Ad exchanges are just markets of information
Online advertisement is sold more and more through ad exchanges and auctions in particular. Ad auctions are an efficient way of buying and selling ad space and they will get more popular simply because they are better for everyone. In theory, auctions are "strategy proof" and hence you can't game them. As we know, theory doesn't exactly match the reality but as usual there's some truth to it. With automated process and automatically and efficiently priced ad space, advertisers and publishers can focus on adding value to all parties.
Auctions offer an efficient way of selling and buying
Automated marketing has been gaining popularity during the last years. Even though not all automated buying and selling goes through ad auctions, their success has been closely tied with automation. From the business perspective, ad exchanges provide a platform to sell and buy efficiently at this milliseconds market price to practically anyone, anywhere.
Ad exchanges are markets of information
Without any information, online advertising would be really simple. No one could know to whom they were advertising to, and the only difference to traditional advertising like TV would be the ability to slice and dice the user space into pieces that fit the campaign sizes. What makes all advertising in the internet so unique is the role information. Because of the detailed information advertisers have, they are able build more sophisticated advertisement campaigns and target more specific customer segments. The value of an ad shown to a random user on a random site is negligible when compared to a user whose interests, intent and location are known.
From a simplistic point of view, an ad exchange can be seen as a market for information. Value from a potential customer in the dark goes to the party that can reveal “who she is”. An ad exchange is not really a single market but a marketplace with multiple overlapping markets. A Finnish female user in her late 20s whom has browsed car related articles and searched for used cars is sold in the markets for Finnish customers, Finnish women, Finnish women in their 20s, potential car buyers, potential car buyers in Helsinki area looking to buy a used car in the medium price range and so on. It is easy to see how the value changes from an advertiser’s perspective but to understand how the price is determined we need to look at the market structure.
How auctions work?
For example, an ad exchange for display advertising consists of three main parties: The users who browse the web, publishers who provide content for the users and advertisers who want to connect to the user. On top of the core parties, there’s a vast infrastructure of data suppliers, data aggregators/platforms, ad networks and analytics/optimization/measurement tools. What is common to almost all is that they are either selling or handling information or bringing parties together. An ad exchange acts as an intermediary between parties showing publishers stock to the advertisers, collecting their bids and determining the winner at astonishing speed. Advertisers strategy depends on the campaign targets but in general the goal is to maximize conversion rate. How conversions are defined (or should be) is a topic that would require another post or two but from an economist’s perspective, the important fact is that in practically all cases the key to a successful campaign is to target the right people.
All major ad exchanges use the second price auction or a slight variation from it. In a second price auction the winner pays the second highest bid. In simple second price auctions with private valuations (meaning that the value of the object depends on the buyer), it is always optimal to bid your true valuation of the object since you can’t affect the price but a low bid can cause you to lose the object you would have wanted. In real life ad auctions, there are complications that provide incentives to deviate from bidding your valuation. Advertisers often have limited time and budget for their campaigns and so the bidding strategy can vary with remaining time and budget. Variance in publisher and advertiser sizes means that there are differences in resources and hence in the quality and quantity of information different parties have. Also, some markets can be fairly “thin” meaning that there are only few bidders and at times maybe just one. Publisher have the ability to set the floor price which is often optimized based on the bidding behavior and so the “game” between advertisers and publishers can get intense especially in thin markets.
What can be done?
There are two ways to increase the size your pie: Increase the pie or take from someone else. The auction processes are designed in a way that there is not much you can do to get a larger share. The ultimate goal of the auction design is to maximize the size of the pie and leave no room for improvement so that you always get the best deal from it.
In reality, “players” have some levers to pull. However, many of the more effective measures that can be taken to boost profits require adding value either in the form of raw data or already extracted information. Hence, content providers who are unable to take full advantage of their information will be harming themselves as well as the other parties.
The industry of information mining works just like any other in principle. The most succesful participants are the ones that can create the most added value. For publishers this usually means taking full advantage of the information that is revealed while users are browsing their content. Better information increases the value of the market and hence also the quantity (and hopefully quality...) of the content that can be accessed without charge. At least in theory, it's a win-win-win.