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Substitution between offline and online advertising markets Avi Goldfarb and Catherine Tucker* November 2010 Abstract Online advertising is increasingly subject to antitrust scrutiny, but there is a lack of empirical analysis on whether the large offline advertising market disciplines the online adv...

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SUBSTITUTION BETWEEN OFFLINE AND ONLINE ADVERTISING MARKETS Catherine Tucker, Avi Goldfarb Journal of Competition Law and Economics

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Substitution between offline and online advertising markets Avi Goldfarb and Catherine Tucker* November 2010 Abstract Online advertising is increasingly subject to antitrust scrutiny, but there is a lack of empirical analysis on whether the large offline advertising market disciplines the online advertising market. Here, we summarize two empirical analyses that begin to fill this void by showing an effect of offline advertising on online advertising.

JEL Codes: M37, M38, L86

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Avi Goldfarb is Associate Professor of Marketing, Rotman School of Management, University of Toronto, 105 St George St., Toronto, ON. Tel. 416-946-8604. Email: [email protected]. Catherine E. Tucker is Assistant Professor of Marketing, MIT Sloan School of Management, 100 Main St, E62-533, Cambridge, MA. Tel. 617-252-1499. Email: [email protected].

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Electronic copy available at: http://ssrn.com/abstract=1721001

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Introduction Advertising markets have been turned upside down by the advent of the internet and online

advertising. The internet has grown as an advertising channel more quickly than either broadcast or cable television, in terms of its share of existing advertising spending (Interactive Advertising Bureau 2010). However, what is less clear is how competition authorities should approach this switch by advertisers towards online advertising. In particular, it is not clear whether or not online advertising markets should be thought of as being distinct from offline advertising markets. Whether online and offline advertising markets should be treated as distinct markets is a key question in many areas of competition authority activity. For example, the European Commission, in its Google/DoubleClick and Microsoft/Yahoo! decisions, declared that, for antitrust purposes, “online advertising is a distinct market from offline advertising” (European Commission 2010, paragraph 61). In its statement on the Google/DoubleClick merger, the Federal Trade Commission makes no direct mention of offline advertising. Interestingly, the FTC does note that “advertisers primarily purchase search advertising space to implement direct response ad campaigns, while directly sold ad inventory is generally purchased for brand advertising campaigns” (FTC 2008, p. 7). In this paper we discuss in non-technical terms two econometric studies which present suggestive evidence about the extent to which offline and online markets interact. These examine both how offline advertising influences how effective online advertising is (Goldfarb and Tucker 2010a) and how offline advertising influences the pricing of online advertising (Goldfarb and Tucker 2010b).

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Electronic copy available at: http://ssrn.com/abstract=1721001

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Identifying substitution between online and offline markets Measuring the extent of substitution is challenging. In order to accurately measure

substitution between channels, ideally one would have a shift in price in one channel that is unrelated to anything that might affect market conditions in the other channel. For example, an ideal experiment would be if Google's computers, due to a mechanical error, started pricing auctions 10 percent higher in Sweden than in Norway. Then one could potentially track how this changed search engine advertising allocations over time and relative to other offline advertising media in Sweden relative to Norway. However, generally, there is no such ideal pricing experiment. More commonly, we might observe the price of offline advertising to rise in Sweden as well as an increase in both prices and quantity sold online. It is possible this is a result of substitution between channels: When the price of offline advertising rises, advertisers substitute into the online channel. However, it is also possible that this is a result of some other factor affecting all prices: An increase in demand for advertising might increase prices offline and online, even if there is no substitution between channels. Therefore, careful analysis requires a situation in which one channel is affected but not the other. Because such situations are rare, and for a variety of other reasons, cases have largely been written up without reference to empirical analysis that examines substitution between online and offline advertising channels. Ratliff and Rubinfeld (2010) discuss the dearth of empirical evidence on how offline advertising might constrain online advertising. Combining novel datasets with difference-in-difference econometric techniques, both of our studies exploit variation in legal restrictions on offline marketing to infer a causal relationship from offline marketing to online marketing. In Goldfarb and Tucker (2010a), we

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examine how restrictions on offline brand (billboard) advertising affect online brand (display) advertising. In Goldfarb and Tucker (2010b), we examine how restrictions on offline direct marketing affect search engine advertising. The purpose of the present paper is to summarize the results of those econometric studies and discuss their usefulness for guiding competition authorities in their approach to market definition in online markets. We recognize that the issue of relevant market definition is a complex and contentious area of competition law and practice (Carlton 2007). For example, according to the European Commission, a relevant product market “comprises all those products and/or services which are regarded as interchangeable or substitutable by the consumer by reason of the products' characteristics, their prices and their intended use.”1 We also recognize that neither of our studies meets a clear-cut criterion such as that used in the EU of whether “customers for the product in question can switch readily to a similar product in response to a small but permanent price increase (between 5% and 10%).”2 In essence, our two studies exploit infinite price increases in the offline channel and examine what happens online. The results are still useful to establish market definition, because they document that the channels are closely related. They do not measure the level of substitution as defined by the regulation, but they should be viewed as suggestive evidence of the existence of extensive substitution between online and offline markets. We will discuss each of our papers in turn, followed by a broader discussion of the evidence for online-offline substitution in other industries.

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Official Journal C 372 of 09.12.1997 http://europa.eu/legislation_summaries/competition/firms/l26073_en.htm

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Goldfarb and Tucker (2010a): Billboards influence online display ad effectiveness In Goldfarb and Tucker (2010a), we use offline marketing restrictions to identify how

offline advertising affects online advertising. 3 Specifically, we examine whether online display advertising is more effective in locations that ban alcohol advertising on billboards. In order to measure the effectiveness of the advertising, we use data from a large-scale set of field experiments that randomized exposure to 275 different online display advertising campaigns for alcoholic beverages between 2001 and 2008. In each field experiment, an average of 223 people completed the survey, half of whom were randomly exposed to the ad for an alcoholic beverage and half of whom were exposed to an alternative placebo advertisement. We measure ad effectiveness as the difference between these two groups in response to the question, “How likely are you to purchase this product?” In other words, ad effectiveness is the difference in stated intention to buy the product between people who saw an ad for the product in question and people who (randomly) saw a different ad. We then examine how the effectiveness of advertising differs in locations that ban billboard (“out-of-home”) advertising with locations that do not. We use two different sources of such advertising bans. First, we compare the 17 states that ban billboard advertising for alcohol with the other 33 states and find that online advertising is approximately 15% more effective in places where offline advertising is banned. This analysis of state-level restrictions is robust to a number of controls and provides a large-sample understanding of the differences between places with and without regulations. Still, we cannot eliminate the possibility that there are state-level differences in advertising responsiveness that drive the effect. Therefore, we also look at four different local regulations 3

This research used data supplied as part of a grant from the WPP/Google Marketing Research Awards.

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that changed over the course of our data. We find that changes in local regulations changed local advertising effectiveness in a way consistent with the state-level effects: Ad effectiveness was substantially higher when the ban was in effect. This result is robust to numerous controls and econometric specifications. These results suggest that the online advertising channel does substitute for the offline channel. From the advertisers' point of view, they get more value from online display advertising when the potential customers do not see any offline billboard advertising. While we do not measure the exact strength of substitution between online display advertising and offline display (billboard) advertising, our evidence strongly suggests that advertisers should be able to substitute relatively easily between the two channels. Still, our results do not directly touch upon the pricing of advertising, an issue we explore in a different paper. 4. Goldfarb and Tucker (2010b): Direct marketing influences prices for search engine ads In Goldfarb and Tucker (2010b), we examine how offline marketing affects the price of search engine advertising.4 To do so, we exploit a quasi-experiment in regulation that restricts the ability of personal injury lawyers to solicit clients directly—also known as “ambulancechaser” regulation. In the fifteen states with this regulation, lawyers face a waiting period before they can contact a person after an accident. We interpret this regulation as an artificial barrier to competition between online and offline advertising. We combine this information on the regulation with data on the prices of location-specific law keywords on Google in April 2007. For example, if a lawyer wanted to have an advertisement show up prominently when a user searched for the keyword string “brain injury

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This research was supported in part by a grant from the NET Institute.

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attorney Baton Rouge”, this would have cost $12.19 for each click received at the time we collected our data. In contrast, the string “divorce attorney Baton Rouge” cost $7.95. We find that the prices of search advertising for the keywords affected by this regulation were five to seven percent higher than the prices of other keyword advertising. In particular, the regulation affects the prices of keywords related to personal injury law but not the prices of other law-related keywords (such as divorce law or traffic law). We show that in the states with solicitation restrictions, personal injury keywords were more expensive relative to the price of other law-related keywords in those states, compared to the price difference between personal injury keywords and other law-related keywords in other states. We use a number of econometric techniques to ensure the robustness of this result and we consistently find that offline solicitation restrictions (effectively, restrictions on direct marketing) increase the price of search engine advertising. Prices of keyword advertisements on Google and other search engines are set using a continuous auction. In that sense, the price changes we observe are not from deliberate pricing decisions by Google management. Instead, the auction mechanism ensures that Google receives something like the marginal value of receiving a click by the second highest bidder (Edelman, Ostrovsky, and Schwarz 2007). Therefore, the observed substitution suggests either that bidders bid more aggressively online when offline direct marketing is limited, or that more bidders bid online when offline direct marketing is limited, or some combination of both. It is important to note that these results do not generate a cross-price elasticity estimate. Typical market definition analysis examines the impact of a moderate price increase in one area on prices and quantities in the other area. Our study examined an outright ban on direct mail marketing over a period of time. Therefore, as noted by Ratliff and Rubinfeld (2010), if the

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offline market is defined as “direct mail within 30 days” the percent change in price of the offline channel is infinite. Ratliff and Rubinfeld (2010, p. 376) argue that therefore our analysis is “of doubtful relevance to determining the boundaries of the relevant market.” While we acknowledge that our analysis examines a ban which could be interpreted as equivalent to an infinite price change for direct mail within 30 days, we still believe it is informative about market boundaries. By shutting off one (of many) types of offline marketing, online advertising increased in price. The channels are clearly related. The depth of the relationship is an open empirical question. We leave it to future work to measure whether the exact degree of substitution warrants competition authorities to consider search engine advertising and direct mail marketing as separate markets. 5. Online/offline substitution in other settings Our results are consistent with an increasing body of evidence that emphasizes the interaction between online and offline behavior in a variety of settings. Much of this literature has focused on competition between online and offline retailers and used a similar empirical strategy: examining how changes in offline availability affect online sales and prices. For example, Brynjolfsson, Hu, and Rahman (2009) document substitution in women’s clothing from the offline channel to the online channel, particularly for the more popular products. Forman, Ghose, and Goldfarb (2009) and Choi and Bell (2010) find similar effects in books and diapers respectively. Using a slightly different empirical strategy, Prince (2007) found that an increase in online availability of personal computer retailers led to substitution to the online channel from the offline channel. Because of the challenges in finding price changes that are independent across channels, research that measures the cross-price elasticity between online and offline markets is rare. The 8

literature that does exist has exploited variation in sales taxes across states to document that people who live in states with higher sales taxes buy more online. In the first and most influential of these papers, examining several product categories, Goolsbee (2000) showed a substantial cross-price elasticity of at least 2.3, and sometimes higher than 5. More recently, Ellison and Ellison (2009), Goolsbee, Lovenheim, and Slemrod (2010), and Anderson, Fong, Simester, and Tucker (2010) showed similar effects of sales taxes on sales of computer memory, cigarettes, and clothing respectively. Therefore, consistent with our results in advertising, in a large number of retail categories the literature suggests substitution between online and offline markets. 6. Conclusion Whether online and offline advertising are distinct markets is an area of increasing concern for competition authorities. In this paper, we have summarized the results of two empirical studies that document the ability of offline marketing to discipline online advertising. We have also argued that these results are consistent with a large body of literature that shows substitution between online and offline retailers. It is challenging to measure actual substitution between channels, due to the potential for spurious correlation that affects prices in both channels simultaneously. In order to overcome these challenges, our studies exploit legal restrictions on offline advertising. We believe our studies refute the hypothesis that online and offline advertising markets operate independently and suggest a default position of substitution. Online and offline advertising markets appear to be closely related. Nevertheless, we acknowledge that these studies do not determine the exact cross-price elasticity between online and offline ads. They therefore should be treated as suggestive rather than definitive when it comes to determining market definition.

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Goolsbee, Austan, Michael F. Lovenheim, and Joel Slemrod. 2010. Playing with Fire: Cigarettes, Taxes, and Competition from the Internet. American Economic Journal: Economic Policy 2(1), 131-154. Interactive Advertising Bureau. 2010. IAB Internet Advertising Revenue Report: 2009 Full-Year Results. IAB and PriceWaterhouseCoopers, April. Prince, Jeffrey T. 2007. The beginning of online/retail competition and its origins: An application to personal computers. International Journal of Industrial Organization 25(1): 139-156. Ratliff...