The Google AdWords system assigns a "Quality Score" to every Advertiser who is participating in the ad auction and this score is determined by the quality of the advertiser’s website, the historical CTR of his ads on Google and a couple of other factors.

For instance, the Google ad system is likely to assign higher Quality Scores to Sony.com or Amazon.com for the keyword "digital cameras" than an advertiser xyz.com who is trying to promote his eBay auction on the AdSense network.

Google than computes the final Rank (or ad position) of each advertiser using their respective quality scores and the maximum amount they are willing to pay for a single click (CPC).

Ad Rank of an advertiser = Quality Score * Maximum CPC Bid

Coming back to our original example, let’s say four advertisers are bidding in an auction to show up on a web page that is about "digital camera".

The advertiser Sony.com has been assigned a score of 8 by Google and they are ready to spend a maximum of $16 per click. Amazon has an even quality score (9) but they have specified their maximum CPC as $14 and so on.

Now the ad position (column 5) of various advertiser in an AdSense unit is determined on the basis of Ad rank (column 4) but the actual cost (or CPC) that these advertiser have to pay per click to Google is not always in that order.

As Dr Varian explains (time 05:50), the price that an advertiser has to pay (his actual CPC) is equal to the Ad Rank of the advertiser just below him divided by his own CPC bid.

So in the case of Sony, they’ll have pay 126 (the Ad Rank of Amazon) / 16 (CPC Bid of Sony) and this is equal to 7.88.

The click cost for Amazon will therefore be 120/14 = 8.57 which is more than that of Sony but the Amazon ad will still show up below the Sony ad since the Ad Rank of Sony is higher.

Google will share a fixed portion of ad revenue (or click price) with the AdSense publisher (where these ads are shown) and therefore a click on a Sony ad will fetch him less revenues even though the ad occupies the top slot.