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) pp16–19.

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 popu-

lar 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 busi-

nesses, 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 advert-

isements 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. Email: greg.taylor@oii.ox.ac.uk.

1

2 GREG TAYLOR

Sponsored Search Results

Organic Search Results

Figure 1: Organic and sponsored search results on Google.

Now, imagine that Google decided to charge a small amount of money for conduct-

ing 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.

Pric

e of

a s

earc

h

Number of searches conducted

Many00

High

By alloiwing free searches, Google maximises its number of users, which increases the value

of the advertisements that it sells.

Figure 2: Google faces a downward sloping demand curve for search. Setting a positiveprice for searching would reduce the number of searches conducted, so Google would earnless money from selling advertisements.

This kind of pricing scheme is known generally as two-sided pricing (the two sides

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 two-

sided 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 appropri-

ate 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 de-

termining 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 ’gener-

alised 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 advert-

isement 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 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 alloc-ate.

Bidder Bid Allocated Slot Price PaidFirm A £10.00 1st £8.50Firm B £8.50 2nd £7.00Firm C £7.00 3rd £6.00Firm 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 assist-

ance 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 en-

couraging honest behaviour from advertisers, per-click pricing not only saves Google the

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 (be-

cause 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 advert-

isement 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 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.

Pric

e

Pric

e

Quantity Demanded Quantity Demanded

Elastic demand: a small increase in price leads to a big fall indemand.

Inelastic demand: a large increasein price leads to a small fall indemand.

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 reputa-

tion 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 con-

sumers 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.

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. Advertise-

ments 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.