Keyword auctions, unit-price contracts, and the role of commitment

Motivated by the enormous growth of keyword advertising, this paper explores the design of performance-based unitprice contract auctions, in which bidders bid their unit prices and the winner is chosen based on both their bids and performance levels. The previous literature on unit-price contract auctions usually considers a static case where bidders' performance levels are fixed. This paper studies a dynamic setting in which bidders with a low performance level can improve their performance at a certain cost. We examine the effect of the performance-based allocation on overall bidder performance, auction efficiency, and the auctioneer's revenue, and derive the revenue-maximizing and efficient policies accordingly. Moreover, the possible upgrade in bidders' performance level gives the auctioneer an incentive to modify the auction rules over time, as is confirmed by the practice of Yahoo! and Google. We thus compare the auctioneer's revenuemaximizing policies when she is fully committed to the auction rule and when she is not, and show that the auctioneer should give less preferential treatment to low-performance bidders when she is fully committed. © 2009 Production and Operations Management Society.