Google's AdWords Auctions

In this week's issue of BusinessWeek (March 6, 2006), an article called The secret to Google's success describes a study by three economists showing that Google's mechanism for auctioning ad space (called AdWords), which is supposed to be a second-price auction, actually "differs in a key respect from the one economists had studied".

I tracked down a report on this study ("The high price of internet keyword auctions" by Edelman, Ostrovsky, and Schwarz) to find out more. And I found out something that is directly related to our work on eBay auctions...

Starting from the basics, a second-price auction is one where the highest bidder is the winner, and s/he pays the second highest bid (+ a small increment). This is also the format used in most of eBay's auctions. According to auction theory (derived from game theory), in a second-price auction the optimal bidding strategy should be to bid your true valuation. If you think the item is worth $100, just bid $100. Going back to the study, the economists found that the mechanism used by Google's AdWords does NOT lead to this "truth telling". Instead, sophisticated users actually tend to under-bid.

The authors' recommendation is "that search engines consider adopting a true Vickrey setup... [where] the system and bids would remain relatively static, changing only when economic fundamentals changed". And this is where I disagree: I have been conducting empirical research of online auctions from a different, non-economist perspective. Instead of starting from economic theory and trying to see how it manifests in the online setting, I examine the online setting and try to characterize it using statistical tools. An important hypothesis that my colleague Wolfgang Jank and I have is that the auction price is influenced not only by factors that economic theory sets (like the opening price and number of bidders), but also by the dynamics that take place during the auction. The online environment has very different dynamics than the older offline version. Think of the psychology that goes on when you are bidding for an item on eBay. This means that perhaps classic auction theory does not account for new factors that might determine the final price. Of course, this claim has always won us some frowns from hard-core economists...

For example, many empirical researchers have found in eBay (second-price) auctions that bidders do not follow the "optimal bidding strategy" of bidding their truthful valuation. In fact, on eBay many bidders tend to revise their bids as the auction proceeds (the phenomenon of last-moment-bidding, or "sniping", is also related). There have been different attempts to explain this through economic theory, but there hasn't been one compelling answer.

In light of my eBay research, it appears to me that the recommendation to Google to use the ordinary second-price (Vickrey) setting does not take into account the dynamic nature of the AdWords auctioning. The streamining updating of bids that is done by advertisers probably creates dynamics of its own. So even if they do change it to the eBay-like format, I am doubtful that the results will obey classic auction theory.