Sponsored Results in Intelligent Recommenders: Impact on Quality Signaling and Consumer Welfare

Search engines, referrals services, advisors, and other forms of information gatekeepers and recommenders, are omnipresent in today’s information-heavy economy. These services widely employ sponsored recommendations, wherein merchants pay the recommender in return for favorable placement in the recommender’s list. As a form of advertising, sponsored results can serve as a signaling mechanism when consumers are uncertain about merchant quality levels. Notably, such advertising occurs over an intelligent recommender which, with some level of precision, can make its own recommendations on merchant quality. We develop and analyze an economic model of sponsored search that illuminates several aspects of this practice. First, we explain how the recommender’s intelligence impacts the merchants’ allocation of signaling effort between price and advertising. Compared with advertising in traditional media, intelligent recommenders reduce merchants’ need for advertising signals and make it more possible to signal via the cheaper instrument, price. Second, however, an increase in a recommender’s precision may neither increase its sponsorship revenues nor make consumers better off: the crucial determinant of this effect is the recommender’s pricing power in the advertising market. Under low pricing power, improvement in precision decreases the advertising expenditure, causing higher prices and lower consumer surplus. Conversely, with substantial pricing power, higher precision yields a higher advertising fee, lower product prices, and increased consumer surplus. Third, the adoption of sponsored results by the recommender may not always improve consumer surplus. Chasing advertising revenues, recommenders may overuse sponsored results when doing so reduces consumer surplus—the better the recommender, the more likely that adoption of sponsored results harms consumers—creating an interesting challenge for regulatory constraints on this practice.