In AdWords, bid price is only one factor in its ad position equation. The other main factor in the ad ranking equation is Quality Score, as calculated by combining a bunch of factors, the 3 main ones being (listed in order of weighting):
1. Click-Thru-Rate (CTR),
2. Ad Relevance (keywords in ad title and copy)
3. Landing page quality (keywords in landing page copy, structure, etc.)

Then Google takes your Quality Score and multiplies it by your bid price (Max CPC), and generates a number, called “Ad Rank”. The higher this number is compared to that of your competitors, the higher your ad ranks on the page for the given keyphrase.

Then, your Cost Per Click for your ad is calculated by dividing your Quality Score into the Ad Rank of your next competitor (thus, higher QS = lower CPC).

Here is an example of how this works, with 4 ads all bidding the same amount for a given keyphrase, but all having different Quality Scores.

Google’s Chief Economist, Hal Varian, posted a video on YouTube back in March explaining how all of this works. The video is embedded below.

So this all points to how important it is to maintain a high Quality Score on all of the ads in your AdWords campaigns, in order to make sure that the ad is relevant for the user (ensuring a possibility of making a sale or gaining a lead) and also to keep costs down.

In my experience, it not good if your QS for a given keyword drops below 8. Incremental improvements to QS can be attained by constantly split testing ads against each other in each ad group in order to improve CTR and also by constantly testing and improving landing pages.

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