Everyone knows that AdWords and most online keyword based advertising systems work on auctions. What is less known to folks who don't work in the online world is how these auctions work. People are familiar with traditional English auctions - this is the where everyone bids and the winner , the one with the highest bid, pays what he/she/they bid and walk away with the prize.
However, online ad auctions are usually a generalized second price auction, similar to a Vickrey auction. In this model, the winner is the person who makes the highest bid. However, the winner only has to pay the amount bid by the *second highest bidder*. The advantages of this model seemed unintuitive to me at first but clear after some investigation.
Generalized second price auctions avoid two key aspects of traditional English auctions - the winner's curse and bid shading. The winner's curse refers to the fact that the winner in an auction is likely to overpay for the item. Since the item's value cannot change, the true price of the item would be somewhere near the average of all the bids made and the winner would be paying a premium. To avoid this phenomenon, bidders engage in bid shading - i.e bid below what they think the true value of the item is.
Generalized second price auctions remove a lot of these guessing games from the table (they bring others but that is another story). By taking the price you pay for the item out of your hands, it encourages bidders to bid the true value of the item at hand (remember that bidders can't see each other's bids).
The Google Connection
There have been several articles documenting the work of Google's Salar Kamangar and Eric Veach in bringing this to AdWords. What is lesser known (atleast to me )is that they implemented this model to solve another problem entirely. I came across this old talk from a Google employee - in the speaker notes, it talks about how Kamangar and Veach implemented this feature to stop advertisers from logging into the system and modifying their bids constantly (since that's what people tend to do in an open English auction). By implementing a second price auction, they were hoping to reduce the load on the system.
I don't mean to take any credit away from them - I just find it ironic that a feature implemented to reduce load has turned into *the* model for bidding for online advertising. Talk about unexpected benefits!