The Economics of PPC

by Becton Loveless

Pay Per Click (PPC) is an Internet advertising model used on search engines, advertising networks, and content sites, such as blogs, in which advertisers pay their host only when their ad is clicked. Of all PPC advertising venues, search engines including Google and Bing are by far the most popular. Search engine advertising, unlike other Internet advertising venues, employs pull marketing as opposed to push marketing. It reaches out to qualified Internet users who are seeking to address a specific and predetermined need. Consequently, website traffic generated by PPC advertising as well as that from organic search engine optimization typically exhibits a higher conversion rate than other forms of Internet and off-line marketing.

Arguably, the greatest benefit of PPC advertising when compared with other forms of search engine marketing (i.e. search engine optimization) is that you can pay for top placement, rather than leaving your rankings to the mercy of a search engines’ proprietary ranking algorithm. One of the disadvantages to PPC advertising is that it operates under a bid ranked system. For example, if you are paying $2.00 per click to show up #1 in Google’s sponsored search results for the keyword “practice management” a competitor can come in and start bidding at $2.15 per click and increase their ranking above yours, whereby increasing the amount of relevant traffic driven to their website and decreasing traffic to yours.

In a competitive industry, the PPC advertising landscape is molded by some very simple economic principles. In most industries where there are number of competitors, companies will continue to bid up PPC fees until the Marginal Revenue (MR) generated by each additional penny invested in PPC is equal to the Marginal Cost (MC) associated with the increase expenditure. This is known as the “Marginal Cost-Marginal Revenue Model” and is typically used to procure revenue and cost figures. It is also very useful for analyzing PPC advertising expenditures and competitive marketing forecasting. The following paragraphs provide a more in-depth explanation of this concept as it relates to PPC advertising.

Marginal revenue is the extra revenue that producing an additional unit of product will bring. Marginal cost is the cost of producing one more unit of product. When marginal revenue is greater than marginal cost, marginal profit is positive and vice versa. The point at which marginal revenue is equal to marginal cost, marginal profit is zero. Since total profit increases as long as marginal revenue is positive, companies will continue to produce until marginal revenue is equal to marginal cost. The same concept holds true for advertising under a bid ranked system. Advertisers will continue to increase their bid amount for each click through to their website until increasing their bid amount is not longer profitable. Again, this is because the advertiser collects positive profit – even if the profit is relatively smaller than it had been in previous months or years – up until the marginal cost associated with increasing a bid amount is equal to or greater than the marginal revenue associated with increasing the bid amount. Simply put, companies will continue to invest in PPC advertising until MR=MC. And they will continue to bid up PPC fees until there is no more profit to be made – again, even if the relative benefit of such advertising has diminished over time. (Note: The above economic principle as it relates to PPC advertising – and search engine marketing in general – is especially true for companies in industries where the cost of goods sold (COGs) is determined in part by volume sales. For example, a company who is able to decrease their COGs by negotiating discounts with raw good manufacturers is going to find that they must maintain volume sales to stay competitive long term.)

The intersection of marginal revenue (MR) with marginal cost (MC) is shown in the diagram below as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profits are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.

PPC Supply Curve

The “Quantity per period of time” shown on the X axis in PPC advertising represents the time it takes from the inception of advertising (i.e. the time a first PPC bid amount is placed) to the time where it is not longer profitable to increase a bid amount. This varies dramatically from industry to industry and is affected by a number of variables (i.e. number of competitors in an industry, industry profitability, ease of entry and exit in the industry, industry attractiveness, etc.) For example, in 2001 the PPC cost in Google for the keyword “vocational schools” was $.10 per click. Seven years later, in 2008, the PPC cost for the keyword “vocational schools” was around $2.50 per click – at which point the PPC cost of the keyword “vocational schools” plateaued – the marginal revenue now equaled the marginal cost and marginal profit was equal to zero. So why did the PPC cost climb so high and why did it take so long? First, in 2001 the business models for converting the keyword “vocational schools” into revenue were not as well developed as the business models that were developed in subsequent years for monetizing the traffic generated by the keyword “vocational schools”. As the business models improved over time, the keyword “vocational schools” became more valuable. Second, between 2001 and 2008: (1) a number of new companies with more strategic business, marketing and conversion models entered the education industry and (2) established companies overhauled their business models to improve profitability. All of these factors, and many more, molded the competitive landscape for this industry and forced companies along the demand curve until they reached point D. (Note: While useful for general analysis, the above diagram does not reflect changes caused by a number of market conditions.)

In the example above it took about seven years to travel the length of the demand curve and reach the point (point A) where it was no longer profitable for any company to increase their bid amount above $2.50 per click. How long it takes an industry to travel the demand curve to point A depends on a lot of factors. It’s important to recognize that as an industry matures and micro economic conditions evolve point A may move, whereby elongating the demand curve and creating a new point where marginal revenue is equal to marginal cost for specific company – and eventually for an entire industry.

So is all this analysis necessary to understand how to invest in PPC advertising and Internet marketing? Absolutely. Companies that ignore, do not understand or do not appreciate the economic drivers of search engine marketing – primarily PPC advertising – will find that they are at a strategic disadvantage. Companies that understand this analysis, internalize it and apply it will find that they are (1) able to better forecast their own marketing expenditures, (2) they are able to enhance their ability to foresee what competitors are going to do and (3) they have a much better understanding of the competitive forces molding their industry.

Conversion as a Factor in PPC Marketing

Conversion is one of the major factors influencing a company’s ability to employ PPC advertising effectively and profitably. Conversion influences PPC marketing in the following ways:

  • Conversion affects Marginal Cost
    The biggest downside to a poorly converting website is that it affects the marginal cost associated with producing one more unit of product via PPC advertising. For example, if the bounce rate on a website is 50% (i.e. 5 out of 10 people who arrive at your site leave your site immediately), your website conversion rate is 5% (i.e. 5% of all website visitors turn into customers) and your cost per click is $3.00 then you’re marginal cost associated with each sale generated is $120. If your cost per click increases, obviously your marginal cost will also increase. Conversely, as you are able to decrease your bounce rate and increase your conversion rate your marginal cost decreases. Based on the above example, a decrease in bounce rate from 50% to 40% combined with an increase in conversion from 5% to 10% will drive marginal cost from $120 to $50 – a nearly 60% reduction in marginal cost associated with search engine marketing. If you are generating 500 sales a month at an average of $350 per sale and are able to decrease marginal cost by $70 per sale, your monthly increase in revenues based on first time sales alone will be approximately $35,000. If you take this a step further and identify that the life time value of a customer (NPV) were $700 then you can also predict that a marginal cost saving of $70 will lead to an absolute increase in realized monthly revenues of $70,000. While the numbers in your industry may vary from those provided in the example above the principles are still the same. Conversion is truly one of the most competitively advantageous or disadvantages aspects of a company’s Internet presence as it can greatly influence the profitability and long term viability of PPC advertising (as well as other forms of search engine marketing including search engine optimization.)
  • Conversion affects PPC Rankings
    Many PPC advertising venues are not based on a pure bid ranked system. Google Adwords for example has incorporated a relevancy algorithm into their sponsored search results, which is expressed as the keyword’s quality score. Google’s ranking algorithm for their sponsored search results functions in a similar manner to their algorithm for their organic results. All things being equal, if one website is experiencing a lower bounce rate (rate at which website visitors leave a website after having visited just one page) for a given keyword, that website may show up more prominently in the sponsored search results whereby driving more qualified traffic to the site. Costs per click also decrease as quality scores increase as Google’s model is built around providing the most relevant information to searchers. A site can continue to bid on keywords with low quality scores, but the costs are substantially higher.

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