The ad auction
Every time an AdWords ad appears, it goes through what we call the ad auction, a process that decides which ads will appear and in which order (or whether any ads will meet the minimum required Ad Rank necessary to show at all). It's not like an art auction where the highest bidder always wins; instead, AdWords does something a little more interesting:
1. The search
Jose searches for "pizza delivery."
2. Ads are narrowed down
The AdWords system finds all ads whose keywords match that phrase "pizza delivery" closely enough. From that set of matching ads, the system ignores any that aren't eligible, like ads that target a different country or are disapproved.
3. Ads are removed
The system then determines which ads have a sufficiently high Ad Rank to show (for example, do the ads have a sufficiently high expected click-through rate, and will the ads and landing pages provide a good user experience). Ads that don't exceed the minimum quality standards necessary to show are also removed.
4. Ads are ordered
The remaining ads are shown, ordered on the page based on Ad Rank, a combination of bid amount, the quality of your ads and landing page, the Ad Rank thresholds, the context of the person's search, and the expected impact of extensions and other ad formats.
5. Ads appear!
Jose sees relevant ads appear and orders the pizza of his dreams.
6. Repeat the process
Every time someone wants a pizza and does a search, the whole auction process starts again with potentially different results each time, depending on the context of the person's search and the competition among advertisers at the precise moment of the search.
Why it matters
The most important thing to remember is that the auction process uses your ad's Ad Rank to determine its position. So even if your competition bids higher than you, you can still win a higher position -- at a lower price -- with high-quality ads and landing pages.
Also remember that the auction process repeats for every search on Google, each time with potentially different results depending on the competition at that moment and which ad you use. So don't worry if your position on the page fluctuates -- it's normal for it to vary each time.
How you'll see it
In step 4 shown above, ads are ordered on the page (that's your ad position) using a formula called Ad Rank. The main components of Ad Rank are your bids, the quality of your ads, and website, the Ad Rank thresholds, the context of the person's search, as well as the expected impact of extensions and other ad formats. If you want to try to boost your position, you'll need to beat your competitors with quality, bid amounts, or a mixture of both.