Why are ad auctions dominating?
The primary reason for the dominance of auctions over alternative placement mechanisms (one-on-one negotiations or fixed prices) is their power, flexibility, and propensity to discover the true value of premium placements on different keywords or categories, in different periods, in different geographies, or for different user demographics.
Different advertisers have a variety of different priorities, preferences, valuations, and constraints, and ad auctions resolve these differences in a simple and elegant way: the highest bidder (adjusted for ad quality and relevance) wins the best placement, and pays an amount sufficient to outbid the next highest competitor.
This amount will vary depending on market conditions, and does not need to be determined by the marketplace—the payment is a direct result of competition among bidders.
By contrast, using a fixed-price mechanism requires the marketplace to forecast demand far in advance, and not just on the overall level, but on a very granular one, for specific category/keyword, geography, user type, etc. (and this includes all the possible combinations of those variables)! This is an intimidating task, virtually guaranteeing that there will be all kinds of mismatches.
Some prices will be too high, pricing out too many advertisers and leaving valuable space unsold. Other prices will be too low, resulting either in over promises to advertisers (and subsequently frustrating conversations with them explaining why their ads could not be shown, even though they were willing to pay the posted price), or in rationing and queues, with advertisers only able to place their ads with a long delay. Posted prices also bring negotiating pressure from the advertisers, who will inevitably try to bargain with the marketplace to try to reduce the prices. By contrast, no such pressure is present in the auction mechanism: prices are set by the overall market competition, not by any individual decision maker.
Ad auctions also give a great deal of power and flexibility to individual advertisers.
They can bid higher for the segments of the market that they value more, and can choose times when they want to bid higher and those when they want to bid lower (or not bid at all). They can also learn from their experience in real time, and adjust their bids and strategies accordingly. They can also easily experiment with the advertising product, with very low barriers to entry. These features make auction-based, self-serve advertising systems incredibly attractive to advertisers, leading to wide adoption—which then translates into higher competition, higher bids, and higher revenue for the marketplace.
Let's also look at Google AdWords.
Perhaps the most striking illustration of these points is the experience of Google with selling sponsored listings. Initially, Google had two separate advertising products.
The first one, Premium Sponsorships, allocated the most desirable space on the page: the very top of the search results, prominently displayed and highlighted. Because this space was so valuable, Google decided to only sell access to it through ad representatives, with a minimum spend of $10,000 for a three-month period. The representatives would then negotiate the terms with advertisers—this was viewed as the best approach, given the premium nature of the placement.
The second one, AdWords, allocated much less desirable space, in small boxes on the right side of the page. For this less desirable space, Google built a self-service, auction-based platform, which allowed advertisers to submit any bids (subject to a small reserve price), customize their ads themselves, and manage the campaigns as they saw fit. After an initial period of experimentation, the company decided on the CPC (cost-per-click) model for these auctions.
Within several months, the success of this product—despite starting in a much less desirable position on the web page—was so overwhelming that Google eliminated the Premium Sponsorships program, subsuming it into the AdWords system, and shifted all advertising, both at the top of the page and on the right-hand side, to an auction-based system. Of course, Google continued to provide premium service to large advertisers, but even for them, their campaigns ultimately participate in the same AdWords auction as those from advertisers who manage their bidding on their own.
The rest is history: Google is now a trillion-dollar company, and advertising is still responsible for more than 80% of their revenue and profit.