To competitors like Microsoft and Yahoo, Google must seem like a greased pig. You can see the damned thing running amok in your garden, but you can’t figure out a good way to get hold of it. The grease that Google has slathered on itself is mainly, I think, pricing, particularly the use of AdWords and other auctions to set the price of advertisements. In a rare but little noticed moment of extreme candor during a November 2005 interview with Fred Vogelstein (which was only recently published), Google CEO Eric Schmidt noted the great competitive importance of the company’s auction pricing:
Schmidt: Another example of Sergey [Brin]’s observations is that our advertising network is very powerful because it’s quite resistant to certain competitive attacks.
Vogelstein: Such as?
Schmidt: Because it’s an auction market you cannot under-price it. This point is lost on many, many people.
The barrier that an auction presents to a price war is, as Schmidt implies, crucial to Google’s strategy – and doubtless a big source of frustration to rivals, particularly Microsoft. Through superior technology, superior foresight, and a generous helping of luck, Google has built up a dominant position in the extremely lucrative market for serving search, or contextual, ads – and that’s providing the beachhead and the cash for its aggressive expansion. One of the best ways to attack a competitor, particularly in a market like automated ad serving where the marginal costs of executing a transaction are basically zero, is by undercutting the competitor’s price. That strategy can be particularly effective if the competitor is much more dependent on the line of business in question than you are – the precise situation that currently obtains between Google and Microsoft in ad-serving. (Slash the price of ads, and Google suffers greatly, whereas Microsoft suffers hardly any immediate material damage.) Needless to say, Microsoft has used precisely this strategy with devastating effectiveness in the past.
But the auction model effectively removes this option because there are no fixed prices to undercut. Every price is set dynamically by the market and is hence outside the supplier’s control. You could subsidize customers’ purchases, by, for instance, providing them with credits to use in an auction, but that would simply distort the auction market, artificially inflate prices, and drive buyers away. The inability to cut prices makes it very hard – not impossible, but very hard – to unseat a dominant rival like Google. You have to fight with one arm, probably your best arm, tied behind your back.
But if Google isn’t vulnerable to a direct pricing attack on its core AdWords service, it is vulnerable to a pricing attack on its AdSense service. AdSense’s customers aren’t the buyers of ads but rather the sellers of ads – publishers and other site owners (including, in its own trivial way, this blog). Google doesn’t directly charge publishers a price for running ads on their sites, but it does take a price, in the form of a percentage of the revenues that the ads it serves generate. Except when it negotiates a special deal with big publishers, Google doesn’t tell its AdSense customers what cut it’s taking, but it’s a substantial one, probably running somewhere around 30 or 40 percent.
So here’s what a Yahoo or a Microsoft or any other competitor could do: Introduce a free version of AdSense. By free, I mean that you tell publishers that if they run your ads on their sites, they get to keep all the advertising revenues. 100 percent. You won’t take any cut. Immediately, you put a lot of pricing pressure on an important source of revenues and profits for Google.
Now, practically speaking, this would be a tough strategy for a Yahoo to undertake, given its own dependence on advertising. But it would not be a tough strategy for a Microsoft to launch, because this is (at the moment) a fairly trivial business for Microsoft. And it would bring two potentially large benefits to the company:
1. It would hurt its competitor a lot more than it would hurt itself. Even allowing for the fact that a chunk of Google’s AdSense revenues come through negotiated arrangements with big publishers (through which Google may already be giving the publishers close to 100 percent of ad revenues), turning the delivery of contextual ads into a free service for publishers would put Google under financial pressure. (Google’s revenue from ads on third-party sites amounted to $1.3 billion in the last quarter, well over a third of its total revenues.) But it wouldn’t cause any harm, of a material nature, to Microsoft.
2. It would help promote Microsoft’s own ad-serving business. In essence what Microsoft would be doing in giving away its product to ad sellers is redefining that product (for itself and its competitors) not as a profit-making business in itself but as a complement to the core ad-serving product that it offers to ad buyers. Expand the presence of your ads on third-party sites, and you make your core ad-serving business more attractive to ad buyers. So Microsoft wouldn’t simply be sacrificing potential revenues; it would be promoting revenues in a complementary (and more important) area of its business.
Now, I’ve made this simpler than it really is, because publishers also have to take into account the productivity of the ads being served, and by all accounts Google continues to maintain a productivity edge. Nevertheless, turning the AdSense market into a free market would help neutralize that edge and generally redefine the competitive dynamic to Microsoft’s benefit. And, anyway, what does it have to lose?