How Does Google Adwords PPC Auction Model Work?
Introduction
 Every time someone goes to Google and does a search, Google runs what's
called the ad auction. It happens hundreds of millions of times per day and it
takes only a fraction of a second, but it's what determines which ads you are
going to see every time you do a search.
Pay Per Click Before Google
In the early days of the web, the model was that whoever was willing to bid
the most for a keyword got that top spot. The second highest bid got the second
spot and so on and so forth. This highest bidder approach was not great for
users, because advertisers had no incentive to actually make their ads relevant
or useful. And users generally do not appreciate non-relevant ads because they
do not offer a searcher any additional value.
If you think about it, the majority of advertisers, they did not benefit from
the old model either. This was a game that only those with the biggest budgets
could win and they would simply buy their way into the top, and the search
engines themselves suffered as well. If those irrelevant ads were not getting
clicked on, then it did not matter how much the advertiser was bidding. They
never had to pay up, because the ad never got clicked.
The Arrival Of Google AdWords
 So Google changed the game by essentially letting more relevant ads be placed
higher on the page, even if their bids were lower. This is essentially the model
that made Google such a powerful force in the online advertising world. They
were not the first PPC ad company, but their algorithms ultimately delivered
better results and aligned the interests of searchers, advertisers, and the
search engine itself. Google calculates something called AdRank for each
advertiser in the auction and the positions on the page are just assigned
according to the highest AdRank. Early on AdRank was just this simple formula.
You not only had to bid enough, but your ad also had to get enough clicks to
justify your ad's position on the page.
Relevance Is Key
This is how Google rewarded better, more relevant ads that users wanted to
click on and it also made Google piles and piles of money. Over the years Google
has updated this formula and instead of just using the click through rate, they
have replaced it with something called the quality score. Now quality score is
still made up mostly of click through rate, but it also includes a number of
other relevance factors. See Google's quality score chart:
We will get into what makes up the quality score a little bit later, but for
now it's just important to know that click through rate is a big part of it. So
the way the AdRank is calculated is still pretty simple. It's just the max bid
price multiplied by your quality score. Now each time someone does a search on
Google the auction begins and everyone who is bidding on that search term gets
their AdRank calculated. Then Google just fills in the ad slots in order of
AdRank with the highest AdRank getting the first position.
How The Auction Works
So let's look at this example. Advertiser number 3 is bidding $4 per click
and they have got a quality score of six. This gives them an AdRank of 24, which
puts advertiser number 3 up in the top spot. Now advertiser number 1 is bidding
twice as much and still they come in last place in the auction, because of their
low quality score. And it's even possible that since their quality score is so
low, Google won't show their ad at all.
Remember, this is pay-per-click and even though advertiser number 1 is
willing to pay eight dollars for that click, Google knows that they won't get
paid if this ad is so bad that it never does get that click. Now here comes the
tricky part. As an advertiser you are not going to be charged exactly what your
max bid is. That's just the highest price that you would be willing to pay.
Check out another example of Scoring with AdRank:
What Do You Actually Pay?
Once AdRank has been determined, the Google auction will determine how much
each advertiser will actually pay if their ad gets clicked. The basic premise is
that you will only have to pay the minimum amount needed to maintain your AdRank
position. So let's take this same example. Advertiser number 3 is willing to pay
$4, but they really only need to achieve an AdRank of 18 to stay in that top
spot. So what price would they have to pay to keep their AdRank at 18? Well, all
you have to do is take the AdRank of the advertiser in the position below you
and divide it by your quality score.
In this case, you take 18 you divide it by 6 and you get $3. So even though
advertiser number 3 was willing to pay $4, Google is only going to charge them
$3. Now let's figure out how much advertiser number 2 is going to pay if someone
clicks their ad. Well, we look at their AdRank, which is 16, and we divide it by
advertiser number 2's quality score, which is 3. So if advertiser number 2 ad’s
gets clicked they are going to get charged $5.33.
The Importance Of Quality Score
 This is below their maximum bid, but it's more than the ad in the first
position. Do you see why it's so good to have high quality scores? Let's keep
going. To figure out how much advertiser number 4 is going to pay we take the
AdRank of the advertiser number 1, which is 8, and divide it by the quality
score of advertiser number 4, which is also 8. So if advertiser number 4 ad’s
gets clicked, they will only be charged $1, which is a nice reward for having
such a high quality score. Lastly, if advertiser 1 manages to achieve Google's
minimum quality score to be included in the auction, they would have to pay the
minimum bid price for the auction, which is set by Google.
Increasing Quality Score
Now let's take a look at what happens when you increase your quality score.
In addition to affecting your overall AdRank, it can also mean that you pay
less. What would happen if advertiser number 3 raised their quality score from a
6 to an 8? Well, their ad rank would now be 32 instead of 24 and advertiser
number 3 is still in the top spot but let us take a look at how much they would
actually be paying for a click now.
To calculate this all we have to do is take a look at the AdRank of
advertiser number 2, which is still 18, and divide it by our new quality score
of 8 to get $2.25. So now we are paying less than half of advertiser number 2
and still beating them out for the top spot. Understanding the auction process
gives us a way to really understand how we can optimize our ads to get the best
positions possible for the best price possible.
And Finally
As you can see from our little example, quality score has a very real effect
on the success of your campaigns and if you understand how AdWords works, you
can get out ahead of your competition for less than they are paying.
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