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Stanford: SEMs Are Getting Screwed

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Search engine marketers that don’t know what they’re doing are getting ripped off in keyword auctions, according to a new study released from Stanford Graduate School of Business. The researchers claim pay-per-click engines like Google and Yahoo! have modified an older bidding model to maximize profits.

In addition to “unsophisticated bidders” overpaying in the current auction, more experienced ad buyers waste a lot of time and money trying to beat the system and outdo competitors.

The Stanford team says that while inexperienced SEM’s are overpaying and experienced SEM’s are misappropriating their energies, revenues from keyword auctions have earned Google more ad revenue than any newspaper chain, magazine publisher, or TV network.

The study was conducted at Stanford by researchers hailing from Stanford, Harvard, and Berkeley graduate programs. They suggest that the current mechanism could be adjusted to create an auction that better serves advertisers. That adjustment is unlikely, however, as it may not necessarily benefit search engines financially.

“At the very least, we want to educate advertisers about the fact that in some sense they are being taken advantage of. Under the current mechanism, if they don’t think carefully about their bidding strategies, they can end up paying a lot more to the search engines than they need to,” says researcher Michael Ostrovsky, assistant professor of economics at Stanford Business School.

Google and Yahoo!’s keyword auction system is based on an earlier version developed by William Vickrey, which won him the Nobel Memorial Prize in 1996. Under that model, ad buyers are to pay what a keyword is worth to them, not how much they’re willing to pay.

“Google says that its mechanism uses the ideas of the Vickrey auction, but fails to mention some important differences, which creates confusion,” says Ostrovsky.

In the current system, advertisers are charged a penny more than the next lowest bid, a method the search engines say encourages participants to bid truthfully since they ultimately pay less than what the click is worth to them. The result though, according to Ostrovsky, is that the market fluctuates by the minute as advertisers scramble to outbid competition and as search engine computers continually recalculate rankings.

Ostrovsky says the key difference between the current system and the Vickrey auction is the measure of “externality,” or the value of clicks lost by being ranked lower.

“For example,” says Ostrovsky, “suppose there were three advertisers truthfully bidding 10, 8, and 7 dollars per click, respectively, and three advertising slots, receiving 100, 70, and 50 clicks per hour.

“Then the presence of the first advertiser moves the second one from the top position to the next one, thus costing him 30 clicks per hour at $8 per click, and moves the third advertiser from the second position to the third one, costing him 20 clicks per hour at $7 per click.

“Hence, the total externality that the first advertiser imposes on others is $240 plus $140 equals $380 per hour, and he would be charged $3.80 per click in a Vickrey auction. Remarkably, under this pricing scheme, it is optimal for each advertiser to bid his actual value per click, regardless of what other advertisers do.”

Under the current system, though, using the same set of bidders, the top bidder would be charged $8.01 per click, over twice as much as the Vickrey auction. What’s more, under the current system a third position can become more profitable for an advertiser. Though only receiving 50 clicks per hour, the price of that position is much lower and may yield higher profits.

Nave buyers often assume they should bid what they’re willing to pay for the top spot, instead of what it is worth to them, causing them to overpay. Ostrovsky and company say that more savvy advertisers know how to strategically game the system to optimize bids and placement. But it’s the gaming that keeps the system in constant price flux.

The conclusion of Ostrovsky and his coauthors then is that search engines should consider reverting to the Vickrey method.

“Overall, this would stabilize the auction system,” Ostrovsky says. “Under such a setup, advertisers would not need to try continually to outsmart one another — and the system and bids would remain relatively static, changing only when economic fundamentals changed.”

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Stanford: SEMs Are Getting Screwed
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