A Call for Transparency: Are Dynamic Price Floors Good for the Industry?

For years, the nirvana for digital display advertising has been targeting and efficiency that is as good as search advertising. Today, through dynamic, real-time bidding (RTB) and the emergence of technologies such as demand-side platforms, the industry is reaching this goal. It’s been exciting to watch RTB re-invigorate and grow the business of digital display advertising. Several years ago, I wrote several columns explaining how RTB works and received thanks and comments from many of you.

Today, as the uptake of RTB for digital display advertising grows, have you ever wondered how the markets operate behind the scenes? The ad exchanges aggregate individual sellers and conduct the auction. They allow publishers to provide agencies and advertisers with direct access to their inventory. Companies like mine manage the bids for buyers through intelligent, algorithm-driven platforms.

From the outset, exchanges were designed to be open marketplaces where buyers and sellers could meet and clear bids efficiently and transparently. However, a troubling and potentially pernicious practice is emerging in the way some ad exchanges are running their auctions – one that I believe the industry needs to examine closely and discuss openly.

Understanding the new practice, somewhat euphemistically referred to as “dynamic price floors,” requires a brief overview of auction theory. Most ad exchanges operate on the principle of the generalized second-price auction. This has proven over time to be a highly efficient auction model for goods or services of uncertain value and short shelf life – which is a perfect description of digital advertising. A second-price auction results in lively bidding (which creates robust liquidity) and stable, long-term equilibrium prices.

Here’s how it works. Suppose you’re willing to pay up to $5 for a display ad spot on a great site to a browser who is in your target market for a new customer acquisition initiative. If you bid $5 and the highest rival bid is $3.50, you will win and pay $3.50. If the highest rival bid to your $5 is $5.50, you’ll lose the auction and the rival bidder will pay $5. You as a buyer fare well simply by bidding the maximum amount at which you value that particular ad spot.

This may sound like an unsound business practice for sellers. Why should a desirable site let you, the winner, pay the second-highest bid when they could demand that you pay the highest bid?

Second-price auctions incentivize buyers to bid aggressively knowing they won’t overpay, and also to bid the most that they’re willing to pay for a given piece of inventory. Among economists, including those from Harvard and Stanford University, the second-price auction creates a highly efficient and liquid marketplace where the optimal strategy for buyers is to bid honestly – not too much, not too little. Many of the largest and most successful exchanges state this as their preferred and standard auction methodology.

A slice of the market, however, is quietly changing its auction model by employing dynamic price floors. Through this practice, the exchange aggregator sets a minimum “reserve” price floor for ads in the auction. So far so good. But here’s the rub: the price floor can be altered on the fly, without the buyer’s knowledge.

As a buyer, you may ask yourself, “What’s to stop sellers from analyzing the bids coming in and raising the floor price selectively?” You can see how dynamic price floors have the potential to be used in ways that are not in buyers’ best interests, or supporting the long-term health of the market overall.

The aggregators using dynamic price floors tout this as a way to maximize publisher revenue and yield, and to help them sell excess inventory. Short-term, this may indeed increase revenues for the seller, but long-term – as buyers become aware of the practice – it discourages buyers from bidding higher, or from bidding as actively as they might otherwise. Who wants to have “winner’s curse” and find themselves buying something they could have gotten cheaper by underbidding the true value, but high enough to beat the competition? Perhaps sellers should think twice before they take this approach. This is not a zero-sum game. Both buyers and sellers can benefit from the second-price auction.

We can all devise clever arguments about the most efficient, effective auction theories and practices. Sellers may say dynamic price floors are good for business. Buyers may consider the practice opaque or even manipulative. Reasonable minds may disagree, but we can all agree that transparency is a prerequisite – that’s what buyers and sellers expect. At a minimum, there should be full disclosure of the exact pricing mechanisms.

After all, transparency and trust are integral to any market. That’s why the Securities and Exchange Commission was established for the financial markets. I believe dynamic price floors undermine the value of the second-price auction, which economists generally agree maximizes the long-term benefits of the auction-exchange model for goods or services with uncertain value.

As an emerging industry, it’s time to think this through and start the conversation. Folks on both sides of the exchange need to know much more about the topic and consider each other’s views. So, what do you think?