Washington Post has a detailed discussion on the strategy:
The auction market for search terms is a central part of its growth strategy.
Every advertiser willing to pay at least a nickel gets the right to place an ad, but only the top bidders as determined by Google get placement on the first page of search results.
Google did not invent the concept of auctions for search terms. That distinction belongs to Overture Services Inc., which is now part of Yahoo Inc., Google’s biggest competitor. But industry experts say Google refined the bidding process and attracted thousands of businesses to participate in its giant marketplace, where consumers looking for information online carry out hundreds of millions of searches daily.
Google also made it extremely easy for businesses large and small to sign up and start bidding. All a company needs is a credit card so it can pay the search engine every time someone clicks on one of its ads.
“You can launch a Google ad in 10 minutes,” said Dana Todd, executive vice president of SiteLab International Inc., an interactive ad agency. “It is a ready-made market.”
Google’s business model reflects that twofold desire. In many ways, the search engine has come to resemble a free-circulation newspaper that makes its profit by selling ads. In Google’s case, the company gives away the search engine for free to Internet users seeking information on the Internet, and then, like the newspaper, makes its money on clearly marked ads.
One difference is that in a free-circulation newspaper, top dollar can buy prime positioning for ads. But on Google, just being the highest bidder doesn’t guarantee that an ad will appear in the top-tier position.
The ranking of ads on Google is the product of two factors: the price a company is willing to bid on keywords and the frequency with which consumers click on the ad. Even if a company bids higher on certain words than any other firm bids, if consumers are not clicking, that ad will move down to a less prominent spot.
Google said it takes this approach so that computer users see the most relevant ads first. Industry experts say the practice also makes good business sense since Google gets paid only when consumers click on an ad.