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Weekly Column

Seeing Is Believing: Thoughts on Apple's Video iPod and the Google AdWord Experiment

Status: [CLOSED]
By Robert X. Cringely
bob@cringely.com

So we have don't have a specific video iPod, but an iPod that does video. We have an Apple deal to distribute TV shows and music videos, but not movies. And the Apple Video Express wireless adapter I predicted is nowhere to be seen yet. Did Apple still change the future of television this week?

Probably.

It is easy to say that Apple's deal to distribute a few ABC and Disney TV shows at $1.99 per show was motivated mainly by Disney's desire to renew its movie distribution agreement with Pixar, Steve Jobs' other company. Corporate deals aren't supposed to work that way, of course, with one public company being effectively paid for something another, completely separate, public company has done or will do. But this is Steve Jobs and his rules are different than yours or mine.

That $1.99 price is actually pretty amazing, too, both because it is so low and so high. The price is low because TV series compilation DVDs average $3 to $4 per episode. The price is high because the cost of goods is presumably close to zero (the show is already paid-for, though there may be some residual payments I am unaware of). There are no manufacturing or inventory costs. Marketing is effectively free if it is done on the network show, itself. That leaves distribution as the major cost and if Apple is able simply to match the kind of deals I've made for NerdTV, that episode of Desperate Housewives will cost just $0.15 to distribute. Double that to cover unanticipated overhead expenses and the gross profit on each $1.99 sale is $1.69. I'm going to guess that ABC gets $1.00 of that, which isn't much revenue for "Desperate Housewives," with its 30-second commercials going for $560,000. But for the Disney Channel's That's So Raven, $1.00 per episode is good money.

But it isn't enough to shake the very foundations of network TV and bring Uncle Miltie back to life. And that's the point. Five TV shows are an EXPERIMENT, not a business. The experiment going on here is all on behalf of the major movie studios, the very outfits that haven't yet signed on to distribute their movies through iTunes. The studios want to see how the market accepts these TV series distributed in this format, whether the ability to download the shows has a material impact on their broadcast viewership (ratings), and most especially whether we see a surge of pirated copies of "Lost" - copies that can be traced back to iTunes distribution.

If the experiment is successful -- if these five shows are able to demonstrate incremental revenue increases that don't harm their existing revenues or pose an unreasonably increased piracy threat -- then the studios and other TV networks will sign on and Apple will be in the movie and TV businesses, big time.

And what they'll do to leverage that business is becoming clear. There's an outfit called DVDstation that puts video distribution kiosks in stores and malls. As its name implies, you go to the DVDstation to pick out a movie and burn it on a DVD right there. Well, DVDstation just announced that you can plug your video-enabled iPod into their kiosk and download an HD movie in 90 seconds or less.

This is a compelling model, placing the equivalent of a completely automated Blockbuster video store in a few square feet at, say, The Gap or any other retailer that doesn't presently have a competing video sales operation. The video-enabled iPod becomes the vessel for transporting movies from store to home and of course they don't have to be returned. Apple, meanwhile, can sell iPods to people who like movies but don't typically carry their music with them -- a whole new class of iPod customers.

For now, of course, this can be done only with the new iPods, but it wouldn't surprise me if at some point older iPods gained this digital vessel capability, minus the screen.

It wouldn't surprise me, either, if we see DVDstation kiosks appearing in Apple's 100-plus retail stores.

But wait, there's more! When the Apple experiment is complete and successful, we'll see the movie studios sign on, at which point Apple will finally announce that Video Express, which is the component still required to practically link this new video system to your TV. That rash of products will also include Apple's much faster 802.11n version of its Airport access point, which suggests that the Video Express will be 802.11n as well, which figures.

And of course that's when Apple will start selling Sony flat panel TVs in its stores. I don't think Apple will do its own brand of TVs like Gateway, Dell, and HP have done. They'll stick with Sony, which makes sense for a ton of reasons including undermining any thought Sony might have to competing with Apple in the video distribution business.

Now (sigh) to the third part of my Google AdWords story that I never thought I would be writing. This stuff is so complex, it makes my head hurt. But it also involves billions of dollars and the future of commerce so what the heck. What follows is a short introduction to a couple important concepts, the claimed results of the Google AdWords experiment I have written about twice before, Google's response to the experiment, and a last word that I get to throw-in because, well, it's my column.

First a look at perceived risk and human behavior. Roulette wheels in Las Vegas have red numbers, black numbers, and a number zero that is neither red nor black. You can bet the zero to win like any other number, but it doesn't qualify if you play just the colors -- red or black -- to win. It is simplistic to say so, but that zero is effectively the casino's profit margin on the game because it will inevitably come up just as often as any other number and when that happens (unless you play only zero to win, which is a sucker's bet) the result is pure profit for the house.

On European roulette wheels there are two such numbers -- zero and double-zero -- meaning the odds in favor of the house (and against you and me) are even higher, the payoff for the casino that much greater.

At the Grand Casino in Monte Carlo the roulette wheels have THREE such numbers -- zero, double-zero, and triple-zero -- giving those games the highest casino profit on the planet.

What's going on here?

These three roulette wheels represent three states of acceptable risk. Casinos are in business to make money and to do that they need customers. Las Vegas casinos would love to have more than one zero on their roulette wheels, but doing so would keep gamblers away and lead to overall lower profits. Casinos -- just like Wal-Mart -- think in terms of revenue and profit per square foot, and they know through experimentation that adding the second zero will raise their margins but lower their total profit. European casinos do the same experiments and found different results because they have a different clientele with a different level of acceptable risk. The Europeans are willing to accept a higher level of risk. And in Monte Carlo, where a glass of water costs $11.00, they don't care about risk -- they gamble for entertainment.

These are three parallel examples of Nash Equilibria. That's John Nash, the subject of the film "A Beautiful Mind" and winner of the 1994 Nobel Prize in Economics. Nash determined that every game has an equilibrium position where the risks and rewards are balanced for all parties. Companies that have the freedom of a lot of price elasticity pay attention to Nash because doing so -- moving the equilibrium point -- can have a huge impact on profits.

Here's how this might be related to Google AdWords and, possibly, to comparable web advertising programs from companies like Yahoo's Overture Systems, according to my friends who ran the AdWords experiments.

My friend finally finished his AdWords experiment after 36 days. He was trying to do a Taguchi optimization of his AdWords campaign, something that has so far eluded Taguchi experts including the PhD (my original contact) who was hired to help him.

The Taguchi Methods of Robust Design are techniques for testing hundreds or even thousands of variables with only a handful of actual experiments. Taguchi considers the process as a black box and looks only at inputs and outputs. In many ways it is a kind of codified reverse-engineering system, but one that is very well proven since its original invention in 1945.

Alas, Taguchi doesn't work well with AdWords for some reason. Just when things are starting to make sense, they stop doing so. That's the way it was for my friend. Things were going well until suddenly they changed for a five-day period ending with the publication of my first AdWords column. The AdWords black box could be optimized for a while, but then it couldn't be. And then it could be again.

This was annoying for the Taguchi experts who were quite used to optimizing black boxes with thousands of internal variables that are never identified or seen. What was going on here? What was introducing what Taguchi calls "noise factors" that kept the optimization from being achieved?

The Taguchi experts concluded that the noise factor was probably some form of Bayes-Nash equilibrium experiment being conducted by AdWords, itself. The Taguchi expectation of rational behavior was being confounded, they believed, by deliberate manipulation intended to move the Nash Equilibrium point improving mid-to-long-term profit for Google. This is possible because, unlike a traditional Nash Equilibrium experiment where all bids are known, the AdWords algorithm is unknown, though (incorrectly) presumed to be rational. In other words, AdWords was deliberately giving up income in the short term (that's considered irrational behavior) to coax AdWords advertisers to bid higher for words, thus leading to greater revenue and profit for Google in the long term.

Those are the conclusions of the experimenters, not me.

So I ran their conclusions by Jeff Huber at Google, who is in charge of engineering for AdWords. I asked a simple question: Is that what you were doing?

"In short, no," said Jeff.

We are not intentionally introducing "noise factors" or any other perturbations in the style the proposed theory suggests to affect near-term or long-term revenues.

I know it's not quite as exciting, but our model is pretty simple. We want our users to have the most relevant possible content, so we work really hard on an on-going basis to optimize end-user perceived quality. We want our advertisers to have a great return on their investment spent with us.

If we do both of these well we'll continue to do fine financially -- more users will come to Google because we provide the most relevant content and the best experience, and more advertisers will come because we provide qualified and cost-effective introductions for their business and they make a lot of money. We may well give up revenue in the near-term to improve end-user perceived quality; this may not appear "rational" to an advertiser (or given modeling method, or wall street analyst for that matter!) to optimize on relevance rather than near-term revenue, but we think it's the right long-term thing to do for users, advertisers, and us.

I'm not an expert on Taguchi methods, but have seen the approach very successfully applied to systems that have relatively linear behavior between inputs & outputs (for example, many websites now use the approach to optimize their home page landing pages based on different test layouts; obviously it has an rich history in manufacturing).

As mentioned in my prior note, the AdWords system is highly dynamic and incorporates user behavior, optimization on end-user relevance (which is continually evolving and improving), competitor behavior, historical performance of advertising campaigns, and non-linear effects based on position, campaign configurations (e.g., rate limiting to manage to advertiser-defined budgets), and policy enforcement (e.g., editorial review on ad creative changes, algorithms to encourage diversity and minimize redundant ads). I think I understand the experiment's spirit and intent, but the implementation could also have run into our double-serving policy where multiple ads are attempting to target the same terms and serving the same or highly similar (re-named) content.

How and if AdWords could be modeled with Taguchi methods, or other approaches, might be an interesting PhD research thesis topic. Without knowing the accounts involved and how the experiment was conducted, it's unfortunately pretty hard to conclude which factors may have been at play in the 5 days that your friends had trouble modeling. I'll reiterate our offer to help investigate if your friend would like; all we'd need is the account(s) used in the experiment.

Who's right? Who's wrong? Does any of this really matter? And is the concept of "evil," which Google claims to avoid, even remotely involved?

Beats me.

It isn't really clear what's going on here, though the experimental side was organized and professional enough that I would tend to believe they were observing SOMETHING, whatever was causing it.

Even if Google was trying to optimize AdWords in that way, there is nothing illegal in it. If they don't do it, someone else will.

Notice how in Jeff's explanation, above, he said the AdWords system adjusts for maximum profitability for Google and "maximum user perceived quality for the advertisers." Not the maximum return on investment for their AdWords budget. The key word is PERCEIVED.

Finally, several months ago Google (and Overture, too) were quite specifically advertising positions for experts in Bernoulli-Nash Equilibria optimization. These were jobs not for programmers, but Operations Research types. One of those people recruited was a friend of mine for many years. From what he told me Google and Overture were looking for EXACTLY the kind of technical capability described above.

Is this a big deal? Not for most people. Not even for most AdWords users who are probably making plenty of money from their campaigns otherwise -- as we now know from Nash -- they wouldn't be doing it at all. But for those AdWords users like my friend the experimenter, it probably means that truly optimizing an AdWords campaign is going to be a lot harder job. I think it can be done, but it won't be easy.

Editor's Note: This page was updated on October 17, 2005 to correct an inaccuracy; it formerly stated that John Nash had received the Nobel Prize in Mathematics. He received it in Economics, as correctly noted above.

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