A Model of Search Intermediaries and Paid Referrals
(Research Seminar, February 20, 2003)
The
Wharton School
University of Pennsylvania
We develop a two-stage model of search intermediaries in a vertically differentiated product market. In the first stage an intermediary chooses a search engine ``design'' that specifies to which extent the search ranking of a firm's product is determined by its bid and to which extent it is determined by the product's true quality performance. In the second stage, based on the engine design, competing firms place their open bids to be paid for each referral by the search engine. We find that the revenue-maximizing search engine design bases rankings on a weighted average of relative quality performance and bid amount. The expected bid amounts are generally nonmonotonic in firm performance and a nonzero pure-strategy equilibrium of the underlying discontinuous bidding game does not exist. We derive the unique nondegenerate mixed-strategy Nash equilibrium of the bidding game, and show that firms of low quality tend to fully dissipate their rents. These rents are appropriated in part by the search intermediary and in part by the high-quality firm and are therefore not socially wasteful. Nevertheless, the intermediary by limiting the weight put on quality in his preferred search engine design does not maximize social welfare. Using data from a search intermediary we examine empirically the bidding behavior of certain firms and find that bid dispersion is indeed substantial. We also find that some firms use intertemporal bidding strategies, which are consistent with the theoretical mixed-strategy profiles.