Will A Volume Cap Make The Yahoo/Google Deal Work?

The WSJ is reporting that Google and Yahoo are negotiating with the Justice Department to remove their objections to the search deal the two companies signed in June but haven’t yet implemented.

The fact everyone’s negotiating isn’t news, but some of the details are. Concessions reportedly being discussed include “capping the volume of Google ads Yahoo would use, assurances that Yahoo would continue to compete in search ads, and a reporting mechanism to ensure compliance.” The article also says the government is looking to impose price constraints to ward off increases in advertising rates after the deal is implemented.

Let’s put the price constraints aside, which are always a bad idea because they disrupt supply/demand equilibrium and generally screw up markets. But the volume caps may not be such a bad idea, if the deal were to go through.

Our main objection to Yahoo and Google teaming up on search advertising is the perverse incentives that are created to encourage Yahoo to abandon their own product over time. Yahoo makes far more money on Google ads than they do from their own (which is why the deal was signed in the first place). Every time Yahoo puts up a Google ad instead of their own, they get a cash payoff but at the cost of the vibrancy of their own ad market. It creates a viscious downward cycle that can only result in Google gaining yet more market share in search marketing over time.

In other words, Google is effectively paying Yahoo off to gain market share. Earlier this month Sen. Herb Kohl (D – Wisc.), chairman of the Senate Antitrust Committee, expressed these same concerns.

A cap means Yahoo can only rely on Google to a point, and if the cap is small enough then Yahoo will be forced to continue to invest in their own search business, so it removes a lot of the meat behind our objections.

However, I doubt Google and Yahoo would be happy to have a cap, since they’ll negotiate it as high as possible. And to date, both companies have argued that Yahoo wouldn’t use many Google ads. A cap effectively shows their hand, since whatever it is, its likely Yahoo will use it all.

But the deal, with or without a cap, keeps Yahoo afloat and independent, and out of Microsoft’s hands. My guess is they’ll take it.