Economics of Online Marketing

The Brain Talent office used to be the house where Adam Smith lived. So it’s quite an appropriate place to be writing about the economics of online marketing.

When I worked in economics I was mainly doing cost benefit analysis for government projects and I also spent some time studying the impact of broadband on a country’s economy. This sounds a huge distance away from online marketing and it is but a lot of the economic tools are the same.

The most obvious place to start is with Pay Per Click advertising on the search engines. Google use a bidding system which is based on a Vickrey auction. William Vickrey won the Nobel Prize for Economics in 1996 but his work on auctions was done in the 1960s. A Vickrey auction works with sealed bids (so you don’t know what the other participants are bidding) but the clever is that the winner pays the second highest price.

This seems a really strange way for the seller to run an auction because it would appear that they would get a higher price for their product if they took the highest price rather than the second highest price. However research has shown that this isn’t the case and in fact the seller does very well out of a Vickrey auction because:

• Bidders are not worried about paying too high a price so they will bid more
• Bidders who bid a high price are more likely to pay the market rate
• The price the winner pays is determined by the other bidders, not the winner’s bid

However there is still a danger of winner’s curse. Winner’s curse is when the winner of an auction pays more than the market rate for the product being sold. In a Vickrey auction two bidders would need to over estimate the value of the product for winner’s case to take effect.

So that’s the theory, but how does it work in practice? The first thing to clarify is that Google AdWords uses a modified version of the Vickrey auction. The main change is that a quality score is also applied to the bids, adverts that are clicked on more frequently have a higher quality score than adverts that are infrequently clicked on. As an example, if one advertiser has a Click Thru Rate of 5% and bidded £0.50 per click but another advertiser had a Click Thru Rate of 2% and bidded £1 per click then Google would make more money from displaying the first advertiser’s adverts as the increased clicks would compensate for the lower bid.

There has been no formal study that I am aware of into winner’s curse and online advertising auctions. I suspect that it applies in a different way from normal. On the positive side the Vickrey auction is less prone to winner’s curse, secondly for an advertiser to win they would need to have bidded too much and also have high quality adverts. I strongly suspect that advertisers who have produced high quality adverts probably understand the market sufficiently that they will not over bid.

Winner’s curse probably arises most often when advertisers get first place. In an AdWords auction the advertiser with the highest combination of bid and quality score will have their advert displayed first, followed by other advertisers in descending order of bid and quality. However there is no evidence from my experience that the first advert is clicked on much more frequently than the third or fourth adverts. So in the AdWords auction it is probably best to come third or fourth, unless you are much more profitable per sale than your competitors.

In summary, the Google approach is not bad from the point of view of sellers, users of Google and Google itself. The main criticism I would make is that Google doesn’t publish the exact details of how it works but I’m sure in time as the company matures they will make more information available to their customers.