The economics of search engines: Search, ad auctions & game theory

Jacob Hansen

Student thesis: Master thesis


This project examines the economics of search engines. It is found that the business model of search engines is based on advertising revenues. This is called search engine marketing. These advertising revenues are generated through an auction where advertisers bid on keywords, a mechanism known as an ad auction. The main focus of this project is an investigation of the challenges that exist in the context of ad auctions. One major challenge that advertisers face is how much to bid for keywords in ad auctions. Therefore we present a practical bidding strategy to advertisers to address this problem. The conclusion is that advertisers should follow a marginal bidding strategy. We start out by investigating the business of search engines. It is conveyed that search engines act as an intermediary between users, advertisers and content providers. We argue that search engines are a scale-intensive business with high fixed costs and low marginal costs. The fundamentals of search engine marketing are presented next. We find that a search engine generates revenue by selling ads that are priced on a cost-per-click basis, which means that the advertiser has to pay each time a user clicks on their advertisement. We study how the ad placement on a search engine result page is a key factor in determining how many clicks an ad receives. The position receiving most clicks is the first position, followed by the second and third position. Due to this, higher positions on a search engine result page are more valuable to advertisers. This project outlines the theoretical foundation of auction and game theory and present why auctions are useful as a pricing mechanism of ads. We conclude that ad auctions today are conducted as a second-price-auction where bidding takes place continuously. Furthermore we introduce a game-theoretic model of ad auctions titled position auctions. We investigate ad auctions as a game and conclude that the current format of ad auctions does not have equilibrium in dominant strategies. Furthermore, the model of position auctions shows that advertisers contemplating entering into an ad auction face a „supply curve of clicks‟. This means that the better the placement of an ad on a search engine result page is, the higher the price-per-click is in that position. In order for advertisers to maximize profit when bidding in ad auctions they must take marginal cost-per-click into consideration. This can be achieved by following the marginal bidding strategy presented in this project.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2009
Number of pages87