COST CURVES
From the viewpoint of the individual advertiser, the fact that prices are determined by an auction is not particularly relevant. In practice an advertiser sets a single bid that applies over many different auctions.
We could think of a reduced form model where the advertiser faced a ‘click cost curve’ which showed the relationship between clicks, x, and the cost of achieving those clicks, c(x). If we assume that the advertiser has a value per click of v, then profit can be written as vx - c(x). The first-order condition for profit maximization is v = c'(x), which simply says the advertiser should operate where value per click equals marginal cost per click. Google’s Bid Simulator service actually depicts an estimated cost curve of this sort, which allows advertisers to rationally choose operating positions.Since v = c'(x) at the optimal position, profit can be expressed as c'(x)x - c(x) and profit/cost can be written as c'(x)∕(c(x)∕x) - 1 = MCIAC6 - 1. Note the somewhat surprising appearance of the Lerner ratio in this expression. This calculation is outlined in Varian (2006) using a somewhat more robust revealed preference approach. Varian (2006) also reports an attempt to estimate bounds on the value/cost ratio using proprietary Google data. It turns that that value/cost is about 2, indicating a return on investment (ROI) of 100 percent. This is a remarkably large number; I will describe why it makes sense in section 18.8 on the importance of competition.
18.7
More on the topic COST CURVES:
- Economic Theory
- The Disintegration of Classical Political Economy in the Age of Ricardo
- The Neoclassical Synthesis
- The Rotemberg Model of Convex Costs of Price Adjustment
- Static Economic Theory
- The Keynesian System
- Developments in the New Welfare Economics and the Economic Theories of Justice