Google AdWords
Keyword Pricing Secrets

The Insider's Guide to Vickrey Auctions

by William Charlwood

When you bid for a keyword to trigger the display of your ad on Google, you are participating in a real time Vickrey Auction.

Okay, so now you know the name, what the heck is a Vickrey Auction? Naming, after all, is not explaining.

A Vickrey Auction is where the highest bidder wins - but he/she only pays the second highest bidding price.

Let's say there's an auction of 3 people

A bids $1.00
B bids $1.15
C bids $1.45

In this case, C wins the bid but pays only $1.15.

So why would anyone selling anything want to sell via a Vickrey Auction when it seems they don't get the best price that way?

The answer is that they do - provided everyone who is bidding knows what is going on. In Google's case, this is far from the truth at the moment but by the time you've finished this article you will be one of the few who do and it could help you plan your AdWords campaigns better.

If you participate in a Vickrey Auction, you can safely bid the maximum price that makes sense to you in the knowledge that if you win, you will pay less than this. If everyone understands this, they will all bid the maximum they can afford and the seller does very nicely. Furthermore, no one ends up paying more than they can afford.

This process also keeps people in the bidding who would otherwise be nervous of pitching too high.

At the moment very few people understand what is really going on behind Google's bidding process and therefore the prices that people bid are often well in excess of what they are really prepared to pay. In fact, unless you are operating in a highly competitive area, you can generally afford to bid high provided no one else is adopting a similar tactic. Here's why.

Why it can be dangerous to bid high

Google uses a variation on the Vickrey Auction model to determine how much you pay when your ad is clicked. Let's look at the situation when three people again are bidding.

A bids $1.20
B bids $2.50
C bids $1.21

B wins the bid, but Google sets the price paid at 1 cent ABOVE the next highest price. In this case then B has to pay $1.22 for the click. This is well below the price he bid.

Now it may be that B simply set his price high because he thought that $2.50 would guarantee top slot and that everyone else would be bidding much lower which in this case was true.

But suppose C also adopted the same philosophy and bid $2.30 instead of $1.21.

A bids $1.20
B bids $2.50
C bids $2.30

In this case, B would still win - but would have to pay $2.31 for the click this time.

This shows why it is dangerous to bid too high just to achieve a high ranking. You can't always assume you will pay much less than your maximum bid price.

2 additional Google twists

Just to make the process more complex, Google adds a couple of twists to this process too.

In the above examples, we talk about bid prices measured in dollars and cents. In practice, Google uses a different "currency". Let's call it your bidding power.

Your bidding power is equal to your bidding price multiplied by your ads popularity for the relevant keyword. What this means is that your bidding power doubles if you run ads that achieve twice the click through rate of competitor ads for a given keyword even if you are bidding exactly the same amount of money per click.

Example:

Bid price $2.12
CTR 2%
Bidding power = 414

Bid price $2.12
CTR 1%
Bidding power = 212

When you bid in Google's real time auction for an ad, it is your Bidding Power and not simply your bidding price that determines where your ad will rank.

If you get a high CTR, you can still have a higher Bidding Power than your competitor who is bidding a higher price than you. This is why it pays to have ads that get the clicks.

How this fits with the Vickrey Auction

The model is the same as the dollar-only model we first discussed but this time, instead of costing you dollars and cents per click, you get charged an amount of Bidding Power.

Example

A bids 400 Bidding Power Units
B bids 300 Bidding Power Units
C bids 349 Bidding Power Units

A wins the bid but pays only 350 Bidding Power Units. (1 more than the 2nd highest bidders bid of 349)

Google charges A in dollars and cents so how much does he pay?

The answer depends on his Click Through Rate. If he has a CTR of 1% he will pay $3.50 because 350 x 1 = 350.

On the other hand, if he is achieving a CTR of 5% (which is what top performing ads can achieve), he will pay 70 cents (70 x 5 = 350)

The second complexity that Google adds to this system is that a similar process goes on for each bidder in order to determine the final order in which ads appear.

Finally don't forget that the click through rate you achieve for each keyword will depend in part on the ad that gets displayed for the keyword. You need to maximise this and the best way to do this is to run several ads at a time and see which ones generate the highest click through rates.

Part of the process of managing your account is to delete poor performing ads and create ads that beat your best performing ad to date.

Key learning points

Treat your Click Through Rate at least as importantly as your Maximum Cost Per Click price.
Don't over bid for keywords unless you are sure no one else is doing the same.

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