Page 668 - Microeconomics, Fourth Edition

c15riskandinformation.qxd 8/16/10 11:10 AM Page 642

642 CHAPTER 15 RISK AND INFORMATION

and thus greater benefits from their spending on ads. probably not very effective. Instead, an auction is a way
Google gets more search-engine users, and higher to assess the amount that advertisers are willing to pay
demand and prices for its sponsored links, if the algo- separately and automatically for each unique user
rithm it uses better achieves those objectives for its search. In effect, Google is running a new auction with
customers and advertisers. every search. Note that this approach is only possible
The price and order of a sponsored link depends because of high-speed computers.
largely on two factors. One is the likelihood that a Google uses a generalized second-price sealed-
user’s search will lead to a click on a sponsored link. bid auction to sell AdWords. This format is similar to
For example, some users are likely to be searching for the second-price sealed-bid auction described in this
a product to buy, while others are looking for infor- chapter, but somewhat more complicated. In the stan-
mation or a weather report. Users who are searching dard second-price auction, there is a single winner of
for something to buy are more likely to click on a the auction, who pays the second highest bid. In
sponsored link and are thus more valuable to Google’s auction, multiple advertisers “win” by hav-
Google’s advertising business. To assess this, Google ing their ads placed on the page as sponsored links.
assigns a “quality score” to each keyword, based on Each ad pays an amount equal to the next highest bid
factors such as how often the user clicks on a link that is below its bid. Thus, links that are higher on the
after using that keyword in their search. page pay more. Google developed this auction
The second factor used in pricing and ordering a method on its own, but before launching it they
sponsored link is how much advertisers are willing to asked economist Hal Varian to analyze its properties.
pay for an ad. Advertisers on Google’s search engine His conclusion was that the method would be quite
page choose keywords that they think are relevant to effective at efficiently allocating Internet advertising.
the product they are advertising. They then bid the At that point, Google launched AdWords to great
maximum amount they are willing to pay for each click success, and hired Varian to be the company’s chief
on their sponsored link from searches using that key- economist. AdWords are highly profitable not only to
word. In other words, Google auctions off sponsored Google, but also to its customers, since Google’s algo-
links. An auction is an effective way to determine pric- rithms increase the likelihood that relevant advertise-
ing in this case because there is enormous variation in ments are presented to users of its search engine. A
the types of keywords and in demand for advertising recent analysis by Varian estimates that the value of
associated with each ad. While Google could try to set the ads to advertising firms are approximately 2 to
prices itself, the market it faces is so complex and ever- 2.5 times the cost of the ads. 20 Thus, firms earn sub-
changing that such an approach would be costly and stantial producer surplus from AdWords.

If bidders respond to the possibility of the winner’s curse by shading their bids in
a sealed-bid auction, one might wonder whether a first-price sealed-bid auction is best
from the auctioneer’s perspective. It turns out that when bidders have common val-
ues, a better auction format for the seller is the English auction, in which bidders can
see the bids of the other players and can revise their opinion of the item’s value as the
bidding progresses. In particular, if you initially have a low estimate of an item’s value,
the fact that other players continue to bid aggressively on it will lead you to revise
your estimate upward. This, in turn, reduces your incentive and the incentives of
other bidders to shade bids downward in fear of the winner’s curse. Game theory
analysis can show that the auctioneer’s average revenue over many auctions will be
higher under an English auction than under a first-price sealed-bid auction, a second-
price sealed-bid auction, or a Dutch auction. 21 This might partly explain why English
auctions are so prevalent in the real world.

20 Hal Varian, “Online Ad Auctions.” Working paper, University of California at Berkeley, 2009.
21 This is true both when bidders are risk neutral and when they are risk averse.