How Google's Ad System Stifles Innovation

The European Commission has launched the first-ever official antitrust inquiry into Google's search and search advertising services. Despite Google's estimated 90 percent share of the European search advertising market, it hasn't necessarily done anything illegal. But its stranglehold may still be a prohibitive barrier to competitors, present and future.

The preliminary inquiry stems from three complaints. Two are from companies offering search services and claim that Google has purposely demoted their links in search results.

More interesting, though, is the third complaint from Ciao!, a German Microsoft-owned search engine, over a lack of transparency behind Google's AdSense system. It's a bit ironic that Microsoft is going to European regulators to complain about anti-competitive behavior. As the Economist explains, Ciao! and the industry group ICOMP, which includes Microsoft among its backers, take particular issue with the "black box" of Google's ad selling algorithms.

It is not clear why certain advertisers have to pay a minimum bid, how advertisements are ranked or how it comes up with the amounts it pays websites when they run advertisements managed by the firm. Without more information, "advertisers and policymakers have no way of verifying whether the dominant firm has exercised its power responsibly," ICOMP wrote in a recent paper.

While Google fiercely defends the secrecy of its ad program (its search algorithm is closely guarded, although Wired exposed some intriguing details this week) the basic structure is publicly available and will be critical to defending against accusations of abuse of power. It works something like this, according to Google's annual 10K filing: Imagine Alan, Betsy and Carl all bid on the same keyword at $1, $0.60 and $0.50 per click, respectively. Alan will receive the best ad placement and pay $0.61, Betsy will pay $0.51 and Carl will pay $0.01.

As The Financial Times reported, Google "has always maintained that advertising prices are set by auction, leaving it without any direct influence over pricing." If it were to set prices, Google would arguably be running, not just participating, in the European online ad market.

Google's defends its lack of transparency by arguing that advertisers can go elsewhere. But, as The Economist rightly argues, "in practice its big market share gives them little choice." Realistically, there is no alternative. The search ad market -- running, admittedly, without price-setting interference -- is nearly entirely run within the confines of Google "black box."

If a competitor were to devise a better, even more effective, way to advertise online, it would be incredibly difficult to begin to compete with Google and its command of online eyeballs. Its dominance effectively locks in advertisers.

To compete you need either to be incredibly well-funded, as Microsoft is, or to develop a game-changing way to advertise online. Merely offering a marginally better way  wouldn't be enough. While Google's dominance alone isn't anti-competitive, the resulting barriers to innovation may be.