How Does Adwords Work?

Adwords is not a straight bidding auction. You can be the highest bidder for a keyword, yet, not get the top spot. The position your ad appears in is determined by two factors: your bid and the quality of your ad. The quality of your ad is called Quality Score by Google. There are many factors involved in calculating the QS, which I’ll discuss later, but for our purposes at the moment, let’s assume that it is your click rate. In fact, your ad’s CTR is responsible for 65% of your QS so that’s not far from the truth. Let’s take five advertisers, their bid in cents, their CTR and resulting ad rank:

Advertiser Bid               CTR Ad Rank

A1      $0.30                  6.7      201.0
A2      $0.28                  5.5      154.0
A3      $0.25                  5.4      135.0
A4      $0.25                  4.9      122.5
A5      $0.20                  5.1      102.0

The two factors, bid and CTR, are multiplied together which results in a number called the ad rank. If you have a CTR of 4.3% and bidding $0.25, your ad rank is 107.5 (4.3 times 25). In order for someone to be placed higher than you, their ad rank calculation would have to be more than 107.5 and can be achieved by increasing their bid or increasing their click rate. If their CTR is only 2%, their bid needs to be at least 54 cents. However, if their CTR was 5%, they only need to bid 22 cents to be ranked higher and only 16 cents if it was 7%.

In other words, Google rewards advertisers for creating good quality ads (read: high click rates) It is therefore best to get higher click rates as much as possible since your bid can remain the same or be lowered to get the same ad ranking you did before, not to mention getting more traffic for the same price. In fact, as we will see next, your actual cost will go down. It is therefore very important to understand the ranking system. Sure, you can always increase your bid to achieve a higher ranking and (possibly) better results. But smart advertisers know they can achieve those same results at lower costs simply by improving their ads.

Note that this explanation is simplified. CTRs are actually normalized to remove the effects of position, since absolute CTR is affected by an ad’s position. But the basis is as explained: ads are ranked by multiplying the advertiser’s maximum bid with the ad’s (normalized) CTR.

By the way, every major PPC advertising system does it this way now. Yahoo, MSN and many others have followed Google’s lead because it places every advertiser on the same level, no matter how much money each is willing to pay. You can be ranked higher than someone bidding more than you simply by having a better quality ad.

From the point of view of the search engines, it provides a better quality product (better and more relevant sponsored listings) and increases their revenues. This is easily shown mathematically.

If advertiser A has a CTR of 2% and bids $0.50 (ad rank of 100) and advertiser B has a CTR of 5% and bids $0.20 (also an ad rank of 100), the search engine makes the same amount of money, $10 per 1000 impressions for each ad.

Since they have the same ad rank, they will likely split the position half and half. This is of course hypothetical because click rates change every time an ad is served. The more likely outcome is that A will slowly gain more and more of the position’s share over time. His click rate will increase while A’s decreases. After a while, B’s rate may become 5.2% while A’s might drop to 1.5%. The ad with the higher CTR will always have an advantage. When that happens, the ads will not longer evenly split the position. The better one may get it 70% or more of the time.

This means advertiser A must increase his bid just to keep up. Now, the search engine gets $10.40 at 5.2% from B and only $7.50 from A at 1.5%. Its overall revenues have dropped.

They don’t make it up if the advertiser increases his bid to say $0.60 either. It also is not in the advertiser’s best interest to increase his bid: it only serves to increase his costs while his quality remains stagnant or drops in relation to the other advertiser.

However, if A increases his CTR to let’s say 2.5%, he gains back lost ground (in fact, he overtakes advertiser B). Not only that, he can reduce his bid down to $0.42 and still remain ahead of B.

Meanwhile, even at $0.42 and 2.5% CTR, the search engine’s revenue increases to $10.50. It is in both the advertiser’s and search engine’s interest to have high quality ads. That’s why Google invented Quality Score. It is an incentive for advertisers to increase their quality for the advertiser’s sake, the searchers who are Google’s real customers and Google itself by making more revenues.

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