in search, for a platform to enter the search advertising market (or increase its market share) and compete with the leader it is crucial to rapidly gain scale and close the technological and information gap on the search queries. At the same time, for a leading platform to maintain its market power it is crucial to protect the information gained through searches and limit the scale of the rivals and their learning by doing. Any exclusivity agreement between the dominant firm and hardware or software distributors to install only its search-related product and services or between the dominant firm and advertisers to rely only on its platform may jeopardize any hope of the competitors to gain scale and compete on the merit. This may be the case of the exclusivity agreements on the Google toolbar or on the search default settings between Google and software vendors as Adobe, hardware vendors as Apple for the iPhone (and others adopting the Android operating system) or browser distributors as Firefox, Safari and Opera. Moroever, scale requires that any search engine must be able to have full access to all websites and "crawl" them to find new informations to be provided in search queries. Clearly, if the dominant platform obtains a privileged access to some relevant websites and limits the access of competitors, competition is penalized: such a strategy of raising rivals' costs may exclude some of these competitors (or accommodate market outcomes with high prices that are detrimental to advertisers). In this case, innovation by the followers is penalized as well. This is what may have happened since the acquisition by Google of YouTube, the main website for video contents, whose access for competing search engines does not appear to be as direct and immediate as for Google.
Multihoming on both sides
The other reason for which network effects in search are different from the network effects of many other markets is that multihoming on both sides (by web visitors and advertisers) can easily spread their benefits between different providers. Of course, multihoming by consumers is key to drive the accumulation of information needed to build scale for a minor search engine. The fact that search engines are free and, most of all, are always "one click away" on the Internet plays a double role in this context. On one side, it allows consumers starting from the dominant search engine to easily try alternative ones to test their capabilities or to perform additional investigations whenever the intial search was not fully satisfactory, which enhances the chances for minor search engines to take off. On the other side, multihoming by consumers allows those who are experimenting a minor search engine to quickly revert to the dominant one jeopardizing the chances of the former to develop and protecting the advantage of the latter. Equally important is multihoming on the advertisers' side. Since advertisers are uniquely interested in the effectiveness of their spending in search advertising, they have good reasons to diversify their investment between alternative platforms in such a way that the marginal returns are equalized. Multihoming guarantees that different Internet users can be reached with different search engines, typically with a higher budget destined to the leading channel (currently Google AdWord) and a smaller budget shared across the others (as Yahoo! Panama or Microsoft AdCenter). Moreover, data analysis can easily allow for a comparison of the return on investment in each channel to optimize spending. It is clear that multihoming by many advertisers would contribute to the development of scale and efficiency of minor search platforms. Notice that this is quite different from what emerges in some of the other software platforms where multihoming on both sides is often not necessary (think of the market for video games, where consumers do not multihome and choose a single platform, but multihoming by game developers guarantees the process of development of network effects for all competing platforms). As a consequence, any policy aimed at limiting multihoming in search advertising (or simply at raising its costs) is going to create obstacles to the creation of network effects. This may be the case for the contracts with which Google prohibits advertisers from using competing platforms, and for the exclusive use by Google of the data on its clients which prevents them from performing data analysis to compare the return on investment of different advertising channels.
