Lots of people seem to be confused about how competition works for search-based advertising. If you think that competition among search engines will lower the prices advertisers pay, you would be one of them. [Check out, The Importance of a Competitive Search Market.]

So here’s a primer and then some observations.

1. Most people use just one search engine to do a search for something they might be thinking of buying. So, the search engine a person is using to look for, say, a new flat panel television has a monopoly over the person for the purposes of that search.

2. Advertisers buy keywords on search engines usually because they want to sell stuff. That person who was looking for a flat panel television set is a solid lead. And for all intents and purposes the only way to sell something to that person is to present an ad to him on the search engine he’s using. So the only question is whether it is worth paying the CPC for that possible lead; it isn’t as if the flat panel television seller could substitute another search engine since that customer isn’t using that other search engine.

3. Search engines sell keywords through second-price auctions. Forget the details: basically this means that advertisers bid up the price of keywords to their maximum willingness to pay. Note that this is unlike how most goods are sold: most sellers engage in some price discrimination that segments different customer groups; search engines engage in “perfect price discrimination” that charges every single user their maximum willingness to pay. That means that search engines print monopoly money so long as there are enough bidders for the key words.

4. The profits from advertisers for the keywords can’t get dissipated through price competition for advertisers, but it could get dissipated in other ways. Since the guy looking for the flat panel television is the source of money the search engines could compete for him and other commercial searchers. One way to do this is to pay people to come and search. That’s where Microsoft’s recent program for rebates to searchers who buy comes in. In fact, if there was more competition in the search business this is what economists who specialize in two-sided markets (see, for example, D. Evans & R. Schmalensee, The Industrial Organization of Markets with Two-Sided Platforms, Competition Policy International, vol. 3(1), 151-79, 2007.) expect. Another way is for the search engines to invest in better search engine technology and features to persuade people to come and use the search engine.

The economics of search says something about why we care about having competition in search. Having multiple search engines seeking advertisers and searchers will result in more search activity through subsidies to engage in search and through investments in technology to increase search on a particular engine. Now, I’m not advocating any artificial attempts to preserve competition in search: sometimes scale makes firms more efficient and helps consumers even if it risks loss of competition; and sometimes firms dominate a market just because they are, in fact, better—we should reward and certainly not penalize firms for their success. That said, we should be clear what a monopoly in search means. The winner, Google, will be able to engage in perfect price discrimination with advertisers and reap massive rewards from its monopoly; as is the case today those profits will go into the corporate coffers and probably won’t get rebated back to consumers. Until behavioral targeting really reaches its promise—which still seems many years off–the search monopoly will mainly face competition from rather imperfect ways of reaching consumers.

For more reading on this see The Role of Economics in Online Advertising.