Internet Advertising and the Generalized Second-Price Auction:

Selling Billions of Dollars Worth of Keywords

By BENJAMIN EDELMAN, MICHAEL OSTROVSKY, AND MICHAEL SCHWARZ*

We investigate the generalized second-price (GSP) auction, a new mechanism

used by search engines to sell online advertising. Although GSP looks similar to the
Vickrey-Clarke-Groves (VCG) mechanism, its properties are very different.
Unlike the VCG mechanism, GSP generally does not have an equilibrium in
dominant strategies, and truth-telling is not an equilibrium of GSP. To analyze
the 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 strategy
equilibrium of VCG. (JEL D44, L81, M37)

This paper investigates a new auction mech- term (query) into a search engine, he gets
anism, which we call the generalized second- back a page with results, containing both the
price auction, or GSP. GSP is tailored to the links most relevant to the query and the spon-
unique environment of the market for online sored links, i.e., paid advertisements. The ads
ads, and neither the environment nor the mech- are clearly distinguishable from the actual
anism has previously been studied in the mech- search results, and different searches yield dif-
anism design literature. While studying the ferent sponsored links: advertisers target their
properties of a novel mechanism is often fasci- ads based on search keywords. For instance, if a
nating in itself, our interest is also motivated by travel agent buys the word Hawaii, then each
the spectacular commercial success of GSP. It is time a user performs a search on this word, a
the dominant transaction mechanism in a large link to the travel agent will appear on the search
and rapidly growing industry. For example, results page. When a user clicks on the spon-
Googles total revenue in 2005 was $6.14 bil- sored link, he is sent to the advertisers Web
lion. Over 98 percent of its revenue came from page. The advertiser then pays the search engine
GSP auctions. Yahoo!s total revenue in 2005 for sending the user to its Web page, hence the
was $5.26 billion. A large share of Yahoo!s namepay-per-click pricing.
revenue is derived from sales via GSP auctions. The number of ads that the search engine can
It is believed that over half of Yahoo!s revenue show to a user is limited, and different positions
is derived from sales via GSP auctions. As of on the search results page have different desir-
May 2006, the combined market capitalization abilities for advertisers: an ad shown at the top
of these companies exceeded $150 billion. of a page is more likely to be clicked than an ad
Let us briefly describe how these auctions shown at the bottom. Hence, search engines
work. When an Internet user enters a search need a system for allocating the positions to
advertisers, and auctions are a natural choice.
Currently, the mechanisms most widely used by
* Edelman: Department of Economics, Harvard University,
Cambridge, MA 02138 (e-mail: [email protected]); search engines are based on GSP.
Ostrovsky: Graduate School of Business, Stanford University, In the simplest GSP auction, for a specific
Stanford, CA 94305 (e-mail: [email protected]); keyword, advertisers submit bids stating their
Schwarz: Yahoo! Research, 1950 University Ave., Suite 200, maximum willingness to pay for a click. When
Berkeley, CA 94704 (e-mail: [email protected]). We
thank Drew Fudenberg, Louis Kaplow, Robin Lee, David
a user enters a keyword, he receives search
McAdams, Paul Milgrom, Muriel Niederle, Ariel Pakes, David results along with sponsored links, the latter
Pennock, and Al Roth for helpful discussions. shown in decreasing order of bids. In particular,
242
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 243

the ad with the highest bid is displayed at the pected revenue to the seller is at least as high
top, the ad with the next highest bid is displayed as in the dominant-strategy equilibrium of the
in the second position, and so on. If a user VCG auction.
subsequently clicks on an ad in position i, that In Section IV, we present our main result. We
advertiser is charged by the search engine an introduce the generalized English auction with
amount equal to the next highest bid, i.e., the independent private values, which corresponds
bid of an advertiser in position (i 1). If a to the generalized second-price auction and is
search engine offered only one advertisement meant to capture the convergence of bidding
per result page, this mechanism would be behavior to the static equilibrium, in the same
equivalent to the standard second-price auc- spirit as tatonnement processes in the theory
tion, coinciding with the Vickrey-Clarke- of general equilibrium and the deferred-
Groves (VCG) mechanism (William Vickrey acceptance salary adjustment process in the theory
1961; Edward H. Clarke 1971; Theodore Groves of matching in labor markets. The generalized
1973), auction. With multiple positions available, English auction has several notable features.
GSP generalizes the second-price auction (hence Although it is not dominant-strategy solvable, it
the name). Here, each advertiser pays the next has a unique, perfect Bayesian equilibrium in
highest advertisers bid. But as we will demon- continuous strategies. In this equilibrium, all
strate, the multi-unit GSP auction is no longer players receive VCG payoffs. Moreover, this
equivalent to the VCG auction and lacks some of equilibrium is ex post, i.e., even if a particular
VCGs desirable properties. In particular, un- player learned the values of other players before
like the VCG mechanism, GSP generally does the game, he would not want to change his
not have an equilibrium in dominant strategies, strategy. This, in turn, implies that the equilib-
and truth-telling is not an equilibrium of GSP. rium is robust, i.e., it does not depend on the
In Section I, we describe the evolution of the underlying distribution of values: the profile of
market for Internet advertisements and the strategies that we identify is an ex post Bayesian
unique features of the environment in this mar- Nash equilibrium for any set of distributions of
ket. In Section II, we introduce a model of advertisers private values.
sponsored search auctions, and we begin our There are several recent theoretical and em-
analysis of the model in Section III. Since ad- pirical papers related to sponsored search auc-
vertisers can change their bids frequently, spon- tions. Gagan Aggarwal and Jason D. Hartline
sored search auctions can be modeled as a (2005), Aranyak Mehta et al. (2005), and Mo-
continuous or an infinitely repeated game. By hammad Mahdian, Hamid Nazerzadeh, and
the folk theorem, however, such a game will Amin Saberi (2006) propose computationally
have an extremely large set of equilibria, and so fast, near-optimal mechanisms for pricing and
we focus instead on the one-shot, simultaneous- allocating slots to advertisers in the presence of
move, complete information stage game, intro- budget constraints and random shocks. Christo-
ducing restrictions on advertisers behavior pher Meek, David M. Chickering, and David B.
suggested by the markets dynamic structure. Wilson (2005) describe incentive-compatible
We call the equilibria satisfying these restric- auctions with stochastic allocation rules, gener-
tions locally envy-free. alizing Vickrey auctions, and argue that such
We then proceed to show that the set of auctions can be useful for selling Internet ad-
locally envy-free equilibria contains an equi- vertising despite being inefficient. Note that, in
librium in which the payoffs of the players are contrast to these papers, we study the mecha-
the same as in the dominant-strategy equilib- nisms actually used by the search engines.
rium of the VCG auction, even though both Xiaoquan Zhang (2005), Kursad Asdemir
the bids of the players and the payment rules (2006), and Edelman and Ostrovsky (forthcom-
in the mechanisms are very different. More- ing) present empirical evidence of bid and rank-
over, this equilibrium is the worst locally ing fluctuations in both generalized first-price
envy-free equilibrium for the search engine and generalized second-price auctions. They ar-
and the best locally envy-free equilibrium for gue that history-dependent strategies can give
the advertisers. Consequently, in any locally rise to such fluctuations. However, Hal R. Var-
envy-free equilibrium of GSP, the total ex- ian (forthcoming) empirically analyzes GSP
244 THE AMERICAN ECONOMIC REVIEW MARCH 2007

auction data from Google and reports that lo- corresponds to a pricing model in which an
cally envy-free Nash equilibria describe the advertiser is charged every time its link is
basic properties of the prices observed in shown to a potential customer. Pay-per-click
Googles ad auction reasonably accurately.1 is a middle ground between the two models: the
advertiser pays every time a user clicks on the
I. The Structure and Evolution of Sponsored link. All three payment models are widely used
Search Auctions on the Internet.3 The specific sector of Internet
advertising that we study, sponsored search auc-
A. Notable Features of the Market for tions, has converged to pay-per-click pricing.
Internet Advertising Since GSP evolved in the market for online
advertising, its rules reflect the environments
A combination of features makes the market for unique characteristics. GSP insists that for each
Internet advertising unique. First, bids can be keyword, advertisers submit a single bid even
changed at any time. An advertisers bid for a though several different items are for sale (dif-
particular keyword will apply every time that key- ferent advertising positions). GSPs unusual
word is entered by a search engine user, until the one-bid requirement makes sense in this setting:
advertiser changes or withdraws the bid. For ex- the value of being in each position is propor-
ample, the advertiser with the second highest bid tional to the number of clicks associated with
on a given keyword at some instant will be shown that position; the benefit of placing an ad in a
as the second sponsored link to a user searching higher position is that the ad is clicked more,
for that keyword at that instant. The order of the but the users who click on ads in different
ads may be different next time a user searches for positions are assumed to have the same values
that keyword, because the bids could have to advertisers (e.g., the same purchase probabil-
changed in the meantime.2 ities). Consequently, even though the GSP en-
Second, search engines effectively sell flows vironment is multi-object, buyer valuations can
of perishable advertising services rather than be adequately represented by one-dimensional
storable objects: if there are no ads for a partic- types. For some advertisers, one bid per key-
ular search term during some period of time, the word may not be sufficiently expressive to fully
capacity is wasted. convey preferences. For example, a single bid
Finally, unlike other centralized markets, ignores the possibility that users who click on
where it is usually clear how to measure what is position 5 are somehow different from those
being sold, there is no unit of Internet adver- who click on position 2; it does not allow for the
tisement that is natural from the points of view possibility that advertisers care about the allo-
of all involved parties. From the advertisers cation of other positions, and so on. Nonethe-
perspective, the relevant unit is the cost of at- less, these limitations are apparently not large
tracting a customer who makes a purchase. This enough to justify added complexity in the bid-
corresponds most directly to a pricing model in ding language. Nico Brooks (2004) finds only
which an advertiser pays only when a customer moderate differences in purchase probabilities
actually completes a transaction. From the when ads are shown in different positions. Fol-
search engines perspective, the relevant unit is lowing search engines approaches and Brooks
what it collects in revenues every time a user empirical findings, we likewise assume the
performs a search for a particular keyword. This value of a click is the same in all positions.

1 3
Varian discovered envy-free Nash equilibria indepen- A prominent example of pay-per-transaction, and
dently and called them Symmetric Nash Equilibria in his even pay-per-dollar of revenue (revenue sharing), is
paper. Amazon.coms Associates Program, www.amazon.com/gp/
2
For manual bidding through online advertiser centers, browse.html?&node3435371 (accessed June 10, 2006).
both Google and Yahoo! allow advertisers to make unlim- Under this program, a Web site that sends customers to
ited changes. In contrast, the search engines impose restric- Amazon.com receives a percentage of customers pur-
tions on the behavior of software bidding agents: e.g., chases. Pay-per-impression advertising, in the form of
Yahoo! limits the number of times an advertiser can change banner ads, remains popular on major Internet portals, such
his bid in a given period of time. as yahoo.com, msn.com, and aol.com.
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 245

One important possibility that we abstract B. Evolution of Market Institutions

away from is that advertisers differ along di-
mensions other than per-click value, i.e., have The history of sponsored search auctions is of
different probabilities of being clicked when interest as a case study of whether, how, and
placed in the same position. (These probabilities how quickly markets come to address their
are known in the industry as click-through structural shortcomings. Many important mech-
rates, or CTRs.) Different search engines treat anisms have recently been designed essentially
this possibility differently. Yahoo! ignores the from scratch, entirely replacing completely dif-
differences, ranks the advertisers purely in de- ferent historical allocation mechanisms: radio
creasing order of bids, and charges the next- spectrum auctions (Paul Milgrom 2000; Ken
highest advertisers bid.4 Google multiplies Binmore and Paul Klemperer 2002), electricity
each advertisers bid by its quality score, auctions (Robert Wilson 2002), and others. In
which is based on CTR and other factors, to contrast, reminiscent of the gradual evolution of
compute its rank number, ranks the ads by medical residency match rules (Alvin E. Roth
rank numbers, and then charges each adver- 1984), sponsored search ad auctions have
tiser the smallest amount sufficient to exceed evolved in steps over time. In both medical
the rank number of the next advertiser.5 In our residency and search advertising, flawed mech-
analysis, we assume that all advertisers are anisms were gradually replaced by increasingly
identical along dimensions other than per- superior designs. Notably, the Internet advertis-
click value, which eliminates this difference ing market evolved much faster than the medi-
between the mechanisms used at Google and cal matching market. This may be due to the
Yahoo!. As we discuss at the end of Section competitive pressures on mechanism designers
III, the analysis would remain largely the present in the former but not in the latter, much
same if there were advertiser-specific differ- lower costs of entry and experimentation, ad-
ences in CTRs and quality scores, although vances in the understanding of market mecha-
the equilibria under Google and Yahoo! nisms, and improved technology.
mechanisms would not be identical.6,7 We proceed with a brief chronological review
of the development of sponsored search
mechanisms.
4
See help.yahoo.com/help/us/performance/customer/
dtc/bidding/, link to How do I figure out my cost? and Early Internet Advertising.Beginning in
searchmarketing.yahoo.com/srch/index.php, link to How
Sponsored Search Works (accessed June 10, 2006). 1994, Internet advertisements were largely sold
5
See www.google.com/adwords/learningcenter/#section1, on a per-impression basis. Advertisers paid flat
links to Ad Ranking and Cost Control (accessed June fees to show their ads a fixed number of times
10, 2006). Initially, Googles pricing mechanism was more (typically, 1,000 showings or impressions).
transparent: quality score was equal to the estimated click-
through rate.
Contracts were negotiated on a case-by-case
6
The analysis would have to change considerably if basis, minimum contracts for advertising pur-
there were specific advertiser-position effects. The magni- chases were large (typically, a few thousand
tude of these advertiser-position effects is ultimately an dollars per month), and entry was slow.8
empirical question, and we do not have the kind of data that
would allow us to answer it; however, judging from the fact
that the two major search engines effectively ignore it in Generalized First-Price Auctions.In 1997,
their mechanisms (Yahoo! ignores CTRs altogether; Google Overture (then GoTo; now part of Yahoo!) in-
computes an advertisers estimated CTR conditional on the troduced a completely new model of selling
advertiser attaining the first position), we believe it to be
small.
7
Another important difference between the search en-
gines implementations of GSP is the amount of information From this information, they can back out estimates of their
available to the advertisers. On Yahoo!, advertisers can competitors rank numbers. Moreover, advertisers can ex-
directly observe the bids of their competitors (uv.bidtool. periment with changing their bids, which can also give them
overture.com/d/search/tools/bidtool). On Google, they can- independent and relatively accurate estimates. Web sites
not. For any keyword and any bid amount, however, they accessed on June 10, 2006.
8
can get an estimated average position and average cost- See www.worldata.com/wdnet8/articles/the_history_
per-click they can expect (adwords.google.com/select/ of_Internet_Advertising.htm and www.zakon.org/robert/in-
KeywordToolExternal, Cost and ad position estimates). ternet/timeline (both accessed June 10, 2006).
246 THE AMERICAN ECONOMIC REVIEW MARCH 2007

Internet advertising. In the original Overture seller. Moreover, if the speed of the robots var-
auction design, each advertiser submitted a bid ies across advertisers, revenues can be very low
reporting the advertisers willingness to pay on even if advertisers values are high. For instance,
a per-click basis, for a particular keyword. The in the example above, suppose advertiser 1 has a
advertisers could now target their ads: instead of robot that can adjust the bid very quickly, while
paying for a banner ad that would be shown to advertisers 2 and 3 are humans and can change
everyone visiting a Web site, advertisers could their bids at most once a day. In this case, as long
specify which keywords were relevant to their as advertiser 3 does not bid more than his value,
products and how much each of those keywords the revenues of a search engine are at most $2.02
(or, more precisely, a user clicking on their ad per click. Indeed, suppose advertiser 3 bids $2.00.
after looking for that keyword) was worth to If advertiser 2 bids $2.01, he will be in the second
them. Also, advertising was no longer sold per position paying $2.01. If he bids any amount
1,000 impressions; rather, it was sold one click greater than that but lower than his value, he will
at a time. Every time a consumer clicked on a remain in the second position and will pay more
sponsored link, an advertisers account was au- per click, because the robot of advertiser 1 will
tomatically billed the amount of the advertisers quickly outbid him. The revenue would not
most recent bid. The links to advertisers were change even if the values of advertisers 1 and 2
arranged in descending order of bids, making were much higher.
highest bids the most prominent. The ease of use,
the very low entry costs, and the transparency of Generalized Second-Price Auctions.Under
the mechanism quickly led to the success of Over- the generalized first-price auction, the advertiser
tures paid search platform as the advertising pro- who could react to competitors moves fastest
vider for major search engines, including Yahoo! had a substantial advantage. The mechanism
and MSN. However, the underlying auction therefore encouraged inefficient investments in
mechanism itself was far from perfect. In partic- gaming the system, causing volatile prices and
ular, Overture and advertisers quickly learned that allocative inefficiencies. Google addressed these
the mechanism was unstable due to the fact that problems when it introduced its own pay-per-click
bids could be changed very frequently. system, AdWords Select, in February 2002.
Google also recognized that an advertiser in
Example. Suppose there are two slots on a page position i will never want to pay more than one
and three advertisers. An ad in the first slot bid increment above the bid of the advertiser in
receives 200 clicks per hour, while the second position (i 1), and adopted this principle in its
slot gets 100. Advertisers 1, 2, and 3 have newly designed generalized second-price auc-
values per click of $10, $4, and $2, respectively. tion mechanism. In the simplest GSP auction,
Suppose advertiser 2 bids $2.01, to guarantee an advertiser in position i pays a price per click
that he gets a slot. Then advertiser 1 will not equal to the bid of an advertiser in position (i
want to bid more than $2.02 he does not need 1) plus a minimum increment (typically $0.01).
to pay more than that to get the top spot. But This second-price structure makes the market
then advertiser 2 will want to revise his bid to more user friendly and less susceptible to
$2.03 to get the top spot, advertiser 1 will in gaming.
turn raise his bid to $2.04, and so on. Clearly, Recognizing these advantages, Yahoo!/Over-
there is no pure strategy equilibrium in the ture also switched to GSP. Let us describe the
one-shot version of the game, and so if adver- version of GSP that it implemented.9 Every
tisers best respond to each other, they will want
to revise their bids as often as possible.
Hence, advertisers will make socially ineffi- 9
We focus on Overtures implementation, because
cient investments into bidding robots, which can Googles system is somewhat more complex. Google ad-
also be detrimental for the revenues of search justs effective bids based on ads click-through rates and
engines. David McAdams and Schwarz (forth- other factors, such as relevance. But under the assumption
that all ads have the same relevance and click-through rates
coming) argue that in various settings, the costs conditional on position, Googles and Yahoo!s versions of
that buyers incur while trying to game an auc- GSP are identical. As we show in Section III, it is straight-
tion mechanism are fully passed through to the forward to generalize our analysis to Googles mechanism.
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 247

advertiser submits a bid. Advertisers are ar- position i is equal to the difference between the
ranged on the page in descending order of their aggregate value of clicks that all other advertis-
bids. The advertiser in the first position pays a ers would have received if i were not present in
price per click that equals the bid of the second the market and the aggregate value of clicks that
advertiser plus an increment; the second adver- all other advertisers receive when i is present.
tiser pays the bid of the third advertiser plus an Note that an advertiser in position j i is not
increment; and so forth. affected by i, and so the externality i imposes on
her is zero, while an advertiser in position j i
Example (continued). Let us now consider the would have received position (j 1) in the
payments in the environment of the previous absence of i, and so the externality i imposes on
example under the GSP mechanism. If all ad- her is equal to her value per click multiplied by
vertisers bid truthfully, then bids are $10, $4, the difference in the number of clicks in posi-
and $2. Payments in GSP will be $4 and $2.10 tions j and (j 1).
Truth-telling is indeed an equilibrium in this
example, because no advertiser can benefit by Example (continued). Let us compute VCG
changing his bid. Note that total payments of payments for the example considered above.
advertisers 1 and 2 are $800 and $200, The second advertisers payment is $200, as
respectively. before. However, the payment of the first ad-
vertiser is now $600: $200 for the externality
Generalized Second-Price and VCG Auc- that he imposes on advertiser 3 (by forcing him
tions.GSP looks similar to the VCG mecha- out of position 2) and $400 for the externality
nism, because both mechanisms set each that he imposes on advertiser 2 (by moving him
agents payments based only on the allocation from position 1 to position 2 and thus causing
and bids of other players, not based on that him to lose (200 100) 100 clicks per hour).
agents own bid. In fact, Googles advertising Note that in this example, revenues under VCG
materials explicitly refer to Vickrey and state are lower than under GSP. As we will show
that Googles unique auction model uses Nobel later (Remark 1 in Section II), if advertisers
Prizewinning economic theory to eliminate were to bid their true values under both mech-
... that feeling that youve paid too much.11 anisms, revenues would always be higher under
But GSP is not VCG.12 In particular, unlike the GSP.
VCG auction, GSP does not have an equilib-
rium in dominant strategies, and truth-telling is C. Assessing the Markets Development
generally not an equilibrium strategy in GSP
(see the example in Remark 3 in Section II). The chronology above suggests three major
With only one slot, VCG and GSP would be stages in the development of the sponsored
identical. With several slots, the mechanisms search advertising market. First, ads were sold
are different. GSP charges the advertiser in po- manually, slowly, in large batches, and on a
sition i the bid of the advertiser in position i cost-per-impression basis. Second, Overture
1. In contrast, VCG charges the advertiser in implemented keyword-targeted per-click sales
position i the externality that he imposes on and began to streamline advertisement sales
others by taking one of the slots away from with some self-serve bidding interfaces, but
them: the total payment of the advertiser in with a highly unstable first-price mechanism.
Next, Google implemented the GSP auction,
which was subsequently adopted by Overture
10 (Yahoo!).
For convenience, we neglect the $0.01 minimum in-
crements. Interestingly, Google and Yahoo! still use
11
See https://www.google.com/adsense/afs.pdf (accessed GSP, rather than VCG, which would reduce
June 10, 2006).
12
incentives for strategizing and make life easier
Roth and Axel Ockenfels (2002) describe another for advertisers. We see several possible reasons
example in which the architects of an auction may have
tried to implement a mechanism strategically equivalent to for this. First, VCG is hard to explain to typical
the Vickrey auction, but did not get an important part of the advertising buyers. Second, switching to VCG
mechanism right. may entail substantial transition costs: VCG
248 THE AMERICAN ECONOMIC REVIEW MARCH 2007

revenues are lower than GSP revenues for the position to g(2), and so on, down to position
same bids, and advertisers might be slow to stop min{N, K}. Note that each advertiser gets at
shading their bids. Third, the revenue conse- most one object. If a user clicks on an advertis-
quences of switching to VCG are uncertain: ers link, the advertisers payment per click is
even the strategic equivalence of second-price equal to the next advertisers bid. So advertiser
and English auctions under private values fails g(i)s total payment p(i) is equal to i b(i 1) for
to hold in experiments (John Kagel, Ronald M. i {1, ... , min{N, K}}, and his payoff is equal
Harstad, and Dan Levin 1987). And, of course, to i(sg(i) b(i 1)). If there are at least as many
simply implementing and testing a new system positions as advertisers (N K), then the last
may be costlyimposing switching costs on advertisers payment p(K) is equal to zero.15
advertisers as well as on search engines. It is also useful to describe explicitly the rules
that the VCG mechanism would impose in this
II. The Rules of GSP setting. The rules for allocating positions are the
same as under GSP: position i is assigned to
Let us now formally describe the rules of a advertiser g(i) with the i-th highest bid b(i). The
sponsored search auction. For a given keyword, payments, however, are different. Each adver-
there are N objects (positions on the screen, tisers payment is equal to the negative exter-
where ads related to that keyword can be dis- nality that he imposes on others, assuming that
played) and K bidders (advertisers).13 The (ex- bids are equal to values. Thus, the payment of
pected) number of clicks per period received by the last advertiser who gets allocated a spot is
the advertiser whose ad was placed in position i the same as under GSP: zero if N K;
is i. The value per click to advertiser k is sk. Nb(N 1) otherwise. For all other i min{N,
Advertisers are risk-neutral, and advertiser ks K}, payment pV induced by VCG will be dif-
payoff from being in position i is equal to i sk ferent from payment p induced by GSP.
minus his payments to the search engine. Note Namely, pV,(i) (i i 1)b(i 1) pV,(i 1).
that these assumptions imply that the number of In the following two sections, we will con-
times a particular position is clicked does not sider two alternative ways of completing the
depend on the ads in this and other positions, model: as a simultaneous-move game of complete
and also that an advertisers value per click does information, resembling a sealed-bid second-price
not depend on the position in which its ad is auction, and as an extensive-form game of incom-
displayed. Without loss of generality, positions plete information, resembling an ascending En-
are labeled in descending order: for any i and j glish auction. Before moving on to these models,
such that i j, we have i j. let us make a few observations about GSP and
We model the GSP auction as follows. Sup- VCG.
pose at some time t a search engine user enters
a given keyword, and, for each k, advertiser ks REMARK 1: If all advertisers were to bid the
last bid submitted for this keyword prior to t same amounts under the two mechanisms, then
was bk; if advertiser k did not submit a bid, we each advertisers payment would be at least as
set bk 0. Let b( j) and g(j) denote the bid and large under GSP as under VCG.
identity of the j-th highest advertiser, respec-
tively. If several advertisers submit the same This is easy to show by induction on adver-
bid, they are ordered randomly.14 The mecha- tisers payments, starting with the last advertiser
nism then allocates the top position to the ad- who gets assigned a position. For i min{K,
vertiser with the highest bid, g(1), the second N}, p(i) pV,(i) i b(i 1). For any i min{K,

13 15
In actual sponsored search auctions at Google and Although we set the reserve price to zero, search
Yahoo!, advertisers can also choose to place broad match engines charge the last advertiser a positive reserve price.
bids that match searches that include a keyword along with We also assume that a bid can be any nonnegative real
additional search terms. number, while in practice bids can be specified only in $.01
14
The actual practice at Overture is to show equal bids increments. Finally, we assume that advertiser g(i) is
according to the order in which the advertisers placed their charged the amount b(i 1) per click, while search engines
bids. typically charge one cent more, (b(i 1) $.01).
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 249

N}, pV,(i) pV,(i 1) (i i 1)b(i 1) We therefore focus on simple strategies and

i b(i 1) i 1b(i 2) p(i) p(i 1). study the rest points of the bidding process: if the
vector of bids stabilizes, at what bids can it stabi-
REMARK 2: Truth-telling is a dominant strat- lize? We impose several assumptions and restric-
egy under VCG. tions. First, we assume that all values are common
knowledge: over time, advertisers are likely to
This is a well-known property of the VCG learn all relevant information about each others
mechanism. values. Second, since bids can be changed at any
time, stable bids must be best responses to each
REMARK 3: Truth-telling is not a dominant other otherwise, an advertiser whose bid is not a
strategy under GSP. best response would have an incentive to change
it. Thus, we assume that the bids form an equilib-
For instance, consider a slight modification of rium in the simultaneous-move, one-shot game of
the example from Section I. There are still three complete information. Third, what are the simple
advertisers, with values per click of $10, $4, and strategies that an advertiser can use to increase his
$2, and two positions. However, the click-through payoff, beyond simple best responses to the other
rates of these positions are now almost the same: players bids?
the first position receives 200 clicks per hour, and One clear strategy is to try to force out the
the second one gets 199. If all players bid truth- player who occupies the position immediately
fully, then advertiser 1s payoff is equal to ($10 above. Suppose advertiser k bids bk and is as-
$4) 200 $1,200. If, instead, he shades his bid signed to position i, and advertiser k bids bk bk
and bids only $3 per click, he will get the second and is assigned to position (i 1). Note that if k
position, and his payoff will be equal to ($10 raises his bid slightly, his own payoff does not
$2) 199 $1,592 $1,200. change, but the payoff of the player above him
decreases. Of course, player k can retaliate, and
III. GSP and Locally Envy-Free Equilibria the most she can do is to slightly underbid adver-
tiser k, effectively swapping places with him. If
Advertisers bidding on Yahoo! and Google can advertiser k is better off after such retaliation, he
change their bids very frequently. We therefore will indeed want to force player k out, and the
think of these sponsored search auctions as con- vector of bids will change. Thus, if the vector
tinuous time or infinitely repeated games in which converges to a rest point, an advertiser in position
advertisers originally have private information i should not want to exchange positions with the
about their types, gradually learn the values of advertiser in position (i 1). We call such vectors
others, and can adjust their bids repeatedly. In of bids locally envy-free.17
principle, the sets of equilibria in such repeated
games can be very large, with players potentially DEFINITION 1: An equilibrium of the
punishing each other for deviations. The strategies simultaneous-move game induced by GSP is
required to support such equilibria are usually locally envy-free if a player cannot improve
quite complex, however, requiring precise knowl-
edge of the environment and careful implementa-
tion. In theory, advertisers could implement such 17
An alternative interpretation of this restriction is as fol-
strategies via automated robots, but in practice lows. With only one slot, GSP coincides with the standard
they may not be able to: bidding software must second-price auction, and the restriction of local envy-freeness
first be authorized by the search engines,16 and simply says that the losing advertiser bids at least his own
value, ruling out various implausible equilibria. Likewise, with
search engines are unlikely to permit strategies multiple slots, the local envy-freeness restriction is equivalent
that would allow advertisers to collude and sub- to saying that the bid of the advertiser who gets position i and
stantially reduce revenues. thus loses position (i 1) is such that his marginal bid
(i.e., the difference between the highest amount that he could
have paid if he had won position (i 1) and the amount he
actually pays for position i) is at least as high as the marginal
16
See, e.g., help.yahoo.com/help/us/performance/ value for the extra clicks he would have received in position
customer/dtc/bidding, questions 7 and 8 (accessed June (i 1). To see this, simply rearrange equation (1) to get
10, 2006). p(i1) p(i) sg(i)(i1 i).
250 THE AMERICAN ECONOMIC REVIEW MARCH 2007

his payoff by exchanging bids with the player then any stable assignment is an outcome of a
ranked one position above him. More for- locally envy-free equilibrium of auction .
mally, in a locally envy-free equilibrium, for any
i min{N 1, K}, We will now construct a particular locally
envy-free equilibrium of game . This equilib-
(1) i s gi p i i 1 s gi p i 1 . rium has two important properties. First, in this
equilibrium, advertisers payments coincide
Of course, it is possible that bids change over with their payments in the dominant-strategy
time, depending on the players strategies and equilibrium of VCG. Second, this equilibrium is
information structure. However, if the behavior the worst locally envy-free equilibrium for the
ever converges to a vector of bids, that vector search engine and the best locally envy-free
should correspond to a locally envy-free equi- equilibrium for the advertisers. Consequently,
librium of the simultaneous-move game in- the revenues of a search engine are (weakly)
duced by GSP. Consequently, we view a locally higher in any locally envy-free equilibrium of
envy-free equilibrium as a prediction regard- GSP than in the dominant-strategy equilibrium
ing a rest point at which the vector of bids of VCG.
stabilizes. In this section, we study the set of Consider the following strategy profile B*.
locally envy-free equilibria. Without loss of generality, assume that adver-
We first show that the set of locally envy-free tisers are labeled in decreasing order of their
equilibria maps naturally to a set of stable as- values, i.e., if j k, then sj sk. For each
signments in a corresponding two-sided match- advertiser j {2, ... , min{N 1, K}}, bid b*j is
ing market. The idea that auctions and two- equal to pV,( j 1)/j 1, where pV,( j 1) is the
sided matching models are closely related is not payment of advertiser j 1 in the dominant-
new: it goes back to Vincent P. Crawford and strategy equilibrium of VCG where all adver-
Elsie M. Knoer (1981), Alexander S. Kelso and tisers bid truthfully. Bid b*1 is equal to s1.18
Crawford (1982), Herman B. Leonard (1983),
and Gabrielle Demange, David Gale, and THEOREM 1: Strategy profile B* is a locally
Marilda Sotomayor (1986), and has been stud- envy-free equilibrium of game . In this equi-
ied in detail in a recent paper by John W. librium, each advertisers position and payment
Hatfield and Milgrom (2005). Note, however, are equal to those in the dominant-strategy
that in our case the nonstandard auction is very equilibrium of the game induced by VCG. In
different from those in the papers noted above. any other locally envy-free equilibrium of game
Our environment maps naturally into the , the total revenue of the seller is at least as
most basic assignment model, studied first by high as in B*.
Lloyd S. Shapley and Martin Shubik (1972).
Consider each position as an agent who is look- To prove Theorem 1, we first note that pay-
ing for a match with an advertiser. The value of ments under strategy profile B* coincide with
a position-advertiser pair (i, k) is equal to i sk. VCG payments and check that B* is indeed a
We call this assignment game A. The advertiser locally envy-free equilibrium. This follows
makes its payment pik for the position, and the from the fact that, by construction, each adver-
advertiser is left with i sk pik. The following tiser is indifferent between remaining in his
pair of lemmas shows that there is a natural positions and swapping with the advertiser one
mapping from the set of locally envy-free equi- position above him. Next, from Lemma 1 we
libria of GSP to the set of stable assignments. know that every locally envy-free equilibrium
All proofs are in the Appendix. corresponds to a stable assignment. The core
elongation property of the set of stable assign-
LEMMA 1: The outcome of any locally envy- ments (Shapley and Shubik 1972; Crawford
free equilibrium of auction is a stable and Knoer 1981) implies that there exists an
assignment.

LEMMA 2: If the number of advertisers is 18

This bid does not affect any advertisers payment and
greater than the number of available positions, can be set equal to any value greater than b*2.
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 251

advertiser-optimal assignment A in that set, locally envy-free equilibrium if and only if, for
such that in any other stable assignment, each any i and j, ig(i)(sg(i) g(i1)bg(i1)/g(i))
advertiser pays at least as much to the search jg(i)(sg(i) g(j1)bg(j1)/g(i)). Dividing both
engine as he does in A. Moreover, Leonard sides by g(i) and multiplying by g(i), we get
(1983) and Demange, Gale, and Sotomayor i(g(i)sg(i) g(i1)bg(i1)) j(g(i)sg(i)
(1986) show that in general assignment games, g(j1)bg(j1)). Hence, the set of bids {bk} is a
payoffs of buyers in the buyer-optimal stable locally envy-free equilibrium under Googles ver-
assignment coincide with their VCG payoffs, sion of GSP with position-specific factors {i}, ad-
which is sufficient to complete the proof. This is vertiser-specific quality scores {k}, and per-click
particularly easy to show in the specific envi- values {sk}, if and only if the set of bids {kbk} is an
ronment that we consider, and so for complete- equilibrium of our basic model with position-specific
ness we include a short independent proof. CTRs {i}, per-click values {ksk}, and no quality
In the model, we assume that all advertisers scores or advertiser-specific factors in CTRs.
are identical along dimensions other than per-
click value, and in particular have identical IV. Main Result: GSP and Generalized English
click-through rates. The analysis remains Auction
largely the same if, instead, we assume that the
CTRs of different advertisers are multiples of In the model analyzed in the previous section,
one another, i.e., if any advertiser k assigned to we assume that advertisers have converged to a
any position i receives ik clicks, where i is a long-run steady state, have learned each others
position-specific factor and k is an advertiser- values, and no longer have incentives to change
specific factor. In this case, the versions of GSP their bids. But how do they converge to such a
implemented by Yahoo! and Google differ. situation? In this section, we introduce the gen-
Under Yahoo!s system, advertisers are still eralized English auction, an analogue of the
ranked by bids, and each of them is charged the standard English auction corresponding to GSP,
next-highest advertisers bid. Then, bids form a to help us answer this question.
locally envy-free equilibrium if and only if, for In the generalized English auction, there is a
any i and j, ig(i)(sg(i) b(i1)) jg(i)(sg(i) clock showing the current price, which contin-
b(j1)). Dividing both sides by the positive num- uously increases over time. Initially, the price
ber g(i), we get i(sg(i) b(i1)) j(sg(i) on the clock is zero, and all advertisers are in
b(j1)), i.e., the necessary and sufficient condition the auction. An advertiser can drop out at any
for a locally envy-free equilibrium in the case time, and his bid is the price on the clock at the
where all k are equal to one. Hence, under Ya- time when he drops out. The auction is over
hoo!s version of GSP, equilibria are not affected when the next-to-last advertiser drops out. The
by changes in s. ad of the last remaining advertiser is placed in
Under Googles system, advertisers are ar- the best position on the screen, and this adver-
ranged by rank numbers. Advertiser ks rank tisers payment per click is equal to the price at
number is the product of his bid and quality which the next-to-last advertiser dropped out.
score k.19 Thus, under Googles system, g(1) The ad of the next-to-last advertiser is placed
is the advertiser with the highest rank number, second, and his payment per click is equal to the
g(2) is the advertiser with the second highest third-highest advertisers bid, and so on.20 In
rank number, and so on. Per-click payment of other words, the vector of bids obtained in the
advertiser g(i) is equal to the smallest amount generalized English auction is used to allocate
x(i), such that g(i1)x(i) is greater than or equal
to the next highest advertisers rank number,
i.e., x(i) g(i1)bg(i1)/g(i). Then, bids form a 20
If several advertisers drop out simultaneously, one of
them is chosen randomly. Whenever an advertiser drops
out, the clock is stopped, and other advertisers are also
19
Initially, Google simply used click-through rates to allowed to drop out; again, if several advertisers want to
determine quality scores, setting k k. Later, however, it drop out, one of them is chosen randomly. If several adver-
switched to a less transparent system for determining qual- tisers end up dropping out at the same price, the first one to
ity scores, incorporating such factors as the relevance of an drop out is placed in the lowest position of the still available
ads text and the quality of an advertisers Web page. ones, the next one to the position right above that, and so on.
252 THE AMERICAN ECONOMIC REVIEW MARCH 2007

the objects and compute the prices according to is the price at which he drops out, i is the
the rules of GSP. With one object, the general- number of advertisers remaining (including ad-
ized English auction becomes a simple English vertiser k), and h (bi 1, ... , bN 1) is the
auction.21 history of prices at which previous advertisers
We view the generalized English auction in have dropped out. (As a result, the price that
the same light as the tatonnement processes in advertiser k would have to pay per click if he
the theory of general equilibrium (see, e.g., An- dropped out next is equal to bi 1, unless the
dreu Mas-Colell, Michael D. Whinston, and history is empty, in which case we say that
Jerry R. Green 1995, sect. 17.H) and the salary bi 1 0.) The following theorem shows that
adjustment process in the theory of matching in this game has a unique perfect Bayesian equi-
labor markets with heterogeneous firms and librium with strategies continuous in advertis-
workers (Crawford and Knoer 1981).22 While ers valuations.23 The payoffs of all advertisers
all these processes, taken literally, happen in in this equilibrium are equal to VCG payoffs.
imaginary time, they are meant to resemble
the underlying dynamics of the actual markets, THEOREM 2: In the unique perfect Bayesian
to help us distinguish more plausible equilibria equilibrium of the generalized English auction
from less plausible ones, characterize their sta- with strategies continuous in sk, an advertiser
bility and other properties, and examine the with value sk drops out at price
significance of the underlying assumptions. As
in the case of the tatonnement and salary ad- i
justment processes, there are many features of (2) p k i, h, s k s k s b i 1 .
real markets not captured by the generalized i 1 k
English auction, but we believe that it provides
a natural and useful approximation. In this equilibrium, each advertisers result-
To define the game formally, assume that ing position and payoff are the same as in the
there are N 2 slots and K N 1 advertis- dominant-strategy equilibrium of the game
ers. (Cases with K N 1 require only minor induced by VCG. This equilibrium is ex post:
modifications in the proof.) Click-through rates the strategy of each advertiser is a best re-
i are commonly known, with N 1 0. Ad- sponse to other advertisers strategies re-
vertisers per-click valuations sk are drawn from gardless of their realized values.
a continuous distribution F on [0; ) with a
continuous density function f that is positive The intuition of the proof is as follows. First,
everywhere on (0, ). Each advertiser knows with i players remaining and the next highest
his valuation and the distribution of other ad- bid equal to bi 1, it is a dominated strategy for
vertisers valuations. a player with value s to drop out before price p
The strategy of an advertiser assigns the reaches the level at which he is indifferent be-
choice of dropping out or not for any history of tween getting position i and paying bi 1 per
the game, given that the advertiser has not pre- click and getting position i 1 and paying p per
viously dropped out. In other words, the strat- click. Next, if for some set of types it is not
egy can be represented as a function pk(i, h, sk), optimal to drop out at this borderline price
where sk is the value per click of advertiser k, pk level, we can consider the lowest such type, and

21 23
This version of the English auction is also known as Without this restriction, multiple equilibria exist, even
the Japanese or button auction. in the simplest English auction with two bidders and one
22
Of course, the generalized English auction is very object. For example, suppose there is one object for sale and
different from the salary adjustment process of Crawford two bidders with independent private values for this object
and Knoer (1981) and its application to multi-unit auctions distributed exponentially on [0, ). Consider the following
(Demange et al. 1986). In Demange et al. (1986), bidding pair of strategies. If a bidders value is in the interval [0, 1]
proceeds simultaneously for all items and the auctioneer or in the interval [2, ), he drops out when the clock reaches
keeps track of a vector of item-specific prices, while in the his value. If bidder 1s value is in the interval (1, 2), he
generalized English auction bidding proceeds, in essence, drops out at 1, and if bidder 2s value is in the interval (1,
sequentially, and the auctioneer keeps track of only one 2), he drops out at 2. This pair of strategies, together with
price. appropriate beliefs, forms a perfect Bayesian equilibrium.
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 253

then once the clock reaches this price level, a auction is a particularly interesting example,
player of this type will know that he has the because it can be viewed as a model of a mech-
lowest per-click value of the remaining players. anism that has emerged in the wild.
But then he will also know that the other re-
maining players will drop out only at price
levels at which he will find it unprofitable to V. Conclusion
compete with them for the higher positions.
The result of Theorem 2 resembles the classic We investigate a new mechanism that we call
result on the equivalence of the English auction the generalized second-price auction. GSP is
and the second-price sealed-bid auction under tailored to the unique features of the market for
private values (Vickrey 1961). Note, however, Internet advertisements. As far as we know, this
that the intuition is very different: Vickreys mechanism was first used in 2002. As of May
result follows simply from the existence of 2006, the annual revenues from GSP auctions
equilibria in dominant strategies, whereas in our were on the order of $10 billion.
case such strategies do not exist, and bids do GSP looks similar to the VCG mechanism,
depend on other players bids. Also, our result is because just like in the standard second-price
very different from the revenue equivalence the- auction, the payment of a bidder does not di-
orem: payoffs in the generalized English auc- rectly depend on his bid. Although GSP looks
tion coincide with VCG payments for all similar to VCG, its properties are very different,
realizations of values, not only in expectation, and equilibrium behavior is far from straight-
and the result does not hinge on the assumptions forward. In particular, unlike the VCG mecha-
of symmetric bidders or common priors. nism, GSP generally does not have an
The equilibrium described in Theorem 2 is an equilibrium in dominant strategies, and truth-
ex post equilibrium. As long as all advertisers telling is not an equilibrium of GSP. We show
other than advertiser k follow the equilibrium that the generalized English auction that corre-
strategy described in Theorem 2, it is a best sponds to the generalized second-price auction
response for advertiser k to follow his equilibrium has a unique equilibrium.
strategy, for any realization of other advertisers This equilibrium has some notable properties.
values. Thus, the outcome implemented by this The bid functions have explicit analytic formu-
mechanism depends only on the realization of las, which, combined with equilibrium unique-
advertisers values and does not depend on adver- ness, make our results a useful starting point for
tisers beliefs about each others types. empirical analysis. Moreover, these functions
Clearly, any dominant strategy solvable game do not depend on bidders beliefs about each
has an ex post equilibrium. However, the gen- others types: the outcome of the auction de-
eralized English auction is not dominant strat- pends only on the realizations of bidders val-
egy solvable. This combination of properties is ues. This is one of the very few mechanisms
quite striking: the equilibrium is unique and encountered in practice that are not dominant
efficient, and the strategy of each advertiser strategy solvable and nevertheless have this
does not depend on the distribution of other property. It is particularly interesting that a
advertisers values, yet advertisers do not have mechanism with such notable features in theory
dominant strategies.24 The generalized English and such enormous popularity in practice devel-
oped as a result of evolution of inefficient mar-
ket institutions, which were gradually replaced
24
Dirk Bergemann and Stephen Morris (2005) show that by increasingly superior designs.
an outcome implementable by robust mechanisms must be
implementable in dominant strategies. Indeed, the outcome
implemented by the generalized English auction can be
implemented in dominant strategies by the VCG mecha- Of course, in our model, values are private, and, crucially,
nism; however, VCG is not the mechanism that is used in signals are single-dimensional, even though multiple differ-
practice. Philippe Jehiel and Benny Moldovanu (2001) and ent objects are for sale. This makes efficient ex post imple-
Jehiel et al. (2006) show that, generically, any efficient mentation feasible. For other examples of mechanisms that
choice function is not Bayes-Nash implementable and any allocate multiple different objects to bidders with single-
nontrivial choice function is not ex post implementable, if dimensional types, see Moldovanu and Aner Sela (2001)
values are interdependent and signals are multidimensional. and Thomas Kittsteiner and Moldovanu (2005).
254 THE AMERICAN ECONOMIC REVIEW MARCH 2007

APPENDIX: PROOFS him. Suppose the advertiser assigned to posi-

tion i is considering rematching with position
PROOF OF LEMMA 1: m i 1. Since the equilibrium is locally
By definition, in any locally envy-free envy-free, we have
equilibrium outcome, no advertiser can prof-
itably rematch with the position assigned to i s gi p i i 1 s gi p i 1 ,
the advertiser right above him. Also, no adver-
tiser (a) can profitably rematch with a position i 1 s gi 1 p i 1 i 2 s gi 1 p i 2 ,
assigned to an advertiser below him (b)if
such a profitable rematching existed, advertiser
a would find it profitable to slightly undercut
advertiser b in game and get bs position and
payment. But this would contradict the assump- m 1 sgm 1 pm 1 m sgm 1 pm.
tion that we are in equilibrium.25
Hence, we need only show that no advertiser Since j j 1 for any j, and sg(i) sg( j) for
can profitably rematch with the position as- any i j, the inequalities above remain valid
signed to an advertiser more than one spot after replacing sg(i) with sg( j). Doing that, then
above him. First, note that in any locally envy- adding all inequalities up, and canceling out the
free equilibrium, the resulting matching must be redundant elements, we get i sg(i) p(i)
assortative, i.e., for any i, the advertiser as- msg(i) p(m). But that implies that the adver-
signed to position i has a higher per-click val- tiser assigned to position i cannot rematch prof-
uation than the advertiser assigned to position itably with position m, and we are done.
i 1 and, therefore, the advertiser with the
highest per-click value must be assigned to the PROOF OF LEMMA 2:
top position, the advertiser with the second- Take a stable assignment. By a result of
highest per-click value to the second-highest Shapley and Shubik (1972), this assignment
position, and so on. must be efficient, and hence assortative, and so
Indeed, suppose s g(i) and s g(i 1) are the without loss of generality we can assume that
values of advertisers assigned to positions i advertisers are labeled in decreasing order of
and i 1. Equilibrium restrictions imply that their bids (i.e., sj sk whenever j k) and that
i s g(i) p (i) i 1 s g(i) p (i 1) (nobody advertiser i is matched with position i, with
wants to move one position down), and local associated payment pi.
envy-freeness implies that i 1 s g(i 1) Let us construct a locally envy-free equilib-
p (i 1) i s g(i 1) p (i) (nobody wants to rium with the corresponding outcome. Let b1
move one position up). Manipulating the in- s1 and bi pi 1/i 1 for i 1. Let us show
equalities above yields i sg(i) i sg(i1) that this set of strategies is a locally envy-free
i1sg(i1) i1sg(i), thus (i i1)sg(i) equilibrium. First, note that for any i, bi bi 1
(i i1)sg(i1). Since i i1, we have (because otherwise we would have, for some i,
sg(i) sg(i1), and hence the locally envy-free pi 1/i 1 pi/i f si pi 1/i 1 si
equilibrium outcome must be an assortative pi/i f i 1si pi 1 isi pi, which
match. would imply that player i could rematch profit-
Now, let us show that no advertiser can ably). Therefore, position allocations and pay-
profitably rematch with the position assigned ments resulting from this strategy profile will
to an advertiser more than one spot above coincide with those in the original stable assign-
ment. To see that this strategy profile is an
equilibrium, note that deviating and moving to a
25
This argument relies on the fact that in equilibrium, different position in this strategy profile is at
no two (or more) advertisers bid the same amount, which most as profitable for any player as rematching
is straightforward to prove: since all advertisers per- with the corresponding position in the assign-
click values are different, and all ties are broken ran-
domly with equal probabilities, at least one such ment game. To see that this equilibrium is lo-
advertisers would find it profitable to bid slightly higher cally envy-free, note that the payoff from
or slightly lower. swapping with the bidder above is exactly equal
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 255

to the payoff from rematching with that players truthful equilibrium of VCG. Therefore, by
position in the assignment game. construction, payments are also the same.
Next, to see that no bidder j can benefit by
PROOF OF THEOREM 1: bidding less than b*j , suppose that he bids an
First, we need to check that the order of the amount b b*j that puts him in position j j.
bids is preserved, i.e., b*j b*j 1 for any j Then, by construction, his payment will be
min{N, K}. For j 2, this is equivalent to equal to the amount that he would need to pay
to be in position j under VCG, provided that
p V, j 1 p V, j other players bid truthfully. But truthful bidding
(3) is an equilibrium under VCG, and so such de-
j 1 j
viation cannot be profitable there hence, it
cannot be profitable in strategy profile B* of

game either.
To see that no bidder j can benefit by bidding
j 1 j s j p V, j p V, j more than b *j , suppose that he bids an amount

j 1 j b b *j that puts him in position j j. Then
the net payoff from this deviation is equal to

( j j )s j ( j b *j j b j 1 ) ( j
j )s j ( j b *j 1 j b j 1 ) j1
ij ( i

j j 1 j s j j 1 j p V, j i 1 )s j j1
ij ( p
V,(i)
p V,(i 1) ) j1 ij
( i i 1 )s j j1ij ( i i 1 )s i 1 . But
since s j s i 1 for any i j, the last expres-

sion is less than or equal to zero, and hence
the deviation is not profitable.
j s j p V, j . To check that this equilibrium is locally
envy-free, note that if bidder j swapped his bids
with bidder j 1, his payoff would change by
For j 1, b *j b *j 1 is equivalent to (j1 j )sj (j1b*j j bj1) (j1
j)sj (p V,( j 1) pV,( j)) (j 1 j)sj
p V,1 (pV,( j 1) pV,( j)) (j 1 j)sj (j 1
(4) s1 j)sj 0. In other words, each bidder is indif-
1
ferent between his actual payoff and his payoff
after swapping bids with the bidder above, and

hence the equilibrium is locally envy-free.
Let us now show that B* is the best locally
1 s 1 p V,1 . envy-free equilibrium for the bidders and the
worst locally envy-free equilibrium for the
To see that for any j, j s j p V,( j) , note first search engine. The core-elongation property of
that in the game induced by VCG, each player the assignment game (Shapley and Shubik
can guarantee himself the payoff of at least 1972; Crawford and Knoer 1981) implies that
zero (by bidding zero), and hence in any there exists an assignment that is the best stable
equilibrium his payoff from clicks is at least assignment for all advertisers and the worst
as high as his payment. To prove that the stable assignment for all positions. Suppose this
inequality is strict, note that if player js value assignment is characterized by a vector of
per click were slightly lower, e.g., s j payments p (p1, ... , pK). Let pV (pV1 , ... ,
instead of s j , s j s j 1 , then his pay- pKV
) be the set of dominant-strategy VCG pay-
ment in the truth-telling equilibrium would ments, i.e., the set of payments in equilibrium
still be the same (because it does not depend B* of game .
on his own bid, given the allocation of posi- In any stable assignment, pK must be at least
tions), and so p V,( j) j (s j ) j s j . as high as KsK 1, since otherwise advertiser
Thus, for any j, b *j b *j 1 , and therefore K 1 would find it profitable to match with
each bidders position is the same as in the position K. On the other hand, pK V
KsK 1,
256 THE AMERICAN ECONOMIC REVIEW MARCH 2007

and hence in the advertiser-optimal stable as- received position i 1. If history h is empty,
signment, pK pK V
. we set b i 1 0.) We will now show that for
Next, in any stable assignment, it must be the any i, k, h, and s k , p k (i, h, s k ) q(i, h, s k ).
case that pK 1 pK (K 1 K)sK Suppose that is not the case, and take the
otherwise, advertiser K would find it profitable largest i for which there exist such history h
to rematch with position K 1. Hence, pK 1 (with the last player dropping out at bi 1),
(K1 K)sK pK (K1 K)sK pK V
player k, and type sk (surviving with positive
V
pK1, and so in the advertiser-optimal stable as- probability on the equilibrium path) that pk(i, h,
signment, pK1 pK1 V
. sk) q(i, h, sk). Since by assumption, all strat-
Proceeding by induction, we get pj pVj for egies up to this stage were pk( , , ) q( ,
any j K in the advertiser-optimal stable as- , ), we know that there exists a value smin
signment, and so in any locally envy-free equi- bi 1, such that all players with values less than
librium of game , the total revenue of the seller smin have dropped out, and all players with
is at least as high as K V
j1 pj . values greater than smin are still in the auction.
Step 1: Suppose for some type s smin ,
PROOF OF THEOREM 2: pmax(i, h, s) maxk pk(i, h, s) q(i, h, s). Let
First, note that in equilibrium, for any player s0 be the smallest type, and let k be the corre-
k, any history h, and any number of remaining sponding player, such that pk(i, h, s0) pmax(i,
players i, the drop-out price pk(i, h, sk) tends to h, s); clearly, s0 s. Without loss of generality,
infinity as sk tends to infinity. (Otherwise, there we can assume that there is a positive mass of
would exist a player for whom it was optimal to types of other players dropping out at or before
deviate from his strategy and stay longer, for a pk(i, h, s0).26
sufficiently high value s.) Next, take any equi- Step 1(a). Suppose first that there is a positive
librium of the generalized English auction. Note mass of types of other players dropping out at
that if in this equilibrium pk(i, h, sk) pk(i, h, pk(i, h, s0) pmax(i, h, s). That implies that with
sk) for some k, h, i, and types sk sk, then it has positive probability, player k of type s0 will
to be the case that both types sk and sk are remain in the subgame following the drop-out
indifferent between dropping out at pk(i, h, sk) of some other player at pk(i, h, s0) (since ties are
and pk(i, h, sk). (Otherwise, one of them would broken randomly). Let us show that in this
be able to increase his payoff by mimicking the subgame, player k of type s0 will be the first
other.) Consequently, we can swap such play- player to drop out with probability 1. Suppose
ers strategies, and therefore there exists an ob- that is not the case, and let l i 1 be the
servationally equivalent equilibrium in which smallest number such that he gets position l
strategies are nondecreasing in types; also, they with positive probability.
are still continuous in own values. Consider this Consider any continuation of history h, hl 2,
equilibrium profile of strategies pk(i, h, sk). such that the last player to drop out in that
Let q(i, bi 1, s) be such a price that a player history gets position l 2 and drops out at price
with value s is indifferent between getting po- bl 2, player k of type s0 is one of the remaining
sition i at price bi 1 and position i 1 at price l 1 players, there is a positive probability that
q(i, bi 1, s). That is, player k gets position l in the continuation sub-
game following history hl 2, and there is zero
(5) i 1 s qi, b i 1 , s i s b i 1

26
Otherwise, we have @j k, pj(i, h, s0) pj(i, h, s)
pmax(i, h, s) pk(i, h, s0) f @j k, pj(i, h, s0) pk(i, h, s0)
and @s s0, pj(i, h, s) pk(i, h, s0). But we also have pk(i,
i h, s0) pmax(i, h, s) q(i, h, s) q(i, h, s0), and so for
qi, b i 1 , s s s b i 1 .
i 1 some s s0 we have pmax(i, h, s) q(i, h, s) and pmax(i,
h, s) pmax(i, h, s). We can then consider s0 in place of s0,
where s0 is the smallest type, and k is the corresponding
Slightly abusing notation, let q(i, h, s) q(i, player, such that pk(i, h, s0) pmax(i, h, s). There is a
b i 1 , s), where b i 1 is the last bid at which positive mass of types of other players dropping out before
a player dropped out in history h. (This player pk(i, h, s0).
VOL. 97 NO. 1 EDELMAN ET AL.: INTERNET ADVERTISING AND THE GSP AUCTION 257

probability that player k gets position m for any i 1(s0 pk(i, h, s0)). Now suppose player k
m l. Note that s0 bl 2 otherwise, it dropped out at a price pk(i, h, s0) instead of
would have been optimal for player k to drop waiting until pk(i, h, s0). If somebody else drops
out earlier. Consider pk(l 1, hl 2, s0). Since out before pk(i, h, s0) or after pk(i, h, s0), or
player k of type s0 gets position l with positive drops out at pk(i, h, s0) but player k is chosen to
probability in this subgame, there must be a drop out first, then these two strategies result in
positive mass of types of other players who drop identical payoffs. The probability that some-
out no later than pk(l 1, hl 2, s0). Take the body drops out in the interval (pk(i, h, s0) ,
highest such type, s, and the corresponding pk(i, h, s0)) goes to zero as goes to zero, and
player j. It has to be the case that s s0 the possible difference in the payoffs is finite, so
bl 2. It also has to be the case that q(l 1, the difference in payoffs due to this contingency
hl 2, s) is less than or equal to pk(l 1, hl 2, goes to zero as goes to zero. Finally, there is
s0). (Otherwise, player j with value s would be a positive probability that somebody else drops
playing a strategy weakly dominated by drop- out at pk(i, h, s0) and is chosen to drop out first.
ping out at q(l 1, hl 2, s), with a positive If player k drops out before that, at pk(i, h, s0)
probability of earning strictly less than he would , his payoff is i(s0 bi 1). If he waits until
have earned if he waited until that price level.) pk(i, h, s0), we know that in the subsequent
Therefore, pk(l 1, hl 2, s0) q(l 1, hl 2, subgame his payoff is i 1(s0 pk(i, h, s0))
s) q(l 1, hl 2, s0) bl 2. Let us show that i 1(s0 q(i, h, s0)) i(s0 bi 1). There-
it would be strictly better for player k with type fore, for a sufficiently small , it is strictly better
s0 to drop out at q(l 1, hl 2, s0) instead of for player k with value s0 to drop out at pk(i, h,
waiting until pk(l 1, hl 2, s0). Indeed, if s0) instead of waiting until pk(i, h, s0),
nobody else drops out in between, or someone which contradicts the assumption that { pj( , ,
drops out before q(l 1, hl 2, s0), these strat- )} is an equilibrium.
egies would result in identical payoffs. Other- Step 1(b). Now, suppose there is mass zero of
wise, payoffs are different, and this happens types of other players dropping out at pk(i, h,
with positive probability. Under the former s0) pmax(i, h, s), but there is a positive mass
strategy, player k earns dropping out before pk(i, h, s0). Consider a
sequence of small positive numbers (n) con-
(6) l 1 s 0 b l 2 . verging to 0 as n 3 and sequences (1n),
( 2n), ... , ( i1
n ), where n is the probability
l

that player k with value s0 will end up in posi-

Under the latter strategy, he earns tion l if another player drops out at price (pk(i,
h, s0) n). Let B 1s0, i.e., the maximum
(7) l s 0 b l 1 , payoff that a player with value s0 can possibly
get in the auction. Now, if ( i1 n ) converges to
1 and ( ln) converges to zero for all l i 1,
where b l 1 is the price at which somebody then, by an argument similar to the one at the
else dropped out. (The probability of getting a end of Step 1(a), it is better for player k of type
spot m l is zero by construction.) With s0 to drop out at some time pk(i, h, s0) .27 If
probability 1, b l 1 q(l 1, h l 2 , s 0 ), and ( i1
n ) does not converge to 1, take the smallest
with positive probability, b l 1 q(l 1, (i.e., best) l for which ( ln) does not converge to
h l 2 , s 0 ), so the expected payoff from wait- zero, and take a subsequence of n along which
ing until p k (l 1, h l 2 , s 0 ) is strictly less ( ln) converges to some positive number . Let
than the expected payoff from dropping out at s1 be the value such that for a random draw of
q(l 1, h l 2 , s 0 ): E[ l (s 0 b l 1 )] types of remaining players other than k, condi-
l (s 0 q(l 1, h l 2 , s 0 )) l (s 0 (s 0
( l 1 / l )(s 0 b l 2 ))) l 1 (s 0 b l 2 ).
Therefore, in the subgame following the
27
If some other player drops out between pk(i, h, s0)
and pk(i, h, s0), the benefit of staying longer tends to zero
drop-out of some other player at pk(i, h, s0), (it is at most B(1 i 1)), while the cost converges to a
player k of type s0 gets position i 1 with positive number (the difference between getting position i at
probability 1, and therefore his payoff is price bi 1 and position i 1 at price pk(i, h, s0)).
258 THE AMERICAN ECONOMIC REVIEW MARCH 2007

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