Targeted advertising with vertically differentiated products

This paper presents an incomplete information game of pricing and targeted advertising with vertically differentiated product. Firms have incomplete information about production costs and can inform consumers about price and product characteristics by either using the mass media, which reaches the whole market, or the specialized media, which reaches only the most eager consumers. In this framework, we show that pure strategy Bayesian Nash equilibria exist, and that, as compared to mass advertising, targeting leads to higher prices. Further, we offer an explanation for permanent market fragmentation, which is related to high production costs, and prove that the probability of such fragmentation is directly related to the degree of precision of the targeting technology. Finally, we show that targeting can only occasionally reduce welfare.