AdWords: not quite a GSP?
If you perform a search query on Google to find out more about AdWords, chances are you’ll encounter articles about Generalized Second Price auctions (GSPs), a relatively new form of auctioning. Most of us are familiar with the traditional English auction were bidders sit in a room and shout incremental amounts as time goes by; the winner is determined by the highest amount. Under a Vickrey-Grove auction (sometimes called second-price), the winner is also determined by the highest bid, but the buyer pays the second highest price. These bids are usually sealed, which means you have no idea how much the others are willing to pay for the good. Under such a setting, the optimal strategy is to bid the maximum amount of money you are willing to pay. That way you maximize your chances of winning the auction without suffering from a loss of well-being because you paid more than you were willing to.
So what’s different under a GSP auction? Simple: this time the optimal strategy isn’t necessarily to bid as high as you are willing to go. It’s well known that top-position ads in Google search receive more attention. However, sacrificing top for lower spots can sometimes lead to better results when the traffic generated from your ads remain about the same, but total advertising costs are lowered.
Now the interesting thing about GSP is that the concept is fairly recent in the economic literature and seems to have been tailored for conducting online space auctions. I haven’t been able to get a hold of a more up-to-date document talking about GSP that mentions the quality variable Google uses to reward or penalize players because of their content. While the basic mechanics remain the same with or without a quality variable, the final outcome (price you actually pay) can vary greatly.
The AdWords auction
For those who are very familiar with Dr Varian’s video, you can skip this part. Every time a search is made, Google’s algorithm first determines who the players are depending on the kind of query performed. It then calculates their order using Rank Value:
The higher your Rank Value, the better your ad’s position on the search pages. Google then determines how much you pay for a click in that auction. That price depends on three factors:
1. Your ranking among the auction competitors
2. The performance of the competitor ranked under you
3. Your Quality Score
Note that we could simplify the equation using the variable ‘Rank value’ from above:
The equation tells us two very important things:
1. The higher your Quality Score, the lower your click’s price.
2. The next advertiser’s performance has an important influence on your click’s price.
The optimal situation for the advertiser is the one where both his quality score and gap between Rank Values are at its highest. Here’s a little example where you compete against two other advertisers:
Rank value=4 (8*0.5)
Rank value=0.3 (2*0.15)
|You the advertiser:
How much should you bid to maximize your CPC value? Bidding $0.41 would beat both advertisers A & B (10*$0.41 = Rank value of 4.1) and the price you pay would be $0.41 (Rank Value of A / Your Quality score + $0.01). Bidding $0.39 or under would only beat advertiser B (10*$0.39 = Rank value of 3.9). However, the price you pay would be only $0.04 (Rank Value of B / Your quality score + $0.01). In this case, bidding $0.39 and losing first place to advertiser A would be a better idea as you would save $0.37 ($0.41-$0.04).
What does this mean for your business?
In reality, so many factors come into play when users select which search result they want to click on and explore, not to mention the fact you cannot actually know who and how well your competitors are doing. Notice that in the example above, we haven’t introduced the notion of click-loss as a result of a lower ranking. Generally, losing ground in the rankings can lead your ads to receive less attention and ultimately less clicks. However, maintaining an average ad position above 1.9 might increase your ROI; you may lose a few clicks but cut on costs too. Hence lowering your bids is sometimes a good strategy.
Having a deep and solid knowledge of what the AdWords and Analytics tools can do for your company is extremely important. Having a basic understanding of the economics driving Google’s main source of revenues isn’t a bad thing either; it can definitely help you understand how it works and how it wants to do business with you.