This is a simple post about some commonly known features of online ad auctions.
Generalized second-price auction (GSP) is a mechanism in which the advertiser pays a marginally higher bid than the advertiser losing to him. It encourages the bidder to place a truthful bid, i.e. one where the price level is such that marginal returns equal marginal cost.
Why is this important?
truthful bid = incentive to bid higher
In other words, if you know a bidder behind is bidding say 0,20 € and you’re bidding 0,35 €, under a standard auction you’d be tempted to lower your bid to 0,21 € and still beat the next advertiser.
In any case you wouldn’t directly know this because the bids are sealed; however, advertisers could programmatically try and find out other bids. When you’re using GSP, manually lowering bids to marginally beat your competition is not necessary. It’s therefore a “fair” and automatic system for pricing.
Of course, for the ad platform this system is also lucrative. When advertisers are all placing truthful bids, there is no gaming, i.e. no-one is attempting to extract rents (excessive profits) and the overall price level sets higher than what would take place under gaming (theoretically, you could model this also in a way that the price level is at equal level in both cases, since it’s a “free market” where prices would set to a marginal cost equilibrium either way).
Joni Salminen holds a PhD in marketing from the Turku School of Economics. His research interests relate to startups, platforms, and digital marketing.