http://seekingalpha.com/article/67381-cpc-advertising-takes-its-toll-on-google?source=financialcontent

In class, we have recently been discussing how Google auctions off its advertising slots. In short, Google uses a General Second Price bid auction (GSP) where the advertisers report some value per click on their advertisement. This value is taken as a bid which then is used to establish prices for the slot. In the end, the advertiser will pay the cumulative price of the price per click multiplied by the click-through rate of that certain slot. The interesting thing about the general second price auction is that even though there will always be a Nash equilibrium among bidders, it is not a dominant strategy for advertisers to bid their true value. Furthermore, even though there may be a Nash equilibrium that maximizes social welfare, this does not always occur. It seems interesting that Google would use a bidding procedure that does not maximize social welfare whereby an auction procedure that did could produce greater revenue. However, there are constraints to consider in Google’s bidding market and it is those constraints that Terence Channon considers in his article “CPC Advertising Takes its Toll on Google.” The model of the General Second Price auction presented in the book had to strip down many of the complexities of Google’s ad market in order to create an understanding of the GSP. Channon reintroduces some of these complexities and how the complex market that Google faces has lowered profits which might make the cost per click auction not a dominant strategy for Google in terms of revenue maximization.

The first challenge Google faces is that the actual companies in the search term have taken actions controlling the advertising market. For example, companies that have trademarks such as Direct TV and Comcast restrict who can advertise on the page when their trademark is used as the search term. These companies are ultimately controlling who can advertise on the page and filtering out major competitors. Such actions have greatly reduced Google’s revenues both in terms of the price per click it can charge and the actual number of clicks that the ads generate. The trademarked companies are reducing the demand for Google’s ad market for that specific search term and reducing the price per click. Furthermore, with fewer relevant advertisers, the number of clicks has reduced greatly. Therefore, such restrictions by the organic search company has generated a double reduction in Google’s revenues. Strategic behavior between parent and subsidiary companies has also had revenue reducing effects for Google. In short, the parent company will tell the subsidiary company not to bid for the top slot. The parent tells the subsidiary that the parent will get the top slot, the subsidiary the second slot and they can share the surplus from the cheaper price per click rate. Though this price ceiling benefits the advertising companies, it is at the cost of Google’s revenue. Finally, Advertising companies are starting their own price per click campaigns which further reduce Google’s supply and revenue.

Another topic brought up in class shortly was the idea of “click fraud” or causing companies to pay large sums of money to Google by clicking on their Ad multiple times. Google has technology to detect fraudulent clicks to protect advertisers and it was posited that 3-15% of clicks are in fact fraudulent. Though the programs installed are not perfect in identifying all fraudulent clicks, even a low percentage of fraud detection could cost Google millions or even billions in revenue because they guarantee reimbursement for detected fraudulent clicks. So, I guess we can’t raise the price of Google’s stocks by clicking more on their Ads and generating more revenue. The costs of any such fraudulent click campaigns goes right back to the advertisers themselves. These complicating issues have led the author to proffer that Google may increase revenue by utilizing a CPA or a cost per acquisition auction rather than a CPC (cost per click auction). It’s interesting to consider if such a program might also lead to bidding your true value to once again become a dominant strategy. This interesting review of Google’s advertising market shows how restrictions on trade and collusion can greatly distort an otherwise fairly efficient market mechanism.