Integrating a Free Online Service: Advertisements and Competitive Implications

ABSTRACT This paper examines firms' incentives to integrate free, advertising‐financed online services with hardware products and their implications. Our analysis shows that service integration has a non‐monotonic effect on hardware prices while reducing advertising levels. Moreover, when the quality advantage is sufficiently large, integration increases both firms' profit by enabling them to monetize different user segments. However, for small to intermediate quality advantage, service integration can make the dominant firm better off and the rival firm worse off when the nuisance cost of advertisement is small to intermediate, and both firms better off when the nuisance cost of advertisement is sufficiently large. Finally, service integration can benefit users but harm advertisers.