Google is not only a powerful search engine, but also a service with a very successful pricing model for their advertising links. Instead of setting prices for clicks, Google creates a real-time auction, where advertisers can decide how much they are willing to pay for the ad. Economists love auctions because they reveal the customers' willingness-to-pay and allow the company to capture a better price.
- Some of you know more about Google Advertising than I do. Let me ask. Google makes money every time a user clicks on a sponsored link, but not all clicks cost the same. How does Google set the price per click? Do they have a huge price list for keywords in different countries? Certainly not. In fact, Google asks every advertiser to indicate their willingness to pay for a click on a specific keyword. So if you are willing to pay up to 20 pounds per click for the keyword mortgage, you will probably be listed very high in the search results so that many users click and Google makes a lot of money.
If you are willing to pay only 10 pence, Google will bury your ad on page 32, which means nobody will ever click. Of course, Google's algorithm is more complex than that, because Google also looks at the likelihood that the user is actually clicking, depending on his or her profile. So here comes the next question for my fellow economists. Why do we love auctions as a pricing-setting mechanism? While Google has millions of advertisers, for this purpose of this video, let's assume we have eight advertisers who all have a different willingness to pay per click.
What we wanna do first is to rank them from the highest bidder to the lowest. What we now see is the demand curve for a certain keyword. If we study this demand curve more closely and focus on the top three advertisements Google is going to display in search result, what revenue can it generate? If Google would not use the auction mechanism but charged the highest price that at least three advertisers are willing to pay, it will be three times nine pounds, for a total of 27 pounds.
This is a lot of money, given that the gross margin per click is close to 100 percent. But Google may not know the ideal price. So if Google charges less, say five pounds, the top three spots go for three times five pounds equals 15 pounds. If they charge more, say 12 pounds, the revenue would actually be 12 pounds, because only one advertiser is willing to pay that much. And now comes the absolute beauty of the auction process.
Instead of making 27 pounds or 15 pounds or 12 pounds, Google can actually make 39 pounds. How? By charging every advertiser his or her full willingness to pay. Auctions are also very powerful when you are selling something unique, like the painting by Pablo Picasso with the intriguing title Nude, Green Leaves and Bust. On May 4th, 2010, it took Christie's only eight minutes to auction that piece for $106.5 million.
Even more shockingly for me (laughs) is that Picasso painted it in one single day in 1932. While it might be impossible for you to sell your products and goods through an auction mechanism, (laughs) and even more impossible to get paid over 100 million for a day's work, you should always consider the idea behind the auction when setting prices. What if you give up your most unprofitable customers and look for the most profitable ones? How many would be willing to pay more for your service? And if you sell your house, you might actually not sell it to the first interested buyer, but search for the highest bidder in your market.
To summarize, economists love auctions, because they reveal the true willingness to pay and enable the seller to capture the full value of his or her offering.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action