How does Google auction ads

There are several steps in the process.

1) Each advertiser enters a list of keywords, ads, and bids.

2) When a user enters a query, Google compiles a list of all the ads whose keywords match that query.

3) The list of ads is then ordered based on the bids and the Ad Quality Scores, which measure the relevance of the ad to the user.

4) The highest ranked ad is displayed in the most prominent position, the second highest ranked ad gets the second most prominent position, and so on.

5) If the user clicks on an ad, the advertiser is charged a price that depends on the bid and Quality Score of the advertiser below it. The price charged is the minimum necessary to retain the advertiser's position in the list.

A simple example is when all ads have the same Quality Score. In this case, the ads will be ranked by bids and the price an advertiser pays per click will just be the bid of advertiser below it in the ranking. Hence the amount that advertisers pay is no more than what they bid and typically less.

In the general case, where ad qualities differ, the price an advertiser pays for a click will depend on its Quality Score relative to the quality of the ad below it in the auction. Roughly speaking, an ad that has twice the quality of another ad will tend to get about twice as many clicks, and will only have to pay half as much per click as the competing ad.

From the Google's official blog.