How Search Engines Can Make More Money From Paid-Placement Advertising

Search engines like Google can earn more revenue from paid-placement advertising when the keywords that people use are not very precise. That is one of the findings of research by Professors Yongmin Chen and Chuan He, which analyses the automated keywords auctions in which advertisers bid for prominent placement. Their study, which is published in the November 2011 issue of the Economic Journal, finds that:

  • When consumers use more precise keywords in their search, the value of being placed in the top position increases, but the value of an ad placed at a lower position decreases.
  • Total payments to the search engine from advertisers may decrease when the keyword precision improves beyond a certain level.
  • This means that it may be optimal for the search engine to restrict the precision of keywords so that the resulting match probability for the most relevant seller is not too high.
  • The search engine also benefits from the presence of more potential sellers for a keyword search. A seller is then less likely to be selected randomly by buyers, and hence placement on the search engine''s recommended list is more valuable.
  • This motivates the sellers to bid more for prominent placement in the search engine''s keyword auctions, thereby increasing the revenue the search engine receives.

If you are one of the millions of online shoppers who use a search engine to find a desired item, the chances are that you have seen paid-placement advertisements. Under paid placement, advertisers are selected through keyword auctions to have their products appear prominently from the results of a keyword search.

The rapid growth of paid-placement advertising has made it one of the most important institutions of the internet, and has led to enormous commercial success for search engines. Google, for example, which derives most of its revenue from paid-placement advertising, received $28.2 billion in ad revenues in 2010. Its market capitalisation is larger than the big three US auto manufacturers combined.

What are the economic forces behind the success of paid-placement advertising? The study shows that this new form of internet advertising leads to lower consumer search costs and higher product sales, thereby improving market efficiency. The central premise of this finding is that paid-placement advertising matches consumers with the ''right'' sellers.

Sellers differ in how likely their products may match a consumer''s need. Since a more relevant seller is more likely to have a successful sale from the attention of the consumer, more relevant sellers are willing to bid more for paid placement, and will thus end up being the advertisers selected through a paid-placement auction.

Consequently, paid placement can allocate the limited ad positions efficiently and guide consumers in their search. Consumers will often find their desired products with less search, and hence lower search costs, by clicking the paid-placement ads in descending order.

Although the role of advertising as a guide for consumer search also exists in traditional media, its benefits are especially significant for the internet, which can have hundreds of sellers at a single marketplace associated with a keyword search.

''Paid Placement: Advertising and Search on the Internet'' by Yongmin Chen and Chuan He is published in the November 2011 issue of the Economic Journal.