Is Search Advertising a Giffen Good?

The Giffen good is a strange beast from economic theory.  For most goods, demand decreases as price increases. A Giffen good defies this normal market behavior -- the demand for it increases even as its price increases.

Giffen goods have a very interesting history. They were postulated originally by Alfred Marshall in his 1895 book The Principles of Economics. The classic example is staple foods such as rice, wheat, and potatoes. As their price goes up, poor people on a tight budget actually consume more of them, because they are forced to cut back on luxuries such as meat, but still need the same number of calories to survive. Until recently, Giffen goods remained a theoretical beast, with no real documented examples -- until 2007, when two Harvard economists demonstrated that rice and noodles behave as Giffen goods in certain poor parts of China.

Google's recent results raise the possibility that search advertising might be a Giffen good. Here's a simple model. Company X spends marketing dollars on two channels: search advertising and brand advertising (on the web or on TV and magazines). Search advertising drives customers directly to their site, resulting in immediate sales. Brand advertising drives organic traffic, albeit in a more unmeasurable way.

In an economic downturn,  companies get more cautious with their marketing budgets, moving more dollars into measurable and direct channels such as search advertising while cutting back on less-measurable brand advertising. Thus, there is more competition for the clicks, driving up the price (cost-per-click, or CPC) of search ads.

Company X, therefore, finds all their increased spend on search marketing actually drives the same or even fewer visitors to their site. At the same time, since they have cut back on brand advertising, organic traffic is decreasing. But wait -- we need to make this quarter's numbers! The easiest way to do that is cut back even more on brand advertising and channel even more dollars into search, which can drive immediate clicks towards the end of the quarter. Brand marketing's ROI is longer-term, while this quarter's revenue is a more pressing concern.

Witness the result: company X spends more on search marketing, driving more search ad clicks to its site, at a higher price point.  The definition of a Giffen good! Interestingly, unlike the rice-and-noodles example, the increased consumption directly leads to the increased price, because of the auction pricing model.

Google's recent results seem to confirm this hypothesis:  paid clicks increased by 20% from Q1 2007, while ad revenues increased by 40%, implying a CPC increase of 16%.  Of course, there's a limit to this phenomenon: companies cannot pay for more their ad clicks than their profit margins allow. Until that time, the sucking sound you hear is everyone's profit margins going into Google. We're going to see a lot of low-margin revenue increases at online retailers and other companies that rely on paid search.

Comments

[Prakash S]

very interesting analysis.

When I came to the part about google, funnily enough, it reminded me of Paul Graham's "What the Bubble got right", specifically about Yahoo in Para's 2 & 3.

http://www.paulgraham.com/bubble.html

[Abhishek Gattani]

Nice post!

It will be interesting to see how sites like shopping.com which rely primarily on SEM traffic from Google and operate on very low margins, will get affected.

[Ravi]

Very interesting... this is inline with Mary Meeker's analysis of Google actually benefiting from this recession.

Shouldn't display ads also benefit from this phenomenon? Perhaps more so than paid search ads? Display advertising is a better medium for brand marketers than paid search! And it is more measurable than print & TV ads. AOL's recent earnings don't seem to point to this, however:
http://www.marketwatch.com/News/Story/Story.aspx?guid=%7b02224C5A-AE58-4C68-9889-5F0411AE4BC7%7d

[Anand Rajaraman]

@Ravi:

I believe the difference between search and display ads, and the reason why they behave differently in a recession, has to do with targeting. Search ads can be targeted much better than display ads, leading to better and more predictable ROI. Most of AOL's ad revenues are from Advertising.com, which is untargeted remnant inventory.

We're seeing the emergence of more targeted display ads, and those may well behave like search ads in a recessionary environment.