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. 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 whittled down
The AdWords system finds all ads whose keywords match that phrase "pizza delivery" closely enough.
3. Ads whittled even more
From that set of matching ads, the system ignores any that aren't eligible, like ads that target a different country or are disapproved.
4. Ads are ordered
The remaining ads are shown, ordered on the page based on a formula we call Ad Rank, a combination of bid amount, the quality of your ads and landing page, and the expected impact of extensions and other ad formats. Keep in mind that a minimum Ad Rank is required for ads to show, so it’s possible for no ads to appear.
5. Ads appear!
Jose sees relevant ads appear and orders the pizza of his dreams.
6. Repeat the process
Every time someone hankers for a pizza and does a search, the whole auction process starts again with potentially different results each time, depending on the competition at that moment.
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, 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.