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Generalized Second Price Auctions

Generalized Second Price Auctions

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Published by Matthew Alecock

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Published by: Matthew Alecock on Jul 18, 2011
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Internet Advertising and the Generalized Second-Price Auction:Selling Billions of Dollars Worth of Keywords
, M
We investigate the “generalized second-price” (GSP) auction, a new mechanismused by search engines to sell online advertising. Although GSP looks similar to theVickrey-Clarke-Groves (VCG) mechanism, its properties are very different.Unlike the VCG mechanism, GSP generally does not have an equilibrium indominant strategies, and truth-telling is not an equilibrium of GSP. To analyzethe properties of GSP, we describe the generalized English auction that corre-sponds to GSP and show that it has a unique equilibrium. This is an ex post equilibrium, with the same payoffs to all players as the dominant strategyequilibrium of VCG.
D44, L81, M37)This paper investigates a new auction mech-anism, which we call the “generalized second-price” auction, or GSP. GSP is tailored to theunique environment of the market for onlineads, and neither the environment nor the mech-anism has previously been studied in the mech-anism design literature. While studying theproperties of a novel mechanism is often fasci-nating in itself, our interest is also motivated bythe spectacular commercial success of GSP. It isthe dominant transaction mechanism in a largeand rapidly growing industry. For example,Google’s total revenue in 2005 was $6.14 bil-lion. Over 98 percent of its revenue came fromGSP auctions. Yahoo!’s total revenue in 2005was $5.26 billion. A large share of Yahoo!’srevenue is derived from sales via GSP auctions.It is believed that over half of Yahoo!’s revenueis derived from sales via GSP auctions. As of May 2006, the combined market capitalizationof these companies exceeded $150 billion.Let us briefly describe how these auctionswork. When an Internet user enters a searchterm (“query”) into a search engine, he getsback a page with results, containing both thelinks most relevant to the query and the spon-sored links, i.e., paid advertisements. The adsare clearly distinguishable from the actualsearch results, and different searches yield dif-ferent sponsored links: advertisers target theirads based on search keywords. For instance, if atravel agent buys the word “Hawaii,” then eachtime a user performs a search on this word, alink to the travel agent will appear on the searchresults page. When a user clicks on the spon-sored link, he is sent to the advertiser’s Webpage. The advertiser then pays the search enginefor sending the user to its Web page, hence thename—“pay-per-click” pricing.The number of ads that the search engine canshow to a user is limited, and different positionson the search results page have different desir-abilities for advertisers: an ad shown at the topof a page is more likely to be clicked than an adshown at the bottom. Hence, search enginesneed a system for allocating the positions toadvertisers, and auctions are a natural choice.Currently, the mechanisms most widely used bysearch engines are based on GSP.In the simplest GSP auction, for a specifickeyword, advertisers submit bids stating theirmaximum willingness to pay for a click. Whena user enters a keyword, he receives searchresults along with sponsored links, the lattershown in decreasing order of bids. In particular,
* Edelman:DepartmentofEconomics,HarvardUniversity,Cambridge, MA 02138 (e-mail: bedelman@fas.harvard.edu);Ostrovsky: Graduate School of Business, Stanford University,Stanford, CA 94305 (e-mail: ostrovsky@gsb.stanford.edu);Schwarz: Yahoo! Research, 1950 University Ave., Suite 200,Berkeley, CA 94704 (e-mail: mschwarz@yahoo-inc.com). Wethank Drew Fudenberg, Louis Kaplow, Robin Lee, DavidMcAdams,PaulMilgrom,MurielNiederle,ArielPakes,DavidPennock, and Al Roth for helpful discussions.
the ad with the highest bid is displayed at thetop, the ad with the next highest bid is displayedin the second position, and so on. If a usersubsequently clicks on an ad in position
, thatadvertiser is charged by the search engine anamount equal to the next highest bid, i.e., thebid of an advertiser in position (
1). If asearch engine offered only one advertisementper result page, this mechanism would beequivalent to the standard second-price auc-tion, coinciding with the Vickrey-Clarke-Groves (VCG) mechanism (William Vickrey1961; Edward H. Clarke 1971; Theodore Groves1973), auction. With multiple positions available,GSP generalizes the second-price auction (hencethe name). Here, each advertiser pays the nexthighest advertiser’s bid. But as we will demon-strate, the multi-unit GSP auction is no longerequivalent to the VCG auction and lacks some of VCG’s desirable properties. In particular, un-like the VCG mechanism, GSP generally doesnot have an equilibrium in dominant strategies,and truth-telling is not an equilibrium of GSP.In Section I, we describe the evolution of themarket for Internet advertisements and theunique features of the environment in this mar-ket. In Section II, we introduce a model of sponsored search auctions, and we begin ouranalysis of the model in Section III. Since ad-vertisers can change their bids frequently, spon-sored search auctions can be modeled as acontinuous or an infinitely repeated game. Bythe folk theorem, however, such a game willhave an extremely large set of equilibria, and sowe focus instead on the one-shot, simultaneous-move, complete information stage game, intro-ducing restrictions on advertisers’ behaviorsuggested by the market’s dynamic structure.We call the equilibria satisfying these restric-tions “locally envy-free.”We then proceed to show that the set of locally envy-free equilibria contains an equi-librium in which the payoffs of the players arethe same as in the dominant-strategy equilib-rium of the VCG auction, even though boththe bids of the players and the payment rulesin the mechanisms are very different. More-over, this equilibrium is the worst locallyenvy-free equilibrium for the search engineand the best locally envy-free equilibrium forthe advertisers. Consequently, in
locallyenvy-free equilibrium of GSP, the total ex-pected revenue to the seller is at least as highas in the dominant-strategy equilibrium of theVCG auction.In Section IV, we present our main result. Weintroduce the generalized English auction withindependent private values, which correspondsto the generalized second-price auction and ismeant to capture the convergence of biddingbehavior to the static equilibrium, in the samespirit as taˆtonnement processes in the theoryof general equilibrium and the deferred-acceptance salary adjustment process in the theoryof matching in labor markets. The generalizedEnglish auction has several notable features.Although it is not dominant-strategy solvable, ithas a unique, perfect Bayesian equilibrium incontinuous strategies. In this equilibrium, allplayers receive VCG payoffs. Moreover, thisequilibrium is ex post, i.e., even if a particularplayer learned the values of other players beforethe game, he would not want to change hisstrategy. This, in turn, implies that the equilib-rium is robust, i.e., it does not depend on theunderlying distribution of values: the profile of strategies that we identify is an ex post BayesianNash equilibrium for any set of distributions of advertisers’ private values.There are several recent theoretical and em-pirical papers related to sponsored search auc-tions. Gagan Aggarwal and Jason D. Hartline(2005), Aranyak Mehta et al. (2005), and Mo-hammad Mahdian, Hamid Nazerzadeh, andAmin Saberi (2006) propose computationallyfast, near-optimal mechanisms for pricing andallocating slots to advertisers in the presence of budget constraints and random shocks. Christo-pher Meek, David M. Chickering, and David B.Wilson (2005) describe incentive-compatibleauctions with stochastic allocation rules, gener-alizing Vickrey auctions, and argue that suchauctions can be useful for selling Internet ad-vertising despite being inefficient. Note that, incontrast to these papers, we study the mecha-nisms actually used by the search engines.Xiaoquan Zhang (2005), Kursad Asdemir(2006), and Edelman and Ostrovsky (forthcom-ing) present empirical evidence of bid and rank-ing fluctuations in both generalized first-priceand generalized second-price auctions. They ar-gue that history-dependent strategies can giverise to such fluctuations. However, Hal R. Var-ian (forthcoming) empirically analyzes GSP
auction data from Google and reports that lo-cally envy-free Nash equilibria “describe thebasic properties of the prices observed inGoogle’s ad auction reasonably accurately.”
I. The Structure and Evolution of SponsoredSearch Auctions
Notable Features of the Market for  Internet Advertising
AcombinationoffeaturesmakesthemarketforInternet advertising unique. First, bids can bechanged at any time. An advertiser’s bid for aparticular keyword will apply every time that key-word is entered by a search engine user, until theadvertiser changes or withdraws the bid. For ex-ample, the advertiser with the second highest bidon a given keyword at some instant will be shownas the second sponsored link to a user searchingfor that keyword at that instant. The order of theads may be different next time a user searches forthat keyword, because the bids could havechanged in the meantime.
Second, search engines effectively sell flowsof perishable advertising services rather thanstorable objects: if there are no ads for a partic-ular search term during some period of time, the“capacity” is wasted.Finally, unlike other centralized markets,where it is usually clear how to measure what isbeing sold, there is no “unit” of Internet adver-tisement that is natural from the points of viewof all involved parties. From the advertiser’sperspective, the relevant unit is the cost of at-tracting a customer who makes a purchase. Thiscorresponds most directly to a pricing model inwhich an advertiser pays only when a customeractually completes a transaction. From thesearch engine’s perspective, the relevant unit iswhat it collects in revenues every time a userperforms a search for a particular keyword. Thiscorresponds to a pricing model in which anadvertiser is charged every time its link isshown to a potential customer. “Pay-per-click”is a middle ground between the two models: theadvertiser pays every time a user clicks on thelink. All three payment models are widely usedon the Internet.
The specific sector of Internetadvertising that we study, sponsored search auc-tions, has converged to pay-per-click pricing.Since GSP evolved in the market for onlineadvertising, its rules reflect the environment’sunique characteristics. GSP insists that for eachkeyword, advertisers submit a single bid—eventhough several different items are for sale (dif-ferent advertising positions). GSP’s unusualone-bid requirement makes sense in this setting:the value of being in each position is propor-tional to the number of clicks associated withthat position; the benefit of placing an ad in ahigher position is that the ad is clicked more,but the users who click on ads in differentpositions are assumed to have the same valuesto advertisers (e.g., the same purchase probabil-ities). Consequently, even though the GSP en-vironment is multi-object, buyer valuations canbe adequately represented by one-dimensionaltypes. For some advertisers, one bid per key-word may not be sufficiently expressive to fullyconvey preferences. For example, a single bidignores the possibility that users who click onposition 5 are somehow different from thosewho click on position 2; it does not allow for thepossibility that advertisers care about the allo-cation of other positions, and so on. Nonethe-less, these limitations are apparently not largeenough to justify added complexity in the bid-ding language. Nico Brooks (2004) finds onlymoderate differences in purchase probabilitieswhen ads are shown in different positions. Fol-lowing search engines’ approaches and Brooks’empirical findings, we likewise assume thevalue of a click is the same in all positions.
Varian discovered envy-free Nash equilibria indepen-dently and called them “Symmetric Nash Equilibria” in hispaper.
For manual bidding through online advertiser centers,both Google and Yahoo! allow advertisers to make unlim-ited changes. In contrast, the search engines impose restric-tions on the behavior of software bidding agents: e.g.,Yahoo! limits the number of times an advertiser can changehis bid in a given period of time.
A prominent example of “pay-per-transaction,andeven “pay-per-dollar of revenue” (“revenue sharing”), isAmazon.com’s Associates Program, www.amazon.com/gp/ browse.html?&node
3435371 (accessed June 10, 2006).Under this program, a Web site that sends customers toAmazon.com receives a percentage of customerspur-chases. “Pay-per-impression” advertising, in the form of banner ads, remains popular on major Internet portals, suchas yahoo.com, msn.com, and aol.com.

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