Pricing or advertising? A game-theoretic analysis of online retailing

Abstract

How should online retailers attract customers? Should they advertise intensively to attract online traffic, or should they simply price lower than their competitors? To answer these questions, we develop a game-theoretic model of two firms choosing advertising levels and prices strategically. We find that only asymmetric equilibria exist, where e-tailers choose different strategies along both advertising and pricing dimensions. When market mobility is low (i.e., the majority of buyers have high search costs), firms engage in fierce competition in advertising, and the firm with a higher advertising level charges a higher price and earns higher profits. When market mobility is high (i.e., the majority of buyers have zero search costs) or medium, one firm may choose to advertise intensely while the other may choose to charge a lower price and not advertise at all. In such cases, either firm may make higher profits. We also compare the market outcome in our model to the case in which firms do not have the option of advertising and find that the option to advertise leads to higher expected prices. We further extend the model to consider e-tailers choosing advertising levels sequentially.