Second Priced Auctions in Google
Google is world renown for their search engine, performing tens of thousands of searches per second. But how exactly does Google generate revenue? The main method is through advertisements, however Google has a very unique program in which advertisers can promote their product through Google.
Called Google Adwords, it is a key-word based advertisement system that triggers whenever you query a search on Google. Google determines what advertisement to show through an auction. For example, if I query “car insurance” into Google and it is relevant to a company’s website, an auction will trigger for different companies to bid on. For a company to earn money off of advertising, it would want the economical value of its bid. If I sell car insurance for a $10 profit with a 25% conversion rate (that is, 1 out of 4 people will buy car insurance), then the economical value of my bid should be $10*0.25 = $2.50, which will be my bid value. But if nobody else is selling car insurance, I would have no reason to bid anything higher than $0.01. Moreover, if another bidder comes along and bids anything lower than $2.50, we should just increase the bid by $0.01, so if my competitor comes along and outbids me with a $0.02 bid, we will bid $0.03, so on and so forth. This is a very repetitive cycle, especially since popular keywords may get multiple thousand bids per second.
Ultimately this leads up to Google Adwords being a generalized second-price auction. I will always bid my economical value of $2.50, but if nobody else bids, then I will win with a bid of $0.01. In general, we will pay $0.01 above the second highest bidder that is below our economical value. This is a very strong system because of 4 primary reasons:
- If you bid lower than your economical value, you could potentially lose the bid for lower than your maximum economical value, but higher than your current bid. (i.e. if I bid $2.20 and lose to $2.21)
- If you bid higher than your economical value, you may have to pay over the economical value of your bid, resulting in a potential revenue loss.
- You pay exactly what you want at a fair game with the other competitors.
- It has a Nash Equilibrium where every bidder i bids their maximum value vi (also called a truthful equilibrium). If everyone bids their economical value, then nobody has a substantial reason to deviate. If they get outbid and decide to go above, they will run into (2).
Note that in the actual Google Adwords auction, they take into consideration the relevance, quality, and click rate because Google only gets paid if the user clicks on the advertisement. However, in the end, everyone wins. Google maximizes revenue by getting users to click on advertisements, advertisers maximize revenue by paying up to their maximum economical value, and users will be able to see properly placed advertisements.
http://www.hss.caltech.edu/~mshum/ec106/gsp.pdf
http://smallbiztrends.com/2011/12/google-adwords-auction.html
http://homepages.cwi.nl/~apt/stra/ch7.pdf