The secret of Google... sort of
But as the business grew, Kamangar and Veach decided to price the slots on the side of the page by means of an auction. Not an eBay-style auction that unfolds over days or minutes as bids are raised or abandoned, but a huge marketplace of virtual auctions in which sealed bids are submitted in advance and winners are determined algorithmically in fractions of a second. Google hoped that millions of small and medium companies would take part in the market, so it was essential that the process be self-service. Advertisers bid on search terms, or keywords, but instead of bidding on the price per impression, they were bidding on a price they were willing to pay each time a user clicked on the ad. (The bid would be accompanied by a budget of how many clicks the advertiser was willing to pay for.) The new system was called AdWords Select, while the ads at the top of the page, with prices still set by humans, was renamed AdWords Premium.
One key innovation was that all the sidebar slots on the results page were sold off in a single auction. (Compare that to an early pioneer of auction-driven search ads, Overture, which held a separate auction for each slot.) The problem with an all-at-once auction, however, was that advertisers might be inclined to lowball their bids to avoid the sucker's trap of paying a huge amount more than the guy just below them on the page. So the Googlers decided that the winner of each auction would pay the amount (plus a penny) of the bid from the advertiser with the next-highest offer. (If Joe bids $10, Alice bids $9, and Sue bids $6, Joe gets the top slot and pays $9.01. Alice gets the next slot for $6.01, and so on.) Since competitors didn't have to worry about costly overbidding errors, the paradoxical result was that it encouraged higher bids.
"Eric Veach did the math independently," Kamangar says. "We found out along the way that second-price auctions had existed in other forms in the past and were used at one time in Treasury auctions." (Another crucial innovation had to do with ad quality, but more on that later.)...
"The mathematical structure of the Google auction," Varian says, "is the same as those two-sided matching markets."
Varian tried to understand the process better by applying game theory. "I think I was the first person to do that," he says. After just a few weeks at Google, he went back to Schmidt. "It's amazing!" Varian said. "You've managed to design an auction perfectly."
Someone you never heard of may actually have made one of the biggest innovations in advertising and online sales. According to this Wired story (h/t The Big Picture) on the economics behind Google's initial foray into the online world, Computer scientist Eric Veach, with the assistance of Salar Kamangar, may be responsible for turning Google into what it is.
The Wired story captures some of the economics that drives Google. The story doesn't cover the other half, which is just as important, dealing with the actual technology deployment and search engine design. Nevertheless, it's interesting that Google's initial success owes a lot to the decision by Eric Veach to use a two-sided matching market.
The story also gives some insight into how it is getting more and more difficult to dislodge Google. For instance, you get the sense that Google is literally a knolwedge-sucking entity, and the more it captures, the more of an advantage it gets. Google probably has more useful information than many intelligence agencies out there.