Separating Advertising and Marketplace Functions of E-commerce Platforms: Is it Social Welfare Enhancing?

The use of sponsored product listings in prominent positions of consumer search results has made e-commerce platforms, which traditionally serve as marketplaces for third-party sellers to reach consumers, a major medium for those sellers to advertise their products. On the other hand, regulators have expressed anti-trust concerns about an e-commerce platform’s integration of marketplace and advertising functions; they argue that such integration benefits the platform and sellers at the expense of consumers and society and have proposed separating the advertising function from those platforms. We show, contrary to regulators’ concerns, that separating the advertising function from the e-commerce platform benefits the sellers, hurts the consumers, and does not necessarily benefit the social welfare. A key driver of our findings is that an independent advertising firm, which relies solely on advertising revenue, has same or lesser economic incentive to improve targeting precision than an e-commerce platform that also serves as the advertising medium, even if both have the same ability to target consumers. This is because an improvement in targeting precision enhances the marketplace commission by softening the price competition between sellers, but hurts the advertising revenue by softening the competition for prominent ad positions.

💡 Research Summary

The paper develops a theoretical model to compare two institutional arrangements for large e‑commerce platforms: (1) an integrated setup in which the platform simultaneously provides marketplace services (charging a sales commission) and advertising services (selling sponsored product slots), and (2) an independent setup in which the advertising function is outsourced to a separate firm that earns revenue only from advertising. The authors consider a duopoly of sellers (A and B) offering imperfect substitutes in a Hotelling line of consumers. Consumers are uniformly distributed, have unit demand, and decide whether to click on ads and purchase based on their location, the ad position’s click‑through rate (CTR), and the product price. The platform (or the independent advertising firm) receives a noisy signal about each consumer’s true location; the probability that the signal is correct is the targeting precision β, which can be chosen endogenously.

The interaction is modeled as a four‑stage game: (i) the regulator chooses the institutional arrangement; (ii) the platform or advertising firm selects β; (iii) sellers simultaneously set prices and submit bids for the two ad slots (the higher bid wins the more‑prominent slot with CTR α, the lower bid gets the less‑prominent slot with CTR δ, α>δ); (iv) the platform/advertiser runs a second‑price auction, assigns slots, consumers click according to the CTRs, and purchase if the net utility is positive. The authors solve the sub‑game perfect equilibrium by backward induction, deriving consumers’ purchase probabilities, sellers’ demand functions, equilibrium bids, prices, and the optimal β under each setup.

Key insights emerge from the differing incentives to improve targeting precision. In the integrated setup the platform cares about two revenue streams: advertising fees (which fall when β rises because better targeting reduces competition for the premium slot) and marketplace commissions (which rise when β rises because higher precision softens price competition between sellers, allowing them to charge higher prices). Consequently, the platform has a positive incentive to increase β up to the point where the marginal gain in commission revenue outweighs the marginal loss in ad revenue. Higher β leads sellers to bid more aggressively for the top slot and to set higher product prices, boosting seller profits and platform profit but lowering consumer surplus.

In the independent setup the advertising firm earns only from ad fees, so any increase in β that reduces competition for the premium slot directly cuts its revenue. The independent firm therefore prefers a lower β and has little incentive to invest in better targeting. As a result, ad slots are allocated at lower bids, price competition between sellers intensifies, and consumer prices fall. Seller and platform (marketplace‑only) profits decline, while consumer surplus rises.

When aggregating consumer surplus, seller profit, and platform/advertiser profit to assess social welfare, the authors find that the independent arrangement improves welfare only under very specific conditions: when consumer preference intensity t is low (weak location preferences) or when the probability of converting a click into a purchase is small. In most realistic parameter ranges—where consumers have reasonably strong preferences and click‑to‑purchase conversion is non‑trivial—the integrated arrangement yields higher total welfare because the gains from more efficient targeting (higher commissions and better matching) outweigh the loss in consumer surplus.

Thus, contrary to the regulator’s intuition that separating advertising from the marketplace would protect sellers and enhance overall welfare, the model predicts the opposite: separation benefits consumers at the expense of sellers and may not raise, and can even lower, total social welfare. The paper advises policymakers to consider the nuanced trade‑offs and the role of targeting incentives before mandating structural separation of advertising and marketplace functions on dominant e‑commerce platforms.