Direct Channel or Distribution Channel? The Role of Internet-Based Targeted Advertising With Vertical Differentiation in Distinct Channels

Abstract

The selection of optimal channels is considered the critical marketing strategy for the firm. Effective vertical channel selection could induce distinct effects on the firm’s profit and social warfare by selecting a specific type of advertising. Otherwise, as the targeted population is quite different for the firm using mass or targeted advertising, this differentiation is becoming more significant for the population in the final marketing channel. Within the vertical differentiation model, the role of Internet-based targeted advertising on direct sales and distribution channels is studied. Compared to mass advertising, the firm using Internet-based targeted advertising in distinct channels can benefit the firm’s equilibrium profit by reducing advertising waste and enhancing the product’s price. The manufacturer might use Internet-based targeted advertising to control the total profit of the channel. Meanwhile, Internet-based targeted advertising might reduce the retailer’s and the entire channel’s profit. Otherwise, the targeting accuracy of the firm shows a bidirectional role in the firm’s equilibrium price in the direct channel. The firm’s equilibrium advertising level and profit might be reduced with the increasing targeting accuracy. The public department of the government needs to consider the potential risk of targeted advertising that might reduce the real benefits of distribution channels and harm the development of the market.

Plain language summary

Study Purpose: This study aimed to analyze how Internet-based targeted advertising influences marketing channel selection, profitability, and social dynamics of firms. Methods: The study utilized a vertical differentiation model to assess the impact of targeted advertising compared to mass advertising on direct sales and distribution channels. It examined firms’ equilibrium profit, pricing, and advertising levels concerning Internet-based targeted advertising. Conclusions: The research indicates that incorporating targeted advertising into specific channels can help decrease advertising waste and increase product pricing, benefiting firms. However, this approach may lower profits for retailers and the overall channel. Moreover, higher targeting accuracy may result in reduced equilibrium advertising levels and profits in the direct channel. Implications: The findings underscore the significance of strategic channel selection and the potential effects of targeted advertising on firm profitability and social dynamics. Manufacturers can leverage targeted advertising to control channel profitability, while policymakers need to consider the risks associated with targeted advertising, including potential limitations on distribution channel benefits and negative impacts on market development. Limitations: It is important to acknowledge that this study focused exclusively on the influences of Internet-based targeted advertising within the vertical differentiation model. Therefore, the results may not be directly applicable to other advertising strategies or industries. The ethical implications and consumer perceptions related to targeted advertising were not explored, necessitating further research for a comprehensive understanding of its broader implications and limitations in diverse contexts.

Keywords

internet-based targeted advertising mass advertising direct sales channel distribution channel

Introduction

With the rapid development of e-commerce, it is easier for manufacturers to distribute their products through retailers to engage in direct sales. That means the manufacturer can sell the products to the final consumers with or without the retailer. Therefore, there are two types of marketing channels, including the direct sales channel and distribution channel, for the firm selling within the marketing system (Lu & Liu, 2015). The manufacturers can send the product to the consumers directly with advertising and prices through the indirect sales channel. However, in the distribution channel, the firm should send the product to the retailers with total expenditures, and then the retailers send the products to the consumers directly. According to the theory of double marginalization, the downstream firm’s price decision and the upstream firm’s production might deviate from the optimum value of the system. Many studies have focused on how vertical integration affects a supply chain’s quantities, prices, and profits (Bhargava & Choudhary, 2001; Perry, 1989). Due to the marginal effect, the firm’s total profit can’t obtain the optimal result (McGuire & Staelin, 1983). However, the retail buffer theory deems that the retailer’s dependent decision can reduce the competition among the channels with a high substitution of competitive products, and the total profit in the distribution channel is higher than that of the direct sale channel (Ryzin & Mahajan, 1999). In intelligent marketing, the homogeneous competition of products is becoming aggregated. Therefore, advertising becomes a critical strategy to improve brand value, especially product-perceived value. With the rapid development of current information technologies, including data mining and big-data analysis, many firms could establish a modern information system to gather enormous information of specific data about their potential consumers. They can precisely obtain these data, including consumers’ personal information such as age, salary, address, and purchasing preference on the product. These technologies enable the delivery of more Internet-based targeted advertising to related consumers, thereby reducing wasted messages. The fundamental feature of targeted advertising is the communication of information. The range and quality of the communication could affect the quality of information. Effective vertical channel selection could induce distinct effects on the firm’s profit and social warfare by selecting a specific type of advertising. Otherwise, as the targeted population is quite different for the firm while using mass or targeted advertising, this differentiation is becoming larger for the population in the final marketing channel. Due to hiding consumers’ information in the vertical channel, even the firm has mastered a high recognition technology to target the consumers. It is still impossible for the firm to recognize all the consumers. They can only send targeted advertising with specific targeting precision to the final consumers. Therefore, in this article, we aim to address two questions: (a) Within the vertical differentiation channel, what’s the role of targeted advertising in direct sales and distribution channels? (b) When the firm can only send targeted advertising with a specific targeting precision, How do we select the optimal distribution channel for the firm?

Literature Review

Distinct Choice of Manufacturers and Retailers in Marketing Channel

Manufacturers and retailers often have conflicting interests when it comes to segmented consumers. Prior research by Shaffer and Zettelmeyer (2004) highlights the benefit conflict between manufacturers and retailers. Lal and Narasimhan (1996) examine the impact of advertising on the margins of manufacturers and retailers, while Shaffer and Zettelmeyer (2002) consider the effect of information on channel member profits. Additionally, Du et al. (2018) study the implementation of online and offline channel integration and segmentation strategies in Chinese manufacturing enterprises.

In a monopoly market, the direct sales channel benefits a firm’s profits without considering advertising decisions. However, in a competitive market, the distribution channel can reduce advertising waste and minimize competition, making it more beneficial than the direct sales channel. But when advertising decisions are taken into account, differences between the direct sales and distribution channels become evident. Manufacturers can either sell products directly or through retailers. While the direct channel may yield more profit without advertising decisions, the distribution channel may take precedence in a competitive market. Zhang et al. (2012) highlight these differences using a horizontal Hotelling model.

In contrast, our study focuses on a vertical differentiation model where manufacturers can offer products with different qualities. Vertical differentiation is common across various industries, such as televisions with varying screen sizes or cinema tickets based on service class. Consumers with a higher valuation tend to choose higher-priced products, as discussed by Tremblay and Martins-Filho (2001). Manufacturers can adjust product qualities and advertising strategies to maximize profits. We aim to explore the targeted advertising strategy within the vertical model based on distinct channel structures.

The Benefits of Targeted Advertising for Firms

Our study is closely related to previous research on the benefits of targeted advertising for firms. As noted by Grossman and Shapiro (1984), targeted advertising is considered a highly efficient marketing tool, addressing the inefficiencies often associated with mass advertising. Some studies suggest that firms can strategically send targeted messages exclusively to consumers who are more likely to make purchases, resulting in the best match between consumer preferences and firm offerings (Esteban & Hernandez, 2007; Iyer et al., 2005). In turn, targeted promotions can enhance profitability for both the seller and the platform. However, the endogenous cost-sharing proportion of targeted promotions can potentially impact the seller’s interests negatively (Hao & Yang, 2022).

Due to its effectiveness and benefits, many advertisers around the world have increasingly turned to online Internet-based targeted advertising. For example, Google Adwords delivers customized ads based on search queries, while InkTAD utilizes location information from users’ emails to deliver targeted ads (Wang et al., 2015). Our findings suggest that Internet-based targeted advertising has the potential to reduce advertising waste and allow firms to set higher prices for their products, excluding consumers who have lower preferences for product quality. Our research aligns with the recent economics literature on informative advertising and targeting. Several studies, including Esteban et al. (2001), Esteban and Hernández (2014), Galeotti and Moaga-González (2008), and Iyer et al. (2005), have confirmed the waste-reducing benefits of Internet-based targeted advertising for firms. On the other hand, in equilibrium, there might exist a lack of ad-blocking, as niche firms compete against mass-market firms utilizing Internet-based targeted advertising (J. P. Johnson, 2013). A recent study also explores how targeting technologies enable firms to reach desired audiences through intermediary platforms (Marotta et al., 2022). However, other literature suggests that Internet-based targeted advertising might not necessarily lead to higher equilibrium profits for firms. Brahim et al. (2011) find that equilibrium profits for firms could be lower with Internet-based targeted advertising compared to random advertising due to intense competition. Moreover, Internet-based targeted advertising may raise privacy concerns, as increased targeting leads to higher competition and reduced profits for websites. Nevertheless, in equilibrium, websites choose maximum targeting as they cannot credibly commit to lower levels of targeting (Kox et al., 2017).

Furthermore, it’s important to note that targeting is not perfect, as the engine directing the consumer to the ideal product may have a probability of less than one. In a study conducted by Jiang et al. (2020), it was demonstrated that e-business firms should target their advantageous markets with optimal precision. Jiang and Wu (2022) further confirmed that the equilibrium profit of each competitive firm varies based on the accuracy of targeted advertising, exhibiting a U-shape variation with precision. This indicates that conducting imperfect targeted advertising with moderate precision can be beneficial for the efficient entry of new rival firms and overall market effectiveness. These findings align with a recent study by Liu et al. (2023) that utilized a game-theoretic framework. However, behavioral advertising has faced criticism and concern, particularly from privacy and consumer advocacy groups, despite offering improvements over more random tactics. G. A. Johnson et al. (2022) investigated consumer privacy choices in the context of online display advertising, where advertisers track consumers’ browsing activity to enhance ad targeting. The study revealed that opt-out users tend to be more technologically sophisticated, and opt-out rates are higher in wealthier American cities. These results shed light on the real-world consequences of an opt-out privacy mechanism and contribute to the ongoing privacy policy discussion.

The Intricacies of Privacy of Targeted Advertising

In a previous study, Shin and Yu (2021) developed a micromodel that examined the competition among multiple firms through targeted advertising. They found that when consumers are targeted by a firm, they tend to make more positive inferences about the product category and the firm’s quality. However, concerns have been raised regarding the potential privacy issues associated with targeted advertising. Blundo et al. (2021) proposed an intelligent method for profiling social media users and a privacy protection technique that matches users’ profiles with advertisements, which could be utilized by advertising agencies. Nonetheless, there are evident security risks involved, and a privacy layer was introduced to prevent the leakage of sensitive information of all the involved parties, including users and advertisers. Similarly, Tulabandhula et al. (2021) presented an efficient redesign of a recommendation system that maintains user profiles solely on their device or web browsers, ensuring privacy preservation while fetching appropriate recommendations from web portals. However, Lim et al. (2023) demonstrated that an increased understanding of persuasion techniques led to improved coping self-efficacy, which influenced privacy concerns and perceived intrusiveness of ads. Thus, earlier studies primarily explored the potential impact of targeted advertising on a firm’s equilibrium profit and competitive environment, contrasting it with mass advertising. In our study, we aim to analyze the role of Internet-based targeted advertising on a firm’s profit within a vertical channel. Taking inspiration from Esteban and Hernandez (2007), we consider products that are vertically differentiated and recognize the close relationship between targeting and the feasibility of price discrimination. Our focus is on a market where consumers are unaware of the existence of certain products, allowing sellers to inform them about the products, prices, and other details using either mass advertising, which reaches the entire potential market, or targeted advertising, which concentrates on specific market segments.

In the past, studies on targeted advertising have mainly discussed its effects on competition, with little attention paid to how advertising influences the distribution of corporate advantages through channels; Additionally, the endogenous connection between targeted advertising and targeted pricing in distribution channels is a recent problem. In this article, we provide the role of targeted advertising in a distinct channel and point out the marketing strategy of targeting. Our results indicate that internet-based targeted advertising plays a distinct role in different channels. This might be due to the balance between the reduction of advertising costs and the redistribution of total channel profit. The rest of the paper is organized as follows. In the next section, we set forth our model. Section “Model Setup” provides an equilibrium analysis and studies the effect between Internet-based targeted advertising and mass advertising in the direct sales channel. Section “The Strategy of Internet-Based Targeted Advertising Indirect Channel With Distinct Qualities” provides an equilibrium analysis of Internet-based targeted advertising and mass advertising in the distribution channel. Section “The Strategy of Internet-Based Targeted Advertising in Distribution Channels With Distinct Qualities” concludes the paper.

Model Setup

Consider a market with the firm promoting sales using informative advertising. Consumers don’t know the products exist, so sellers can let them know about them, as well as their price and other details, by using either mass advertising, which reaches the entire potential market, or specialized advertising, which focuses the ads on a specific market segment. With the standard vertical model, we assume that all the consumers are distributed with distinct preferences $θ \in [0, 1]$ on the qualities of products. The distribution channel is comprised of one manufacturer and one retailer. The manufacturer produces the product at the cost of $c_{M}$ for each product. According to the previous report, the product’s cost is related to quality. That means $c_{M} = k s^{2}$ , that the parameter $k$ is a constant. Here, the parameter $s$ represents the customer’s value evaluation of the same product. The customer’s utility is deemed as $U = θ s - p_{M}$ . Here, $p_{M}$ is considered as the price for the product that sells to the consumer.

Mass advertising: we assume that advertising is the only way to obtain information on the product as long as the consumer receives the advertising, and the consumers might purchase the product. The cost of the advertising that sending to all the consumers $θ$ considered being $λ ϕ^{2}$ . The parameter $λ$ is the advertising cost parameter, which is decided by the technological level of the advertising. Otherwise, the parameter $λ$ is large enough to confirm that the advertising level $ϕ \leq 1$ .

Internet-based targeted advertising: when the consumer’s utility is less than zero, the consumers might not purchase the product or even receive the advertising. Therefore, the cost of advertising is considered as $λ \int_{\hat{θ}}^{1} {[g (θ)]}^{2} d θ$ .

Lemma 1. In the equilibrium, the advertising level of Internet-based targeted advertising on the segmented consumers is considered constant.

Proof. After delivering the Internet-based targeted advertising to the consumers, the firm’s profit can be expressed as follows.

π = (p_{M} - c_{M}) \int_{\hat{θ}}^{1} ϕ_{M} (θ) d θ - λ \int_{\hat{θ}}^{1} {(ϕ_{M} (θ))}^{2} d θ

(1)

According to F.O.C on the advertising level,

\frac{\partial π}{\partial ϕ_{x}} = (p_{M} - c_{M}) - λ ϕ_{M} (θ_{x}) = 0

(2)

From the above equation, $ϕ_{M} (θ_{x}) = (p_{M} - c_{M}) / λ$ . That means the advertising intensity is a constant, and we deemed it as $ϕ_{M}$ . Q.E.D.

From the lemma, the advertising equilibrium intensity is inverse proportion to the advertising parameter $λ$ . A higher parameter means the firm need to provide a low advertising intensity. When the firm’s targeting technology is fixed with unchanged advertising parameters, the advertising intensity will not change.

According to the above hypothesis, the sequence of game theory is shown as follows. Firstly, in the structure of the direct sales channel, producers have the ability to directly reach the end consumers without involving any retailers. As a result, the manufacturer takes on the responsibility of making decisions regarding advertising and retail pricing strategies. Secondly, in the distribution channel structure, the manufacturer and retailer act as independent decision-makers. The manufacturer assumes the role of a leader in the Stackelberg game, where they make the initial decisions regarding advertising and overall pricing. Subsequently, the retailer determines the quantity of products and sets the retail price. This sequential decision-making process, involving advertising, and pricing strategies, is illustrated in Figure 1, representing the game theory within the direct sales channel.

The Strategy of Internet-Based Targeted Advertising Indirect Channel With Distinct Qualities

This part discusses the optimal decision strategy for the firm and its profit using mass or Internet-based targeted advertising. After comparing the two types of advertising, we can still find that the manufacturer can improve the firm’s profit with an Internet-based targeted advertising strategy in equilibrium when producing particular products. The advertising strategy of this section is shown in Figure 2.

The Equilibrium When the Manufacturer Sends the Mass Advertising Directly

In the direct sales channel, the manufacturer uses advertising and price strategies. Then the firm can sell the product to the consumers directly. Therefore, the actual demands of the market can be deemed as the quantities of consumers who received the advertising and have a positive utility. Thus the total amount of products with mass advertising can be expressed as $q_{M} = (1 - \frac{p_{M}}{s}) ϕ_{M}$ . Therefore, the manufacturer’s profit can be described as follows.

max_{p_{M}, ϕ_{M}} π_{M} = (p_{M} - c_{M}) (1 - \frac{p_{M}}{s}) ϕ_{M} - λ ϕ_{M}^{2}

(3)

Obviously, the firm’s optimal pricing decision can be expressed with the F.O.C (first-order condition) condition. Meanwhile $\frac{\partial^{2} π}{\partial ϕ_{M}^{2}} = - 2 λ < 0; \frac{\partial^{2} π}{\partial p_{M}^{2}} < 0$ .

{\begin{matrix} \frac{\partial π}{\partial ϕ_{M}} = (p_{M} - c_{M}) (1 - \frac{p_{M}}{s}) - 2 λ ϕ_{M} = 0 \\ \frac{\partial π_{M}}{\partial p_{M}} = (1 - \frac{p_{M}}{s}) - \frac{(p_{M} - c_{M})}{s} = 0 \end{matrix}

(4)

The equilibrium price ( $p_{DM}^{*}$ ) and advertising level ( $ϕ_{DM}^{*}$ ) can be solved according to the equations. Therefore, $p_{DM}^{*} = \frac{s + c_{M}}{2}; ϕ_{DM}^{*} = \frac{(p_{M} - c_{M})}{2 λ} (1 - \frac{p_{M}}{s}) = \frac{{(s - c_{M})}^{2}}{8 λ s}$

Therefore, the manufacturer’s optimal equilibrium profit ( $π_{DM}^{*}$ ) is considered in the following equation $π_{DM}^{*} = \frac{{(s - c_{M})}^{4}}{64 λ s^{2}}$ . Generally, due to the consumers’ preferences for the product’s quality, the range of $[0, \frac{s - c_{m}}{2 s}]$ will not purchase the firm’s products. Meanwhile, the wasted advertising cost can be expressed as $A_{wasted} = \frac{{(s - c_{M})}^{3}}{128 λ s^{2}}$ .

The Equilibrium When the Manufacturer Sends the Internet-Based Targeted Advertising Directly

In the direct sales channel, the manufacturer uses advertising and price strategies. Then the firm can sell the product to the targeted consumers directly. Therefore, the actual demands of the market can be deemed as the quantities of consumers who received the advertising and have a positive utility. Thus the firm’s products selling to the consumers with Internet-based targeted advertising can be expressed as the following equation of $q_{T} = (1 - \frac{p_{T}}{s}) ϕ_{T}$ . Meanwhile, the cost of Internet-based targeted advertising on the preferred consumers describes as the following expression $λ ϕ_{T}^{2} (1 - \frac{p_{T}}{s})$ . Therefore, the manufacturer’s profit can be defined in the following expression (5).

max_{p_{T}, ϕ_{T}} π_{T} = (p_{T} - c_{T}) (1 - \frac{p_{T}}{s}) ϕ_{T} - λ ϕ_{T}^{2} (1 - \frac{p_{T}}{s})

(5)

Obviously, the firm’s optimal pricing decision with Internet-based targeted advertising can be expressed with F.O.C condition. Meanwhile, $\frac{\partial^{2} π}{\partial ϕ_{T}^{2}} = - 2 λ < 0; \frac{\partial^{2} π}{\partial p_{T}^{2}} < 0$ .

{\begin{matrix} \frac{\partial π}{\partial ϕ_{T}} = (p_{T} - c_{T}) - 2 λ ϕ_{T} = 0 \\ \frac{\partial π_{T}}{\partial p_{T}} = \frac{- 1}{s} [(p_{T} - c_{T}) ϕ_{T} - λ ϕ_{T}^{2}] + (1 - \frac{p_{T}}{s}) ϕ_{T} = 0 \end{matrix}

(6)

The equilibrium price ( $p_{DT}^{*}$ ) and advertising level ( $ϕ_{DT}^{*}$ ) can be solved according to the equations. Therefore, $p_{DT}^{*} = \frac{2 s + c_{T}}{3}$ ; $ϕ_{DT}^{*} = \frac{s - c_{T}}{3 λ}$ . Thus, the manufacturer’s equilibrium optimal profit ( $π_{DT}^{*}$ ) is considered a $π_{DT}^{*} = \frac{{(s - c_{T})}^{3}}{27 s λ}$ .

Comparison of Firm’s Profit With Mass Advertising and Internet-Based Targeted Advertising

In the above equations, it seems that Internet-based targeted advertising plays a critical role in diminishing the waste of advertising and improving its accuracy. Therefore, we compare the firm’s equilibrium price, advertising level, and profit differences, as shown in Table 1.

Table 1.

Price, Advertising Level, and Profit of Manufacturer Under the Direct Sales Channel.

Equilibrium variables	Mass advertising	Internet-based targeted advertising
p ^*	$s + c_{M} / 2$	$2 s + c_{T} / 3$
φ^*	${(s - c_{M})}^{2} / 8 λ s$	$s - c_{T} / 3 λ$
π^*	${(s - c_{M})}^{4} / 64 λ s^{2}$	${(s - c_{T})}^{3} / 27 s λ$

Table 1 illustrates that the firm’s production cost only relates to the product’s quality. Therefore, the following expressions on the equilibrium price and advertising intensity difference with distinct advertising strategies can be obtained.

Δ p = p_{DT}^{*} - p_{DM}^{*} = \frac{2 s + c_{T}}{3} - \frac{s + c_{M}}{2} = \frac{s + k s^{2}}{6} > 0

(7)

Δ ϕ = ϕ_{DT}^{*} - ϕ_{DM}^{*} = \frac{s - c_{T}}{3 λ} - \frac{{(s - c_{M})}^{2}}{8 λ s} > 0

(8)

Proof 1.

$\frac{ϕ_{DT}^{*}}{ϕ_{DM}^{*}} = \frac{s - c_{T}}{3 λ} \frac{8 λ s}{{(s - c_{M})}^{2}} = \frac{8}{3} \frac{s}{s - k s^{2}} > 1$ Q.E.D.

Δ π = π_{DT}^{*} - π_{DM}^{*} = \frac{{(s - c_{T})}^{3}}{27 s λ} - \frac{{(s - c_{M})}^{4}}{64 λ s^{2}} > 0

(9)

Proof 2.

$\frac{π_{DT}^{*}}{π_{DM}^{*}} = \frac{{(s - c_{T})}^{3}}{27 s λ} \frac{64 λ s^{2}}{{(s - c_{M})}^{4}} = \frac{64}{27} \frac{s - c_{M} + c_{M}}{s - c_{M}} = \frac{64}{27} (1 + \frac{k s^{2}}{s - k s^{2}}) > 1$ Q.E.D.

Proposition 1. In the direct sale channel, the manufacturer can manipulate a much higher price and a higher level of advertising within vertical differentiation for the product, thereby obtaining more profits.

That means $π_{DM}^{*} < π_{DT}^{*}, p_{DM}^{*} < p_{DT}^{*}, ϕ_{DM}^{*} < ϕ_{DT}^{*}$ .

According to proposition 1, the consumers with the preference $[0, θ]$ are precluded from the market by Internet-based targeted advertising. Meanwhile, the manufacturer manipulates a higher price and advertising level, thereby sending more profit to consumers with an increased preference for higher quality. That means Internet-based targeted advertising can reduce the wasted advertising cost of products with distinct attributes.

The Strategy of Internet-Based Targeted Advertising in Distribution Channels With Distinct Qualities

The manufacturer first determines the wholesale price and advertising strategy in the distribution channel, including the effective advertising range and level. Then the retailer will determine the quantities of the products and the retail prices. The advertising strategy of this section is shown in Figure 3.

The Manufacturer Adopts Mass Advertising That Sells Products With Distinct Qualities

According to Figure 3, the retailer considers the price decision of $p$ , and then the manufacturer makes a sufficient decision on the total price of $ω$ and the advertising level of $φ$ . The retailer’s profit function can be expressed as follows for the fixed $ω$ and $φ$ .

π_{r} = (p - ω) (1 - \frac{p}{s}) φ

(10)

According to F.O.C.’s condition, the retailer’s retailing price decision on the products with distinct qualities can be expressed as follows.

\frac{\partial π_{r}}{\partial p} = (1 - \frac{p}{s}) - \frac{(p - ω)}{s} = 0

(11)

Therefore, the equilibrium price of the retailer is considered as $p^{*} = \frac{s + ω}{2}$ .

The manufacturer’s profit function is considered as the following expression.

π_{m} = (ω - c_{M}) (1 - \frac{p_{M}}{s}) φ_{M} - λ φ_{M}^{2}

(12)

Then, the retailer’s price decision can be substituted into equation (12), and the following expression can be obtained.

π_{m} = (ω - c_{M}) (1 - \frac{s + ω}{2 s}) φ_{M} - λ φ_{M}^{2}

(13)

According to F.O.C.’s condition on advertising level and the total price,

{\begin{matrix} \frac{\partial π_{m}}{\partial φ_{M}} = (ω - c_{M}) (1 - \frac{s + ω}{2 s}) - 2 λ φ_{M} = 0 \\ \frac{\partial π_{m}}{\partial ω} = (1 - \frac{s + ω}{2 s}) - \frac{ω - c_{M}}{2 s} = 0 \end{matrix}

(14)

Therefore, the manufacturer’s whole price ( $ω_{r}^{*}$ ) is considered to be $ω^{*} = \frac{s + c_{M}}{2}$ . Otherwise, the advertising level ( $φ_{M}^{*}$ ) is considered to be $\frac{{(s - c_{M})}^{2}}{16 λ s}$ , and the equilibrium profit ( $π_{M}^{*}$ ) is deemed as $\frac{{(s - c_{M})}^{4}}{256 λ s^{2}}$ .

Additionally, the equilibrium retailer’s price is $p^{*} = \frac{3 s + c_{M}}{4}$ , and the retailer’s equilibrium profit ( $π_{r}^{*}$ ) can be expressed as $π_{r}^{*} = \frac{{(s - c_{M})}^{4}}{64 λ s^{2}}$ .

The total profit of the distribution channel is $π^{*} = π_{m}^{*} + π_{r}^{*} = \frac{{(s - c_{M})}^{4}}{256 λ s^{2}} + \frac{{(s - c_{M})}^{4}}{64 λ s^{2}} = \frac{5 {(s - c_{M})}^{4}}{256 λ s^{2}}$ .

The Strategy of Internet-Based Targeted Advertising in the Distribution Channel

As the manufacturer in the distribution channel does not determine the price decision, the effective range of advertising might not follow the effective price range. Lemma 2 shows that the manufacturer will deliver Internet-based targeted advertising to the consumers who have a positive utility while purchasing the product.

Lemma 2. In equilibrium, the manufacturer in the distribution channel must send the Internet-based targeted advertising to the consumers in the range of $[\frac{p_{r}}{s}, 1]$ .

According to lemma 2, the firm’s equilibrium decisions on price, advertising level, and equilibrium profit can be solved with backward induction. Likewise, the manufacturer’s total expenditure and advertising strategies are manipulated, and then the retailer’s decision on retailing price is obtained.

π_{r} = (p - ω_{T}) (1 - \frac{p}{s}) φ_{T}

(15)

According to F.O.C.’s condition, the retailer’s retailing price decision on the products with distinct qualities can be expressed as follows.

\frac{\partial π_{r}}{\partial p} = (1 - \frac{p}{s}) - \frac{(p - ω)}{s} = 0

(16)

Therefore, the equilibrium price of the retailer is considered as $p^{*} = \frac{s + ω}{2}$

The manufacturer’s profit function is regarded as the following expression.

π_{m}^{T} = (ω - c_{T}) (1 - \frac{p}{s}) φ_{T} - λ ϕ_{T}^{2} (1 - \frac{p}{s})

(17)

According to F.O.C. condition on advertising level and total price,

{\begin{matrix} \frac{\partial π_{m}^{T}}{\partial φ_{T}} = (ω - c_{T}) - 2 λ φ_{T} = 0 \\ \frac{\partial π_{m}^{T}}{\partial ω} = (\frac{s - 2 ω + c_{T}}{2 s}) φ_{T} + \frac{λ {φ_{T}}^{2}}{2 s} = 0 \end{matrix}

(18)

Therefore, the manufacturer’s whole price ( $ω_{r}^{*}$ ) is considered to be $ω^{*} = \frac{2 s + c_{T}}{3}$ . The advertising level ( $φ_{T}^{*}$ ) is considered to be $\frac{s - c_{T}}{3 λ}$ , and the equilibrium profit ( $π_{T}^{*}$ ) is deemed as $\frac{{(s - c_{T})}^{3}}{54 λ s}$ .

Additionally, the retailer’s equilibrium price is $p^{*} = \frac{5 s + c_{T}}{6}$ , and the retailer’s equilibrium profit ( $π_{r}^{*}$ ) can be expressed as $π_{r}^{*} = \frac{{(s - c_{T})}^{3}}{108 λ s}$ . The total profit of the distribution channel is considered as $π^{*} = π_{m}^{*} + π_{r}^{*} = \frac{{(s - c_{M})}^{3}}{54 λ s} + \frac{{(s - c_{M})}^{3}}{108 s λ} = \frac{3 {(s - c_{M})}^{3}}{108 λ s}$ .

The comparison of Strategies Between the Direct Sales Channel and Distribution Channel

we compare the firm’s equilibrium price(including the total price and retailing price), advertising level, and profit differences under the distribution channel, as shown in Table 2.

Table 2.

Price, Advertising Level, and Profit of Manufacturer and Retailer Under the Distribution Channel.

Equilibrium variables	Mass advertising	Internet-based targeted advertising
p ^*	$3 s + c_{M} / 4$	$5 s + c_{T} / 6$
$ω^{*}$	$s + c_{M} / 2$	$2 s + c_{T} / 3$
φ^*	${(s - c_{M})}^{2} / 16 λ s$	$s - c_{T} / λ$
$π_{m}^{*}$	${(s - c_{M})}^{4} / 256 λ s^{2}$	${(s - c_{M})}^{3} / 54 λ s$
$π_{r}^{*}$	${(s - c_{M})}^{4} / 64 λ s^{2}$	${(s - c_{M})}^{3} / 108 s λ$
π^*	$5 {(s - c_{M})}^{4} / 256 λ s^{2}$	$3 {(s - c_{T})}^{3} / 108 s λ$

The Comparison of Strategies Between the Direct Sales Channel and Distribution Channel With Mass Advertising

According to Tables 1 and 2, we can compare the equilibrium price, advertising level, and total profit between direct selling channels and distribution channels while using mass advertising.

Δ p = p_{IM}^{*} - p_{DM}^{*} = \frac{3 s + c_{M}}{4} - \frac{s + c_{M}}{2} = \frac{s - c_{M}}{4} \geq 0

(19)

Δ ϕ = φ_{IM}^{*} - ϕ_{DM}^{*} = \frac{{(s - c_{M})}^{2}}{16 λ s} - \frac{{(s - c_{M})}^{2}}{8 λ s} < 0

(20)

Δ π = π_{IM}^{*} - π_{DM}^{*} = \frac{5 {(s - c_{M})}^{4}}{256 λ s^{2}} - \frac{{(s - c_{M})}^{4}}{64 λ s^{2}} = \frac{{(s - c_{M})}^{4}}{256 λ s^{2}} > 0

(21)

Proposition 2. In the strategy of mass advertising, compared to the direct sales channel, the firms within the distribution channel shows a higher equilibrium profit and a higher price, whereas the equilibrium advertising level is reduced.

Compared with the direct sales channel, the retailer in the distribution channel is inclined to set a higher price so as to obtain more valued consumers. The effective range of the price is reduced with a higher price. Moreover, the wasted advertising cost is concentrated in a smaller capacity. In this condition, the manufacturer can reduce the advertising cost. Meanwhile, those manufacturers can improve the practical demands to improve the total profit of the distribution channel. Our results are pretty different from the horizontal model from Zhang et al. (2012). This difference might be due to the inner discrepancy of model setup between informative advertising and persuasive advertising.

The Comparison of Strategies Between the Direct Sales Channel and Distribution Channel With Internet-Based Targeted

In the above equations, it seems that the retailer will set a high price for the product and a high advertising level for the product, even with Internet-based targeted advertising. Therefore, the comparison of equilibrium price and equilibrium advertising level, as well as the total profit between the direct sales channel and distribution channel with Internet-based targeted advertising can be obtained.

Δ p = p_{IT}^{*} - p_{DT}^{*} = \frac{5 s + c_{T}}{6} - \frac{2 s + c_{T}}{3} = \frac{s - c_{T}}{6} \geq 0

(22)

Δ ϕ = φ_{IT}^{*} - ϕ_{DT}^{*} = \frac{s - c_{T}}{3 λ} - \frac{s - c_{T}}{3 λ} = 0

(23)

Δ π = π_{IT}^{*} - π_{DT}^{*} = \frac{3 {(s - c_{T})}^{3}}{108 λ s} - \frac{{(s - c_{T})}^{3}}{27 s λ} < 0

(24)

Proposition 3. In the strategy of Internet-based targeted advertising, compared to the direct sales channel, the firms within the distribution channel shows a higher equilibrium retailing price, whereas the equal advertising level, whereas the total profit in the indirect channel is less than the direct channel.

According to Proposition 3, the phenomenon of double marginal effect can indeed cause the retail price to deviate from the optimal value, resulting in a reduction in total profit. However, within the distribution channel, the firm sets the total price equal to that in the direct sales channel. As a result, the manufacturer does not change the advertising level. This consistency in pricing and advertising strategies between the direct sales and distribution channels can be explained by the need for maintaining cooperative relationships and mutually beneficial equilibrium within the supply chain. By maintaining consistency in pricing, the manufacturer can build trust and establish stable relationships with the distributors, ensuring the smooth flow of products and maintaining a stable market share.

Although the double marginal effect may have a negative impact on retail prices and total profits, the manufacturer recognizes that keeping the advertising level unchanged in the distribution channel can yield greater long-term benefits. Consistency in pricing and advertising strategies helps stabilize market demand and consumer awareness of the product. Furthermore, the manufacturer realizes that adjusting the advertising level in the distribution channel may disrupt the trust of distributors, leading to instability in the supply chain and unfavorable consequences. Thus, despite the potential negative impact on total profits from the double marginal effect, the manufacturer chooses to maintain the advertising level unchanged in the distribution channel to uphold the stability of the supply chain and maintain good relationships with partners. The long-term benefits of this strategy often outweigh the short-term profit loss, making it strategically significant for the manufacturer.

The Comparison of Strategies Between Internet-Based Targeted Advertising and Mass Advertising Within the Distribution Channel

We can compare the advantages and disadvantages of Internet-based targeted advertising and mass advertising in the distribution channel according to the analysis mentioned above.

Δ p = p_{IT}^{*} - p_{IM}^{*} = \frac{5 s + c_{T}}{6} - \frac{3 s + c_{M}}{4} = \frac{s - c}{12} > 0

(25)

Δ ω = p_{IT}^{*} - p_{IM}^{*} = \frac{2 s + c_{T}}{3} - \frac{s + c_{M}}{2} > 0

(26)

Δ ϕ = ϕ_{IT}^{*} - ϕ_{IM}^{*} = \frac{s - c_{T}}{3 λ} - \frac{{(s - c_{M})}^{2}}{16 λ s} > 0

(27)

Proof 3.

$\frac{ϕ_{IT}^{*}}{ϕ_{IM}^{*}} = \frac{s - c_{T}}{3 λ} \frac{16 λ s}{{(s - c_{M})}^{2}} = \frac{16}{3} \frac{s}{s - k s^{2}} > 1$ . Q.E.D.

Δ π = π_{IT}^{*} - π_{IM}^{*} = \frac{3 {(s - c_{T})}^{3}}{108 λ s} - \frac{6 {(s - c_{M})}^{4}}{256 λ s^{2}} > 0

(28)

Proof 4.

$\frac{π_{IT}^{*}}{π_{IM}^{*}} = \frac{3 {(s - c_{T})}^{3}}{108 λ s} \frac{256 λ s^{2}}{5 {(s - c_{M})}^{4}} = \frac{6}{5} \frac{s - c_{M} + c_{M}}{s - c_{M}} = \frac{6}{5} (1 + \frac{k s^{2}}{s - k s^{2}}) > 1$ Q.E.D.

Proposition 4. The manufacturer using an Internet-based targeted advertising strategy in the distribution channel can manipulate a higher total price and a higher advertising level. Meanwhile, the retailer can set a higher retail price within Internet-based targeted advertising strategies. In addition, both manufacturers and retailers can obtain much higher profits than with mass advertising, thereby inducing a higher total gain than mass advertising.

According to proposition 4, the firm can use Internet-based targeted advertising and manipulate a higher price to preclude the consumer with a low preference for product quality from the market. Otherwise, when the firm uses informative Internet-based targeted advertising for the product, it can reduce the waste cost of the product and improve the advertising level in a specific range. For the manufacturer, Internet-based targeted advertising is used to reduce advertising waste and benefit the manufacturer. For the retailer, the increased advertising level on a specific range makes the advertising more beneficial, and the consumers might purchase at a higher price. That means the manufacturer within the distribution channel can benefit from targeted advertising due to its reduced cost and decreased consumer heterogeneity. However, the reduced cost has little effect on the retailer, whereas the increased price might affect the retailer’s benefit. In all, the application of targeted advertising strategies might change the distribution of channel profits, thereby affecting the total profit of the channel. As long as the investment cost for the targeted advertising is appropriate, the manufacturer will adopt targeted advertising strategies. However, its potential risk to the development of the whole market should not be neglected.

Model Extension

In the above model, we consider that Internet-based targeted advertising is perfect due to accurate information about the consumers. However, it is difficult for the firm to get sufficient information about the consumers via the web in the current situation. Besides that, some information acquired by the firm might not be correct due to consumers’ anonymous information. Then, the match between the consumers and the internet-based targeted advertising is inaccurate. In the setup, we assume the manufacturer makes the strategies of advertising and price. Otherwise, the manufacturer can only send internet-based targeted advertising with a specific variable of targeting accuracy $α_{i}$ . The internet-based targeting technology, such as data mining, is directly related to the firm’s profit and advertising. The firm’s maximal profit model with internet-based targeted advertising can be expressed as the following expression.

max_{p_{T}, ϕ_{T}} π_{T} = (p_{T} - c_{T}) (1 - \frac{p_{T}}{s}) ϕ_{T} α_{i} - λ ϕ_{T}^{2} (1 - \frac{p_{T}}{s}) α_{i}^{2}

(29)

The parameter $α$ is the imperfect targeting accuracy parameter.

Obviously, the firm’s optimal pricing decision with Internet-based targeted advertising can be expressed with F.O.C condition. Meanwhile, $\frac{\partial^{2} π}{\partial ϕ_{T}^{2}} = - 2 λ (1 - \frac{p_{T}}{s}) α_{i}^{2} < 0; \frac{\partial^{2} π}{\partial p_{T}^{2}} < 0$ .

{\begin{matrix} \frac{\partial π}{\partial ϕ_{T}} = (p_{T} - c_{T}) - 2 λ ϕ_{T} α_{i} = 0 \\ \frac{\partial π_{T}}{\partial p_{T}} = \frac{- 1}{s} [(p_{T} - c_{T}) ϕ_{T} α_{i} - λ ϕ_{T}^{2} α_{i}^{2}] + (1 - \frac{p_{T}}{s}) ϕ_{T} α_{i}^{2} = 0 \end{matrix}

(30)

According to the equations, the equilibrium price ( $p_{DT}^{*}$ ) and advertising level ( $ϕ_{DT}^{*}$ ) with imperfect targeting accuracy of $α_{i}$ can be solved.

Therefore, according to the equation above, we can obtain the firm’s equilibrium price and advertising level with internet-based targeted advertising.

p_{DT}^{*} = \frac{2 α_{i} s + c_{T}}{1 + 2 α_{i}}; ϕ_{DT}^{*} = \frac{s - c_{T}}{λ (1 + 2 α_{i})} .

Thus, the manufacturer’s equilibrium optimal profit ( $π_{DT}^{*}$ ) is considered a $π_{DT}^{*} = \frac{{(s - c_{T})}^{3}}{{(1 + 2 α_{i})}^{3} λ s}$ . According to the result, we can obtain the following proposition.

Proposition 5. The targeting accuracy of the firm shows a bidirectional role in the firm’s equilibrium price. With increasing targeting accuracy, the equilibrium price of the firm increases and then reduces. However, the firm’s equilibrium advertising level and the firm’s equilibrium profit might be reduced.

According to the proposition mentioned above, targeting accuracy remains critical for manufacturers. This implies that firms in the retailing channel should place a greater emphasis on targeting accuracy when delivering imperfect targeted advertising in order to maximize profits. In other words, when manufacturers are able to identify heterogeneous consumers, they should prioritize sending targeted advertising to the optimal consumers. That means achieving perfect targeting accuracy still presents challenges as consumers’ preferences and behaviors may change over time, and different channels (such as social media and search engines) have unique advertising delivery methods. Therefore, businesses need to continuously optimize and adjust their targeted advertising strategies to adapt to the ever-changing market environment and consumer demands.

Conclusion

This study demonstrates that manufacturers can manipulate prices and advertising levels more effectively through Internet-based targeted advertising, resulting in increased profits in the direct sales channel. However, employing this strategy may lead to a higher retail price but lower overall profit in the distribution channel compared to direct sales. Internet-based targeted advertising, due to its lower costs, emerges as a preferable alternative to mass advertising across distinct advertising channels. The findings reveal that targeted advertising reduces manufacturer costs, while also meeting consumer needs and reducing consumer heterogeneity in the distribution channel. Notably, the reduced costs have minimal impact on retailers, but an increased targeting price may affect their benefits. Consequently, manufacturers can exploit targeting strategies to squeeze retailer profit margins under certain conditions. Even if retailers can set specific prices, they may not benefit from targeting strategies if manufacturers increase wholesale prices, thus diminishing retailer margin benefits. However, due to imperfect consumer information, achieving perfect advertising precision remains challenging. Retailers, therefore, need to prioritize targeting precision within their advertising strategies.

Overall, this article contributes by providing optimal choices for manufacturers and retailers regarding targeting strategies and highlighting the differences across distinct channels when utilizing various advertising approaches. It is worth noting that Internet-based targeted advertising can enhance manufacturer profits, potentially jeopardizing retailer benefits and overall distribution channel profitability. Public departments of governments should consider the potential risks associated with targeted advertising, as it may diminish true distribution channel benefits and hinder market development. Strategies should be adopted to prevent firms from obtaining highly accurate consumer profiles, and increased supervision is necessary to address potential risks introduced by such firms.

Regarding the study’s limitations, it assumes that all advertising is informative. Future research could explore the role of persuasive Internet-based targeted advertising across different channels. Additionally, if the accuracy of targeting advertising is less than perfect, further evidence is needed to determine its effectiveness for firms. Another aspect for future investigation could be the impact of decision timing changes for both manufacturers and retailers in a dual supply chain, as this study assumes that manufacturers decide on prices and advertising strategies first, followed by retailer determination of retail prices.

Footnotes

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: The projects supported by the National Social Sciences Foundation of China (No. 23BGL148), Zhejiang Provincial Soft Sciences Program (No. 2024C25045), Major Humanities and Social Sciences Research Projects in Zhejiang higher education institutions, Grant Number (No. 2023QN040) and the Youth Foundation of Social Science and Humanity, Yangzhou University (No. Xjj2021-06), are greatly acknowledged.

ORCID iDs

Zhao Jiang

Data Availability Statement

The authors confirm that the data supporting the findings of this study are available within the article and its supplementary materials.

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