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What Google earnings say about Google-Yahoo; pricing power & a 'derivative problem'

Google's earnings provide an excellent window into why the DOJ has serious antitrust concerns with the proposed ad partnership between Google and Yahoo.

  • Google's discussion of its 4Q08 earnings provides DOJ with substantial fresh evidence that Google is:
    • Exercising substantial pricing power; 
    • Not running fair and competitive 'auctions;' and 
    • Anti-competitively self-dealing.

I.   Pricing Power Evidence:

Any economist will explain revenue is simply volume times price. In 4Q08, virtually all of Google's revenues continued to come from search monetization. Google reported that its 'volume' i.e. "aggregate paid clicks... increased approximately 18%" over 3Q07. Google reported that 'revenues' increased by 31% over 3Q07.  

  • If revenues = volume x price, then Google's +31% revenue increase = +18% volume increase x ~+11% pricing power increase.
  • What Google euphemistically and benignly characterizes as "ROI for advertisers" and "relevance for users" is clever misdirection from the term economists and antitrust investigators call -- 'pricing power.'  
  • Google explains away its revenue strength by "the Walmart effect' i.e. that in an economic downturn people are more cost conscious and thus do more search/price comparisons.
    • The more straightforward explanation for why Google continues to dramatically outgrow competitors is that Google has market power to take substantial share (volume), while substantially raising prices -- at the same time. 
  • When Yahoo, Microsoft, AOL and report earnings we will see if all online advertisers are enjoying this general 'Walmart effect' benefit or if Google is the only beneficiary. 
    • If Google turns out to be the only beneficiary, it will be additional evidence that the marketplace that Google and Yahoo claim to 'compete' in -- is in fact not very competitive. 

II.  Evidence Google Does Not Run a 'Competitive Auction'

Google claims it runs an auction. Any dictionary defines an auction as a public sale to the highest bidder. On the earnings call Google CEO Eric Schmidt,in answering a question about the DOJ concerns with the proposed Google-Yahoo partnership, explained that the reason that some advertisers were opposed to the deal was because they didn't understand Google's auction process. He also referred listeners to check out a Google blog post that better explains Google's auction process -- by Hal Varian, Google's Chief Economist.   

  • The first antitrust 'auction' red flag here is that Google still maintains that advertisers don't understand Google's auction. There are a couple of possible explanations here. One is that Google is surprised and frustrated that its advertiser clients are not smart enough to grasp the basic concept of an auction where the sale goes to the highest bidder. Another is that what Google euphemistically calls an auction, is not in fact an auction, otherwise its customers could readily understand it -- since an auction is one of the most basic concepts in business.
    • The fact that Google's CEO admits in a public forum that customers don't understand what they are buying from Google, can't give antitrust investigators any warm fuzzies that all is well with Google's auction process.
    • Google's Mr. Varian in his post asks rhetorically: "Why can't advertisers just buy their way to the top ad position?" (Funny, I have essentially been asking that same question on Precursorblog for awhile. Why can't they?)
  • The second 'auction' antitrust red flag here is that what Google euphemistically calls an auction is more accurately described as a 'derivative allocation process.' Why?
    • First, customers are not allowed to bid directly for what they want to buy -- an ad placement.
    • Second, customers can't control their own destiny by outbidding their rivals because factors beyond their control and knowledge determine who ultimately gets allocated the ad placement. 
    • Third, BEFORE the so-called 'auction,' Google requires customers to tell them the highest price they are willing to pay for clicks on a potential ad and also how much they are willing to spend i.e. their overall budget.
      • In a competitive market, customers are not required to ante up the forfeiture of all their negotiating leverage, and then also put total trust in an all powerful, opaque, monolithic auctioneer.

    • Fourth, customers can only bid for what they would pay for a click on their ad. This is a classic derivative transaction because the payment outcome depends not on the original action by the customer, but on a mysterious secondary action by Google, and an uncertain tertiary action by the customer.
      • This opaque $20b Google derivative allocation process for Internet advertising is eerily and disturbing similar to the opaque derivative allocation process of subprime loans and credit default swaps we have unfortunately become familiar with.
        • That's because in both instances, the process involves highly technical and complex mathematical derivatives designed and blessed by the same entity that runs the market.
        • Unfortunately, the Google market situation actually is worse than the unevenly  regulated financial system. That's because with the credit raters like Moody's and S&P, which created and packaged the derivatives, like Google does in Internet ads, Moody's and S&P did not operate the auctions of these derivative offerings like Google does for Internet ad auctions. 
        • So in Google's case, Google gets to unilaterally play all the roles in the derivative allocation system:  subprime mortgage originator, Fannie Mae, Moody's/S&P rater, and credit default swap market auctioneer -- all in one and all with no transparency, no oversight, no accounting and no audit process. 
        • Google expects total trust, with zero verification of that trust, or no real competitive check and balance on its exceptional market power.   
    • To make this more clear, this is like a poker game where Google requires all the game's players:
      • to tell Google, up front, what they will bid, how much total they are willing to put into the game's pot;
      • play blindfolded so they can't see what Google or any competitor is doing; and
      • totally trust Google that the poker game is not rigged. 

III.  Evidence of Self-Dealing:

Mr. Varian describes Google's 'auction' process as a "neat way to align incentives..." Translation: "Its neat to rig the game so everyone maximizes the House's take." 

Mr. Varian also explains another clever Google euphemism: 'quality scores.' What could be wrong with anything called a 'quality score'? Everyone is for quality right? Being anti-quality is like being anti-puppy.

  • The problem here is that the quality score is really about the quality of Google's pricing power.
  • As Google benignly explains the 'quality score' it is a variable that maximizes the number of paid clicks on ads.
  • To be accurate, the 'quality score' is really an algorithm, or an optimization equation, that searches for the inputs that maximize the outputs -- i.e. revenue for Google.
    • To be clear, it is not designed for advertisers because Google is clear that the highest bidder of price per click may never end up winning an ad placement with Google because their bids make Google less money than other bids. 
    • Almost by definition, Google's euphemistically called 'quality score' is a automated self-dealing algorithm in that whatever goes in, comes out maximizing Google's revenue, the mother's milk of Google's market dominance.     

Bottom line:

Evidence, provided by Google in its earnings and in its blog posts, continues to mount that Google indeed has substantial market power and is indeed exercising it anti-competitively.

History will judge that Google made a monumental blunder in proposing an ad partnership with Yahoo and asking DOJ to review it.

  • Google broke the age-old wisdom: let sleeping dogs lie. Google's kick woke up the antitrust watchdog and now Google is surprised that the watchdog is growling and bearing its teeth to protect competition.
  • Google also spotlighted for its advertiser customers how little real choice/competition there is in search advertising and provided advertisers a convenient and effective organizing catalyst to argue for a true 'auction' process and a more competitive search advertising industry.  

As I have written many times before, Google is its own worst enemy. If there is a rake out there, Google will find it and step on it.