Kamal Jain gave a talk today on "atomic economics". Here is my own description of what he meant, though it seemed Kamal disagrees with at least some of my description :)
Think of credit cards. Whenever I pay with one, the store only gets 1-x% of the posted price, i.e. the the credit card company makes x% of the money. That is nice profit for the CC company, but as always, competition is driving all profits towards zero. Since there are multiple banks willing to give me a CC, and they all retain the same percentage from a merchant, they need to compete on the customer side --- they have to fight for the honor of counting me as their customer. So they start giving me points / miles / cash back / etc. Getting 1% of your money back is already quite standard, and customers need more to be impressed. To some extent, this incentivizing actually works (personally, I tend to use my AmEx card due to the better reward system).
Now, Google and Yahoo are making money because of me (merchants pay them when I click on an ad). In principle, this means we are not at an equilibrium: since these companies are competing for customers (equal ad revenue), one of them should start offering me a share of their profits whenever I click, and the other will have to follow suit.
Kamal sees several problems (market inefficiencies) that will prevent this welfare-maximizing scenario. I also see them as problems, but I have a different opinion on the degree of surmontability. Problems:
- Customer abuse: profit sharing has to be tied to some actual buying event, or otherwise I will have an incentive to spend my day clicking on ads (and not buying anything), driving the merchant out of business. This is a problem for branding ads (e.g. eBay likes to display worthless ads all the time to build its name into collective conscience), and for ads that are separated from the actual purchase (e.g. an ad to a restaurant). But for e-commerce, which seems to be the raison d'etre of search advertising, this detail can be worked out by sharing information between Google and the merchant.
- Merchant fraud: the merchant marks the price up by $5, adds $5 to the advertising budget (getting a top slot), and tells me that I will get $5 cash-back from Google (which means I don't care their price was $5 higher than the competition). Realistically, this won't happen, for several well-understood reasons. Common sense dictates that Google will only share a percentage of their profit, so I'll only get, say, $2.5 back, which means I care about the price markup. Like credit-card companies, Google and Yahoo have a weapon to enforce this common sense: customer differentiation. This is oligopolistic behavior, but one that is remarkably stable. What happens is that frequent buyers (resp. people with good credit histories) get better cash-bask deals, because they are presumed to have more authority to "negotiate". Then, the merchant gets a mix of people with different cash-back percentages, but who look the same to the merchant.
- Bounded rationality, a heavily used buzzword, and the really exciting consideration. Unlike traditional advertising, Google and Yahoo have really tiny costs. This means they can still make a ton of money with a razor-thin cut of the merchant's profit. For instance, if Google is paid 0.1% percent of the transaction value, what could they offer me as an incentive? Maybe 0.05% of the price. But that will be irrelevant to me -- the mental cost of remembering that Google gives me more cash back on lingerie gifts vastly outweighs the 0.05% payoff.
The market inefficiency generated by the small scale of Web transactions is great for Web-based companies like Google, since it means they can make huge profits below the radar of competition forces. The sad news (for a scientist) is that it all becomes a social competition, instead of a scientific/economic one. It's much more important if I, the customer, like Google's colors than if I'm getting my fair share of cash back.
On a larger scale, is this a social problem? I guess so, but not a very big one. If our threshold for irrationality is below 1%, the total income of such companies cannot grow above 1% of the money we all spend. But we're already paying the Federal government some 30% of what we make, and quite possibly many of us are happier with the success of Gmail than the hearts-and-minds campaign in Iraq.
PS: Given the topic, the number of jokes and anecdotes in Kamal's talk was too small by an order of magnitude. This reinforces my belief that we shouldn't be doing this kind of thing (i.e. study pure economics, because it is has something to do with networks or computers). If such pursuits will be more than wasted theoretical brain-cycles, they need to impact managers and policy-makers. But for that to happen, we need to give talks at the level of political speeches, and no self-respecting theorist is willing to do that. People in economics (who incidentally serve on policy-making boards every now and then) have already developed the art of communicating to politicians.