There’s been much commentary on Bill Gates’s suggestion that Microsoft plans to reward users of its search engine by sharing ad revenues with them. Interesting posts have come from, among others, Doc Searls, Mitch Ratcliffe, Umair Haque, Michael Parekh, Peter Hershberg, and Ratcliffe again. Mitch Shapiro does a nice job of summarizing the various viewpoints.

There are two questions in play here. First (and of lesser importance) is the question of whether Microsoft could actually figure out a way to pay users for using its search engine and, if it can, whether it would be a smart thing to do. Haque argues that such a move would be “strategically meaningless.” It would spur fraudulent or valueless clicking, and “Google can imitate it overnight.” I think Haque makes good points, but I don’t think he’s right. Microsoft could probably figure out ways to reward users without encouraging gaming. Amazon, for instance, gives users of its A9 search service a small discount off Amazon purchases. As long as you don’t tie rewards directly to the raw number of clicks a person makes, you avoid much of the fraud problem. As for the fact that “Google can imitate it overnight,” that’s precisely why it would be strategically meaningful for Microsoft. A price war for search would hurt Google much more than it would hurt Microsoft because search-related profits are a sideline for Microsoft but they’re everything for Google. One good way to hurt a competitor is to cut off its oxygen supply, a tactic that Microsoft has used with great success in the past.

The second question – and the one of greater importance – is whether the profit margins of serving up online ads will tend to shrink. I’ve argued that they will, as competition heats up and pricing becomes more transparent, but Haque argues that my reasoning “is fatally flawed.” On the transparency side, he says that Google’s AdSense program isn’t a black box, as I called it, because you can figure out in the aggregate how much of the revenue Google shares with publishers. But the aggregate doesn’t matter. The reason it’s a black box is that individual publishers can’t tell what kind of cut they’re getting. That information asymmetry, as economists call it, gives Google a lot of power. Competition, though, will almost certainly bring more transparency to the market, which in turn will weaken Google’s hand.

As for competition, Haque also takes issue with my statement that “markets abhor oversized profits.” “In fact,” he writes, “the opposite is true.” He’s way off base here, for the simple reason that he confuses market forces with anti-market forces. Markets promote competition, and competition erodes profit margins. That’s why companies spend so much effort trying to block the natural, profit-destroying workings of the market – by, say, creating superior products or sexy brands or high switching costs or monopolies or information asymmetries. Google has had weak competition up until now, but the outsized profits it’s been earning are (as they always do) attracting strong competitors, like Microsoft and Yahoo, and the intensified competition will squeeze profit margins. That’s particularly true in a software-based market, where the marginal costs of executing an additional transaction are basically zero. There’s a lot of room for discounting.

Now, the size of the market could continue to expand so quickly that Google reaps higher profits even if its margin shrinks and its competitors gain share. But at some point the worm will turn. Google may also come up with an innovation, in search or in ad-serving, that allows it to once again leap so far ahead of Yahoo, Microsoft, and other rivals that it can avoid competition and, in effect, impede the natural workings of the market. That’s certainly possible, but five years ago Google had the luxury of innovating in a market that no one else was paying much attention to. That’s far from the case today. There’s going to be fierce competition from here on out, and don’t expect any holds to be barred.