The Hidden Risks of Micro-Targeting

On July 21, 2024, Google announced its decision to reverse its plan to eliminate third-party cookies (text files with small pieces of data). This move has significant implications for the digital advertising ecosystem. Originally, Google intended to phase out third-party cookies by 2022 as part of its Privacy Sandbox initiative, which aimed to create a more privacy-centric web environment. However, this plan faced substantial pushback from the advertising industry, which relies heavily on third-party cookies to track user behavior across websites and deliver personalized ads. 

July’s reversal allows advertisers to continue using these cookies if individual users give express permission. This enables Google to collect detailed user data, create comprehensive user profiles, and implement highly targeted ad campaigns by using cookies to track their behaviors across the web. 

This ability to track users across multiple sites is expected to help publishers increase their revenue by offering advertisers the chance to reach specific, high-value audience segments with precision. In theory, this should lead to more effective ad campaigns and higher returns on investment for the ad network.

However, the benefits of such precise targeting come with significant drawbacks that could undermine the overall effectiveness of digital advertising.

First, for ad publishers, research by Levin and Milgrom (2010) and Bergemann and Bonatti (2011) illustrate that when targeting becomes too granular, it can fragment the market into numerous small segments. In these fragmented markets, fewer advertisers compete for each customer segment, leading to a phenomenon known as market thinning. 

Google ads work by creating auctions where key words used in searches are bid upon by potential advertisers. The more popular a term is, the higher the cost of buying that particular phrase for an ad. Reducing competition comes from the fact that micro-segmentation narrows the pool of potential bidders for each ad impression. This diminishes auction intensity and drives down the price per impression. As the number of advertisers interested in each specific segment decreases, publishers are forced to sell ad space at lower prices, which then leads to decreased overall revenues. 

The downsides of finer targeting for ad publishers are further highlighted in research by Rafieian and Yoganarasimhan (2020). They empirically examined the impact of targeting strategies in mobile advertising. They found that when targeting is coarser – i.e., limited to broader, less granular customer information– it prevents the market from thinning. This broader targeting maintains robust competition among advertisers, leading to higher bidding prices and increased ad network revenues. This suggests that coarse targeting—such as not using third-party cookies to gather general user information across the web—can be more beneficial in preserving the profit margin in the online advertising industry for the ad network.

The potential negative effects of micro-targeted marketing are not limited to publishers alone. Even though the market becomes fragmented, multiple advertisers still compete for the same set of customers, and the competition among them is expected to become more intense. Shaffer and Zhang (2002) explore the impact of personalized promotions on price competition and find that such strategies could also negatively affect sellers (or advertisers). When firms use personalized promotions based on detailed customer preferences, they engage in aggressive discounting to capture the targeted segments. This intense competition can drive down prices and reduce profit margins, especially for smaller firms. 

The key insight from these studies is that the benefits of third-party cookies are not straightforward; while they offer tools for precise targeting in digital advertising, they may also lead to reduced profit margins for inefficiencies for both publishers and advertisers. Uncertainty remains as to whether the continued use of third-party cookies will necessarily benefit the advertising industry in the long term. Publishers and advertisers may want to consider whether strategies focused on coarse targeting (which maintains broader competition across customer segments for bids and reduces price competition towards final consumers) might offer more sustainable outcomes.