Search Ad Auction Models Flawed, Economists Say

Paid search advertisers who bid what they’re actually willing to pay end up paying more than they need to, according to research by economics scholars at Stanford Business School.

The research paper by Michael Ostrovsky, assistant professor of economics at Stanford; Benjamin Edelman, doctoral candidate in economics at Harvard; and Michael Schwarz, RWFJ Scholar at UC Berkeley, blames both the naivete of bidders and the “generalized second price” (GSP) auction mechanisms used by Google and Yahoo

“We want to educate advertisers about the fact that in some sense they are being taken advantage of,” Ostrovsky said in a statement. “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.”

Search marketers have long intuitively known getting the top position isn’t always necessary. Often, it’s not even the best strategy. To further quantify that belief, Atlas undertook a research project called the Atlas Rank Report, looked at how a paid search ad’s rank affects traffic in July 2004, and how rank affects conversion in October 2004

“Position one is not always the optimal position to maximize search ROI. This is true in cases where incremental return from position one, such as traffic or sales, does not justify incremental investment,” Andrew Levasseur, senior search manager of Avenue A|Razorfish Search, told ClickZ News. “There are times where the top spot is justified based on search ROI. Other times, however, some advertisers battle for top placement needlessly because they have not successfully defined search ROI, do not have a way to track, report and optimize search ROI, or because they suffer from ‘CEO syndrome,’ the desire to see their company name in bright lights.”

Marketers shouldn’t get hung up on ad position without regard for other factors to improve profit, including optimizing landing pages, offers and product pricing, opines Dave Williams, chief strategist at 360i.

“Utilizing tools like portfolio optimization technology allows media managers to think strategically about paid search campaigns and shift focus to more value-added activities such as expanding keyword lists, adjusting advertising creative, and testing landing page response rates,” Williams said.

The issue with current auction methods arises when an advertiser bids the maximum amount they can afford, which ends up costing more, according to the Stanford report. Under the current bidding system, advertisers are charged only a penny more per click than the next lowest bid, with some adjustments depending on the quality of the ad. This leads to a more volatile auction in which advertisers try continually to outsmart one another, rather than placing bids based on what makes sense for them.

“Companies would be much better off using such resources to enhance their products, improve customer service, or what have you,” Ostrovsky said.

More savvy advertisers do strategically bid lower than true value. But in order to do so, they must spend a significant amount of time and money to calculate optimal bids, and to monitor and respond to competitors’ bids, says Ostrovsky. It would be possible to implement an auction model that eliminated this effect, but this would be less profitable for the search engines, he added.

Such a model, known as a Vickrey-Clarke-Groves (VCG) mechanism, would still charge advertisers less than their actual bid, but that cost would be based on a measure of the “externality,” the value of lost clicks, a bidder imposes on others by pushing them down in the ranking from one slot to the next.

“Remarkably, under this pricing scheme, it is optimal for each advertiser to bid his actual value per click, regardless of what other advertisers do,” Ostrovsky said.

Companies using SEM agencies with highly automated systems aren’t spending as much of their resources on search marketing as it may seem, according to Kevin Lee, Did-It’s co-founder and executive chairman.

“Actually, for a good SEM agency, the fee pays for itself through increased efficiencies, freeing up additional budget for other media opportunities, or for marketers looking to increase spending by keeping the cost of customer acquisition on target even at higher scale,” Lee told ClickZ News.

And before a marketer begins to look for other non-search ways to spend their marketing budget, they need a full understanding of the relative value of all their media and advertising opportunities, including the interaction effects between media and search, he said.

“Advertising actually drives increases in search behavior and also increases the clickthrough rate on ads due to awareness and familiarity of the searcher with the brand,” Lee said.

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