What Makes Google Tick?

Transcription

1 What Makes Google Tick? Greg Taylor Oxford Internet Institute, University of Oxford, Oxford, UK This short article is an educational piece for aspiring economists, written for and published in Economic Review, Vol. 28, No. 2 (2010) pp Nine of the twenty most visited websites in the world are either web search engines (such as Google.com) or Internet portals (such as Yahoo.com) that provide access to a web search service. Every second of every day, somewhere in the world, around three thousand people hit the search button on Google, with thousands more using other popular search tools. As such a central point of departure for users, search engines represent the beating heart of the web. It seems natural that economists who are so concerned with the trade of goods and services should be fascinated by a tool that can be used to help consumers find things to buy; but search engines also conceal a hive of economic activity in their own right, and this lends search engines like Google a double allure for the curious economist. In this article we will look at how search engines function as businesses, act as a service to web users, and transform the very nature of the World Wide Web. 1 TWO-SIDED PRICING An immediate puzzle is: why exactly has Google been so successful as a business, given that it allows its users to search for free? The answer to this question lies in a closer examination of a Google page. Most Google searches produce a results page that looks like the one pictured in Figure 1. Along with the main body of (so-called organic) search results, there is a separate list of links across the top and along the right hand side of the page these are the so-called sponsored search results, which are nothing but advertisements by another name. These advertisements are links pointing to the websites of firms that pay for the opportunity of appearing close to the top of the first page of Google results. The value of this opportunity (that is, how much firms can be expected to pay to appear in the list of advertisements) is dependent upon the number of consumers exposed to the ads. Correspondence address: Oxford Internet Institute, University of Oxford, 1 St. Giles, Oxford, UK, OX1 3JS. greg.taylor@oii.ox.ac.uk. 1

2 2 GREG TAYLOR Organic Search Results Sponsored Search Results Figure 1: Organic and sponsored search results on Google. Now, imagine that Google decided to charge a small amount of money for conducting a search. People with important search queries would be prepared to pay, but most people would search less often not running searches that they deemed unimportant. Thus, Google faces a downward sloping demand curve for its search service (see Figure 2). When fewer search queries are conducted, a smaller number of people are shown advertisements. By allowing users to search for free, Google maximises the number of people that see sponsored search results, which in turn maximises the income that Google enjoys from selling advertising space. High By alloiwing free searches, Google maximises its number of users, which increases the value of the advertisements that it sells. Price of a search 0 0 Number of searches conducted Many Figure 2: Google faces a downward sloping demand curve for search. Setting a positive price for searching would reduce the number of searches conducted, so Google would earn less money from selling advertisements. This kind of pricing scheme is known generally as two-sided pricing (the two sides

3 WHAT MAKES GOOGLE TICK? 3 being advertisers and consumers), and is remarkably common. In a similar fashion, free daily newspapers are given to commuters to maximise advertisement revenues; game consoles are sold at a loss so that more people buy games (and firms like Nintendo and Sony maximise their royalties from game sales); and night clubs offer free entry to women in order to attract more fee-paying men. It s fairly rare to find a night club that offers free entry to men whilst charging women a positive admission fee. That s because the club owners believe that men care more than women about having many members of the opposite sex around. Economists say that the women s presence creates a positive externality for the men. Thus, the general profit maximising strategy of two-sided pricing is to subsidise participation on the side of the market (e.g., female nightclub patrons, search engine users, newspaper readers, or console owners) that generates the largest externality, and use a high price to extract that created value from the other side of the market (e.g., male nightclub patrons, advertisers, or console game makers). The twosided strategy works so well for Google because advertisers care so much about having a large audience of search engine users. 2 CLICK AUCTIONS This, though, exposes another dilemma for the search engine. A search for ipod nano produces a list of around ten advertisers, and Google must determine what the appropriate price for appearing at each of the ten positions (or slots) in that list should be since ads close to the top of the list receive more clicks. Moreover, a search for London hotel produces another list of advertisements, which must also be priced. In fact, there are an infinite number of possible search queries, and far too many advertisers for Google to determine separate prices for each. Luckily, there is a millennia-old method for determining the appropriate price for things whose value is unclear, and that is to run an auction. It is precisely by running an auction for each keyword that Google determines the proper price for the advertisements that it shows. In fact, online ads are often sold using a special kind of auction known as a generalised second price (GSP) auction. For any keyword, advertisers are asked to enter a bid into Google s computer system and are then ranked, with the top advertisement slot being allocated to the highest bidder and the second to the second highest bidder and so on. If a firm not currently on the list thinks that it can make more money than the cost of an advertisement slot, it will try to outbid the other firms and the price of the advertisement slots will rise. The price will continue its increase to a level such that only the included firms are willing to pay Google is thus ensured a good price for its advertisement slots without having to know the value of each one. Moreover, in a GSP auction, winning bidders pay not their own bid, but the bid of the firm in the slot below them. The advertisers thus know that they never have to pay more than is necessary to win a

4 4 GREG TAYLOR given advertisement slot. Table 1 illustrates how bids translate into prices and slots in an imaginary GSP auction to allocate three slots. Table 1: Example bidding in a generalised second price auction with three slots to allocate. Bidder Bid Allocated Slot Price Paid Firm A st 8.50 Firm B nd 7.00 Firm C rd 6.00 Firm D 6.00 none none The price set by the auction is charged on a per-click basis each advertiser pays once for each user that clicks on its ad. This has the advantage that advertisers do not have to pay for consumers that see, but are not interested in their respective advertisements reducing the risk that the firm has an expensive but ineffective advertisement campaign. This risk is, instead, borne by Google, which faces the danger that many of its precious ad slots will receive few clicks. However, Google hosts so many different advertising campaigns that the chances of them all performing badly is miniscule, and so Google is much better placed to diversify away this risk. This is exactly the same principle that makes insurance companies possible. Such companies are willing and able to provide insurance cover in return for a small fee because the chances of everyone experiencing, for example, a theft at the same time is very low. Per-click pricing, however, introduces a new challenge. Ranking firms by their bid for a click is all well and good, but the price per click isn t all that Google cares about. Google would rather have ten users click on an advertisement that it has sold for 1 per-click than just one consumer clicking on an ad priced at 5 per-click. More generally, what Google cares about is how much money it receives in total (which is the per-click price multiplied by the total number of clicks), rather than the price per click. Thus, in order to get the most value out of an ad slot, Google uses a slight variation of the GSP auction in which it forecasts how many users will click on a firm s advertisement and then ranks the advertisers according the product of this forecast and their bid. 3 MAKING USERS CLICK Given the importance of having a high volume of ad clicks, is there anything Google can do to tempt users into clicking? The very use of per-click pricing is of immediate assistance here. Since an advertiser has to pay for every click on its ad, it has a strong incentive to make sure that consumers it cannot serve do not click. This can, in part, be achieved by making the text of its advertisement as honest and informative as possible. By encouraging honest behaviour from advertisers, per-click pricing not only saves Google the

5 WHAT MAKES GOOGLE TICK? 5 trouble of policing its advertising space, but also makes consumers more likely to trust (and click on) those same ads. Sometimes there are fewer potential advertisers than there are slots available. Then it would seem that a firm could be sure of a spot on the list, even with a very low bid. In these circumstances, Google prevents such firms from appearing by using a reserve price a minimum bid necessary to win inclusion on the list of advertisers. The use of such a reserve price has two desirable effects for Google. Firstly, if the firm values the advertisement opportunity highly then it will be willing to increase its bid to meet the reserve price, and the minimum price thus forces the firm to pay more for its slot than would otherwise be the case. The second advantage to reserve prices is a little more subtle: if a potential advertiser expects to sell to only a small fraction of its visitors (because most of them do not like the products that it sells) then it will make little money from an advertisement, and will balk at being asked to pay the minimum price instead dropping out of the auction altogether. Thus, the use of a reserve price eliminates those advertisers that consumers find least useful. In the long run, this should mean that search engine users click on more advertisements since they expect the average advertisement to be more useful (i.e., to lead to a site which is more likely to satisfy their needs). By eliminating bad advertisers, Google delivers more consumers to the good advertisers, who pay more in return. Users also have to decide the order in which to click on advertisements. They face an entire list of advertisements, and must decide which are most likely to be useful to them. The auction helps here too the firms close to the top of the list tend to be the ones that bid the most because they believe that they can make the most money, which often means they are the most likely to sell what the user wants. Thus, the auction helps consumers by putting the most relevant advertisements right at the top. But perhaps the site at the top of the list is willing to bid more simply because it has a higher price and makes more money on each sale? in that case, the list order doesn t help consumers very much. Suppose for one moment that consumers do click ads at the top of the list first. Those top advertisers would get lots of clicks from people who know that there are plenty of other links lower down the list to view. If the firm sets its price too high, the consumers will just carry on searching lower down the list. Only by offering a very low price can such a firm convince many of these early visitors to buy immediately rather than looking carefully at some of the other advertisers websites. However, if top firms do offer a low price, even more consumers will want to visit them first so that low prices for the top firms are self-sustaining. By contrast, a firm at the bottom of the list knows that many of its visitors were sufficiently unimpressed with the firms above it to make them want to continue searching. Since such a firm knows that it is effectively the only show in town for many consumers, it can get away with charging a high price. When a group consumers are very sensitive to price increases (e.g., consumers who

6 6 GREG TAYLOR click on the ad at the top of the list), we say that their demand is highly elastic. The demand of consumers who are not price sensitive (e.g., consumers who click on the bottom ad) is often described as being inelastic. Figure 3 shows an elastic and inelastic demand curve. Elastic demand: a small increase in price leads to a big fall in demand. Inelastic demand: a large increase in price leads to a small fall in demand. Price Price Quantity Demanded Quantity Demanded Figure 3: Elastic and inelastic demand. 4 COMPETITION The vast financial rewards that a successful search engine like Google enjoys attract other companies such as Microsoft into the Internet search business. But, as we saw above, search engines tend not to charge users of their service. How, then, do competing search engines attract users to their site? Since consumers can use any search engine for free, search engines have historically worked fiercely to win users by building a reputation for providing the best results. Teams of software engineers work behind the scenes writing and refining the search algorithms that are responsible for ranking the organic search results that make up the bulk of the typical search result page. Search engines receive no money for providing these results, but rather offer them as a honey pot to attract consumers in the hope that they will stay to click on an advert or two. Providing great organic results, however, brings its own complications. When consumers choose which link to click next, they must decide which of the available sponsored and organic links looks like the most relevant. The better are the organic links, the more consumers will click on one of them, rather than on the adjacent advertisements. Since Google receives money only for advertisement clicks, this implies a fall in revenues for the search giant. This problem is not small: the top organic links receive several times more clicks on average than the top advertisement.

7 WHAT MAKES GOOGLE TICK? 7 5 CONCLUSION To summarise, search engines are in the business of selling advertisement space. Since the value of an advertisement increases as more people view it, great care is taken to make search engines as attractive to users as possible. In particular, a valuable search service is provided to end users for free in order to attract them to the site. Advertisements are sold by auction to ensure that the price is neither too low nor too high, and that the best firms are chosen as advertisers. The rules of this auction are carefully chosen to be compatible with the search engine s overall objective of delivering relevant ads that consumers want to click on.